Brian Gaynor 's Opinion

Brian Gaynor is a Weekend Herald columnist.

Brian Gaynor: Picking end of growth cycle key challenge

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Deciding when to move into more defensive companies, or out of the market altogether, a conundrum for sharemarket investors

Growth cycles can be hard to predict and anticipating the end of the current growth cycle is a problem for investors. Photo / Thinkstock
Growth cycles can be hard to predict and anticipating the end of the current growth cycle is a problem for investors. Photo / Thinkstock

One of the biggest challenges facing investors is to accurately predict sharemarket cycles. This includes overall market movements as well as the relative performance of low-growth versus high-growth companies.

Low-growth companies with high dividend yields performed particularly well in 2011 with the seven NZX50 Index property companies achieving an average gross return of 11.9 per cent compared with a negative 1 per cent for the market's benchmark index.

In 2012 the property companies also did well with an average return of 23 per cent compared with the market's 24.2 per cent.

However, momentum has swung away from property stocks in the past 12 months with the seven companies having an average gross return of just 4.7 per cent compared with 19 per cent for the benchmark index.

As economic activity and confidence has picked up following the global economic crisis investor attention has switched from income companies to growth stocks in New Zealand and most other countries.

The accompanying table divides NZX50 companies into three groups - defensive cost-cutting companies, low-growth stocks and high-growth companies.

The defensive stocks had an average negative return of 2 per cent over the past 12 months, the low-growth sector 9.2 per cent and high-growth companies an amazing 70.9 per cent.

Defensive, low-growth and high-growth classifications are subjective and a number of companies will argue that they should be in the high-growth column. However the table represents a personal assessment of these companies based on their past performance and strategies outlined at the latest interim and final year results presentations.

The defensive group represents 19.5 per cent of the benchmark index, low-growth companies 41.3 per cent and high growth 27 per cent. Property companies, the two Australian banks and OceanaGold, which represent 12.2 per cent of the index, have been excluded from the table because property companies have unique characteristics and the other three are based overseas.

Six of the eight companies in the defensive, cost-cutting group had negative returns in the past 12 months and three were positive. Meridian Energy and Mighty River Power are excluded from the average return figure because they haven't been listed for a full year.

Most of the post-result presentations by these companies have focused on cost cutting and efficiency gains.

Electricity demand is static and the five electricity sector companies are focusing on increased efficiencies and hoping that climatic conditions will favour them.

One or two of them are looking for growth opportunities overseas, or in related activities, but many major shareholders do not support this diversification because it has not been successful in the past.

Chorus is struggling under the weight of an oppressive regulatory regime and Telecom is diversifying into the entertainment sector once again as it tries to find ways to compensate for the decline in revenue from its traditional activities.

Five of the companies in the low-growth sector - Hallenstein Glasson, Infratil, NZ Oil & Gas, Trade Me and Tower - had negative returns over the past 12 months and Z Energy is excluded from the average returns figure because it hasn't been listed for a full 12 months.

Fletcher Building may argue that it is a high-growth company but the group's recent results do no justify this. Its interim profit announcement seemed to have more focus on cost cutting than growth and it hasn't been as aggressive as the retirement village operators in acquiring new land for development although the group has purchased the Manukau Golf Course and the Peninsula Golf Course in Orewa.

Fletcher Building can't seem to get ahead of construction industry cycles as it is still talking about cost cutting when the sector is entering a strong expansion stage and previously talked about growth when construction activity was contracting. The company's purchase of Crane in early 2011, when the latter's share price did not fully reflect the downturn in the construction sector, was a good example of this.

Heartland may also claim that it is a high-growth company but the newly registered bank would be best advised to take a measured, long-term approach as overly aggressive lending could lead to loan impairment problems in the future.

Restaurant Brands is expanding its Carl's Jr brand but is finding it difficult to acquire sites for new outlets while Skellerup's recent profit announcement did not outline a clear growth strategy.

Trade Me's recent results have been disappointing and it has moved from the high to low-growth sector.

The Warehouse announced plans to raise $100 million of new equity this week to grow its financial services operations. The retailer has yet to prove that its new growth initiatives, which include the purchase of Noel Leeming, will be successful.

The high-growth sector is hot at present with nine of the 12 companies having a gross return in excess of 30 per cent over the past 12 months. The exceptions were Diligent, which was down 12 per cent, Fonterra off 6.4 per cent and Mainfreight up only 12 per cent.

Xero was the clear star, with a 12-month return of 451.6 per cent, but even when this is excluded the other 11 companies had an average return of 36.3 per cent.

Air New Zealand has a clear growth strategy as reflected by its acquisition of a stake in Virgin Australia and strategic alliance with Singapore Airlines.

A2 Corporation has been one of the market's best performers with gross returns of 140 per cent in 2011, followed by 120.8 per cent in 2012 and 50.9 per cent last year.

Diligent is still a growth company even though it had a setback last year because of accounting problems.

Ebos has had a very successful acquisition strategy and we can expect more of the same when chief executive Mark Waller becomes chairman next year.

Fisher & Paykel Healthcare has had a fantastic performance over the past year even though the strong New Zealand dollar created huge headwinds for the company.

Fonterra is included in the high-growth sector because its exports are booming and the listed security is supposed to capture the benefits of the co-op's added value operations.

However, the performance of the listed security has been hugely disappointing because it has fundamental flaws as an investment instrument and Fonterra is poor at communicating its growth plans.

The three NZX50 Index retirement village operators, Metlifecare, Ryman Healthcare and Summerset, are on an aggressive growth path and achieved an average gross return of 51.1 per cent over the past twelve months.

One of the most frustrating aspects of the strong bias towards growth companies is that the NZX has yet to establish its new growth market, which will replace the existing NZAX market. CEO Tim Bennett said in March 2013 that the NZX "might move quite quickly" on this development but 12 months later we do not have an official start-up date.

The NZAX has not been a success and the new growth market, which will have less regulation than the NZX's main board, should encourage small and medium-sized growth companies to list.

The NZX may miss the boat if it takes too long because the strong bias towards growth companies will not last forever.

One of the challenges for investors is to anticipate the end of this growth cycle and to move into more defensive companies, or substantially out of the market, before the growth bias comes to an end.

This is easier said than done, particularly for new and inexperienced investors who are attracted to the sharemarket by a sustained upturn in growth stocks.

Brian Gaynor is an executive director of Milford Asset Management which owns shares in most of the companies mentioned in this column on behalf of clients.


- NZ Herald

Brian Gaynor

Brian Gaynor is a Weekend Herald columnist.

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the Financial Markets Authority (FMA) in 2011. He is also a Portfolio Manager at Milford Asset Management.

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