Feltex a disaster for small investors

With the shares down 65 per cent since listing, Feltex has been a disaster for its estimated 10,000 Mum and Dad shareholders.

However, as an IPO offering brokerage of 1.75 per cent, a 10 per cent yield and with tonnes of stock available, it first appeared as something of a godsend for stockbrokers and investors alike.

But mum and dad investors can't put all the blame on their advisers. In most cases it was their decision to buy and their decision to hold on after the bad news started to leak out.

In fact behavioural finance tells us that most people hate taking a loss, so the odds are many of the retail investors who bought in at $1.75 will still be there. In fact much of the trading in Feltex, especially just after the first profit warning, involved institutional brokers selling and retail-oriented brokers buying.

The scale of Feltex's impact on Mums and Dads can only be guessed at, but given that many direct equity investors often only own 10-12 stocks and the almost limitless supply of Feltex stock then it could have been disastrous for some retirement plans, and ultimately bad news for the growth plans of the NZX.

Even if Feltex was just equal weighted in a 10 stock portfolio then its effect would be (assuming the other 10 stocks did as well as the stockmarket index) to reduce returns for the 12 months to June 28 from 18.3 per cent to 10.1 per cent.

So, with the benefit of hindsight, what can we learn from the experience?

First, how do institutional investors cope with an IPO like Feltex? The truth is that they often don't know any more than anyone else but their jobs are on the line so they diversify.

If a fund manager rolled up to work one day and informed the Trustees of the XYZ pension fund that they owned only 10 New Zealand stocks - one of which was Feltex - the fund manager, at the very least, would lose his or her job.

Fund managers are always telling potential clients that they have complex risk management systems that will minimise the impact of disasters like Feltex.

Among these complex systems is a simple strategy called closet indexing whereby you build a portfolio according to the relative size of each company.

This means you generally avoid making really big, really dumb decisions. However, if the totally unexpected happens and a big stock like Telecom goes bust you won't lose your job because everybody else made the same mistake.

So how big was Feltex at listing? At the $1.75 issue price Feltex had a total value of $250 million, representing around 0.6 per cent of the total value of the NZSE 50 index.

So if Mum and Dad had a total of $100,000 in NZ shares then $600 of it should have been in Feltex. An institution that liked Feltex might go to a 2 per cent weighting, that's $2000. Very few institutions would have gone near the 10 per cent or so implied by a 10 stock retail portfolio.

A Harvard University study suggests that you need to own 50 stocks to achieve a properly diversified portfolio so low-cost managed funds would make much more sense than direct equities for most people. A 2 per cent weighting in Feltex would then be embarrassing but not a disaster.

The second lesson is don't rely on your adviser to tell you to sell.

Admitting you have made a mistake and urging your client to sell at a loss is the ultimate test of faith for the client/adviser relationship.

James Montier, an expert on behavioural finance with Dresdner Kleinwort Wasserstein in London, says that people are not risk averse but they are loss averse. Faced with a certain loss people prefer to gamble.

In this case, averaging down on those Feltex shares meant less discomfort than selling.

The investment manifestation of this is that people sell their winners too soon and keep their losers.

Research suggests that once the loss gets over 30 per cent, for many people selling is just out of the question whereas stocks with large positive returns are likely to be sold.

A typical cycle is that as Feltex shares dropped shareholders were reluctant to believe they had made a mistake. That view was reinforced a little by comments from management and maybe their advisers also said hold.

So they hang on, hope for the best or average down. However, as the price falls further and bad press comments increase, the pressure on the individual rises until a point is reached where some throw in the towel and sell out, more often than not at the worst possible time.

What some professional investments do to get round these behavioural problems is to have rules like: sell if the loss exceeds a certain per cent, or sell on a profit warning.

Whether these strategies add value overall or not is debatable, but they would mean most people would have sold and avoided the latest plunge.

The third lesson is that IPOs aren't guaranteed to make you rich unless perhaps you are the one doing the selling.

Of the 55 companies that floated between January 2000 and March 31 this year, 69 per cent have performed worse than the broader market since listing, with five going bust.

The average unweighted annual return for IPOs in 2000-05 was 3 per cent compared with the broad market, which returned 8.9 per cent.

Warren Buffett says: In an IPO, the sellers decide when to come to market, so it's way less likely that it's going to come at a time that suits you.

A last point might be - if you are managing your own share portfolio, regularly calculate your portfolio's returns and compare your performance with that of the index. For many people managed funds, especially those with low fees, might be the cheaper alternative.

* Brent Sheather is a Whakatane-based financial adviser.