Be wary of the optimistic broker

By MARY HOLM

Question: I have read several articles where brokerage companies say the New Zealand sharemarket is about 15 per cent undervalued.

What I want to know is that if you took out Telecom, Telstra, Air NZ, Carter Holt, The Warehouse and Nat Gas, is the NZ sharemarket then not overvalued?

A: Were you wagging school last week, when we "did" efficient sharemarkets?

In an efficient market, shares are priced at their correct value, reflecting all the information available about them.

If analysts in a big financial institution think a share is undervalued, they will promptly buy it, pushing its price up to the point where it's no longer a bargain. If they think it's overvalued, they'll sell and the price will fall.

As I said last week, the New Zealand market may be a bit inefficient when it comes to shares that are too small for the big institutions to bother with.

But that wouldn't apply to the big companies you have listed. Their numbers will be crunched enough that their share prices should be about right, with what we know now.

What about the New Zealand market as a whole?

I, too, have read that it's undervalued. But, come to think of it, I've been reading that for the last few years.

And one of these days, or one of these years, the writers will be proven correct. Our market will rise fairly quickly for a while. But nobody knows when.

Keep in mind three things about broker forecasts:

* Brokers profit if you buy shares, so of course they'll be positive.

* Brokers tend to be optimists anyway. In any year, there's a bigger chance shares will rise than fall. So forecasts will always be positive, even though results aren't.

* If a broker really had some hot information, whether about a company or a whole market, they wouldn't be telling the media or putting it in newsletters. Only their best mates and richest clients would be in the know.

Q: I was very interested to read those annual rates of share returns in New Zealand dollars quoted in your column (August 11). Those returns are excellent.

I was left wondering how much of those returns were due to our exchange rate, and how those returns would have looked if discounted for our inflation.

Would there be any value in breaking the total returns down into the components of the total return calculated in the currency of origin, the exchange rate benefit and the discount factor to be applied for New Zealand's inflation.

The result would be a real rate of return in New Zealand dollars. Then, one could say, "If I invested in the S&P500 for 25 years, my money would have grown in real terms after inflation on average so many per cent a year."

I would appreciate your thoughts.

A: You make an excellent point about inflation.

The foreign exchange story is less straightforward. I'll get on to that in a minute.

But first, it's certainly valid to look at returns in terms of how many more goods and services you can buy with your money.

In the '70s and '80s, when inflation was soaring in New Zealand, returns on term deposits were lower than inflation, so savers' buying power was falling.

That was also true in some periods for houses. Their real value - after adjustment for inflation - fell some years, particularly in the last 1970s.

For shares, of course, there will always be some years when even their nominal value - before adjusting for inflation - falls.

If that happens in a high-inflation year, their real value falls quickly.

On the other hand, there are many years when shares rise quickly, even in real terms, as you'll see.

Here, then, are annual returns on gross (including dividends) indexes, adjusted for New Zealand inflation.

The figures are in New Zealand dollars, and are for periods ending on March 31 this year.

They show how a New Zealand investor would have fared in the different markets - the "result" that you seek.

* Over the past five years: New Zealand 4 per cent, Australia 10, World 19, UK 20, Europe (except UK) 22, US 25.

* Over the past 10 years: New Zealand 9 per cent, Australia 9, UK 12, World 12, Europe 15, US 17.

* Over the past 20 years: Australia 6 per cent, New Zealand 8.

* Over the past 25 years: New Zealand 8 per cent, World 9, Europe 9, US 10, UK 11.

You also wanted data on the effects of foreign exchange movements.

Another reader asked for similar numbers. He points out that the New Zealand dollar has fallen a long way against the American dollar since the 1970s.

And that, he says, has really boosted American and world share returns when they're given in Kiwi dollars.

He adds: "I believe the New Zealand dollar will most probably re-value from now on, perhaps to US60c, within five years."

And that would hurt overseas returns for New Zealanders.

All of this, though, is more complicated than it seems. Levels of returns, inflation and foreign exchange all affect one another. So isolating one of those factors can be misleading, rather than enlightening.

I've decided to give real share returns in four countries, in their currency and using their inflation rate.

Then you can compare how New Zealanders have fared in our market with how Aussies, Britons and Americans have done in their markets.

Here are annual real returns on gross indexes, for periods ending on March 31.

* Over the past five years: New Zealand 4 per cent, Australia 9, UK 9, US 11.

* Over the past 10 years: New Zealand 9 per cent, UK 9, Australia 10, US 11.

* Over the past 20 years: Australia 7 per cent, New Zealand 8, UK 11.

* Over the past 25 years: New Zealand 8 per cent, US 9.

When you get rid of the effects of the falling Kiwi dollar, that makes a big difference to the American and British numbers over the past five years, and quite a difference over the last 10 years.

But it has little effect over 20 or 25 years. And it doesn't change the Australian numbers much.

In whatever currency, these are still healthy returns - especially as they're adjusted for inflation.

A couple of important points need to be made about foreign exchange and overseas investment.

One is that the reader's US60c forecast is iffy. At any time, the dollar is just as likely to fall as rise, regardless of what you read.

A while ago, I quoted BNZ chief economist Tony Alexander on foreign exchange forecasts. Perhaps I'd better repeat it.

"Is it realistic," he asked in a newsletter, "to base one's investment strategy upon currency forecasts made by economists who have a very poor record of picking exchange rate moves over at least the past two years - if not the long term?"

He writes of "massive uncertainties" in the markets, and adds: "Fresh factors appear all the time and can change the logic overnight."

In February last year, when the New Zealand dollar was worth 49USc, the BNZ predicted it would be at 59USc at the end of the year. Instead, says Alexander, it was at 44USc.

I applaud his honesty.

Another point is that changes in foreign exchange rates don't necessarily make foreign investing riskier, as most people think.

It depends on what you hope to buy with your invested money when you eventually spend it, probably in retirement.

It's highly likely you'll already have a mortgage-free home. You might move to a different home, but probably not a much more expensive one.

All going well, a fair chunk of your savings will probably go on travel, cars, and other imported leisure goods. Their prices are affected by foreign exchange rates.

If the Kiwi rises between now and your retirement, returns on your foreign investments will be lower than they otherwise would be. But so will the costs of travel, cars and so on. So you won't mind too much.

If the Kiwi falls, your foreign returns will be higher than otherwise. The costs of travel and cars will zoom, and you'll be so glad you didn't stick with New Zealand shares.

Just ask any New Zealander who invested overseas during the 1990s.

As long as you're travelling or buying imports, you can't avoid foreign exchange risk. Investing overseas, in fact, reduces that risk.

One more final point about this whole exercise. It's easy to get too caught up in historical returns.

Sure, they give you a feel for what's going on. And it's useful to compare historical returns on different types of assets.

But the only sure conclusion we can reach is that the future won't be the same as the past.

* Mary Holm is a freelance journalist and author of Investing Made Simple.

Send questions for her to Money Matters, Business Herald, PO Box 32, Auckland; or e-mail: maryh@pl.net. Letters should not exceed 200 words. We won't publish your name, but please provide it and a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice outside the column.