Brent Sheather: Botherway by country mile

It's a bit of a mystery how fund managers of the year get chosen. It doesn't seem to depend too much on the provision of investor-friendly initiatives like whether the manager has low fees or offers the no-load exchange traded index funds so popular overseas last year.

But if anyone deserves to be the Fund Manager of the Year in 2005 it is Simon Botherway and his team at Brook Asset Management.

Brook is making the local stockmarket a better and safer place for all investors. Fresh from addressing governance issues in the property trust sector, Botherway has put the directors and management of Vector on notice that any proposals for uneconomic capital investment could see them looking for new jobs.

Good stuff Simon. We need more activist institutional shareholders keeping the directors and management of public companies up with the play and reminding them that they work for us.

The Vector stoush is also of interest because it goes to the heart of how the sharemarket works.

Because Vector has monopolies within its electricity and gas distribution businesses, the Commerce Commission tells it how much of a profit it can make on its investments in these areas.

Vector is looking at investing some $200 million in gas pipelines in Auckland over the next 10 years. But the commission has told the company it is allowed to make only a 7.2 per cent after-tax return on that capital.

Hang on, you can get a 6 per cent tax-free return from dividends alone on Australian-listed gas pipeline funds - why should Vector shareholders risk their capital to get a lower return than they could get in Australia?

That is exactly Brook's point. It believes the minimum required return for a regulated utility in NZ is about 10.8 per cent a year, after tax.

In a submission to the commission, Brook has said that if Vector is allowed to earn only 7.2 per cent on its capital, it will either lobby Vector to refrain from making further investment and instead return the cash to shareholders or invest in Australian utilities, many of which produce dividend returns alone of 9 per cent a year. And if the Vector directors don't agree, Brook has threatened to get them removed.

Brook owns about 5 per cent of Vector and, so far, is the only institutional shareholder to voice concerns at the low rate of return permitted. What about the other shareholders, are they all asleep?

Apparently. No one else has spoken up publicly to support Brook's demand for rational behaviour from the Vector directors. Other major shareholders include the Auckland Electricity Consumers Trust with 75 per cent, the NZ Super Fund and the AMP Society.

Maybe some of the other shareholders can't be publicly seen to be urging Vector to raise its prices but are happy enough for Brook to do the dirty work for them.

Vector's chief executive doesn't seem too concerned about the 7.2 per cent cap on returns either; he apparently remarked that Brook was just one shareholder which is rather a strange response given that maximising profits for shareholders has to be close to the top of the list in terms of his responsibilities.

The issue being debated is what minimum rate of return is appropriate on Vector's capital.

This depends on the riskiness of Vector's business and its capital structure and is known as its weighted average cost of capital (wacc).

The wacc is calculated by looking at what rate of return is appropriate for the company's shares and its borrowings then weighting those according to its financial structure.

The cost of capital varies by industry. Risky undertakings - like hotels, make lots if full but tend to lose heaps if occupancy falls below 70 per cent - have high costs of capital. Lower risk businesses, like Goodman Fielder, have low costs of capital.

The cost-of-capital figure is useful to management as a benchmark for new investment, capital expenditure or acquisitions. If the economic return on the project exceeds the cost of capital, it is more likely to appeal.

But this isn't always the case. All over the world company managers are tempted to empire-build, so the stockmarket is often suspicious that management is more inclined to spend its cash instead of paying dividends.

Companies with high dividends tend to produce more in the way of future capital growth than those with low dividends.

Institutional investors criticised Kiwi Income a few months ago because its Sylvia Park project apparently generated an initial cash return on cost of only 7 per cent (before management fees). Investors believed the total return on the project might be below its cost of capital.

An industry's cost of capital is also important from a broader economic perspective because if it is too low, which perhaps occurred within the technology sector in 1999/2000, lots of investments occur which, ultimately, won't produce an economic return. Japan is an example of the dangers of too low a cost of capital.

Alternatively if a company or industry's cost of capital is high (low share prices), this will tend to starve it of investment and, ultimately, improve the supply/demand balance in its markets. As share prices rise, a firm's cost of capital falls as the dividend payments as a proportion of the share price decline. High share prices tell directors the market thinks they are doing the right thing in terms of their strategies for growth.

Low share prices and thus a high cost of capital signal to directors and management that they had better carefully consider new investment as against returning the funds to shareholders. Because directors and management tend to like being in charge of a big business rather than a small one, and want to make sure they stay in charge, they try to keep their share prices high.

Brook's moves are reminding the Vector directors that making intelligent capital expenditure decisions is key to keeping one's share price high and one's job safe.


* Brent Sheather is a Whakatane-based financial adviser. He is a Vector and Kiwi Income Property Trust shareholder.