KEY POINTS:
Finance company investments have been a way of life for investors for generations. But as few Kiwis could fail to notice, a rash of them curled up and died following the 1987 stock market crash. Again in 2006 and 2007 this sector proved to contain more than
its fair share of lemons with 13 companies going out of business taking millions of dollars of investors' money.
They have a relatively simple business model offering mostly what's called debentures. This involves borrowing money from private investors and paying regular fixed interest on that money. That money is pooled and lent to businesses or individuals at a higher rate.
Sadly, few investors understand what finance companies invest in. Some, such as Equitable, lend money on commercial first mortgages. Others offer business finance or second-tier residential mortgages. Yet more lend money to cash-strapped people to buy second-hand cars, or even worse, fish and chips on a Friday night.
Some of the 13 companies that collapsed relied almost totally on investments from the public, and when others collapsed their source of funding dried up.
There is no magic formula that says lending to business is good and lending on second-hand cars is bad. How well those companies were run made a difference.
One of the big problems with the failed finance companies is that the investors really didn't understand what they were investing in or what to look for in each company's prospectus. Some of the failed companies were little more than one-man bands with a few employees, such as Rod Petricevic (a former bankrupt) founder of failed Bridgecorp.
Yet conservative investors thought finance companies were safer than shares from stock market giants such as Fletcher Building or Telecom.
What's more, once one or two finance companies fell over, there was a domino effect because the public became too nervous to invest money and the lack of new funds pushed less healthy companies into crisis.
Many of the finance companies that collapsed or got into trouble, as well as some of those already around, played on investor psychology or ignorance with their flash adverts and smooth talk.
Diversification is key
Finance company collapses are usually followed by a series of sad stories about investors who lost everything. The thing to remember is that those who lost everything broke one of the most basic rules of investing: to diversify. They had all their money in one investment.
One alternative to finance company investments that DIY Mum and Dad investors rarely consider are debt securities, also known as bonds. Governments and companies raise money through debt securities. Even relatively secure banks such as Westpac, for example, may pay more than 10 per cent per annum for money they raise through the NZDX.
Most finance companies were offering less than 10 per cent at the end of February. Yet their investments were almost way more risky than Westpac's.
One big advantage debt securities have over finance company debentures, is that they are liquid, meaning there is a market on which they are traded: the NZDX, which is a subsidiary of the NZX. Unless you're really unlucky you can sell out within a day's notice. The disadvantage is that prices rise and fall with supply and demand but rarely as much as share prices do.
In the case of finance company debentures, investors almost always have to wait until the end of their term, whether they need the money or not.
That's not to say that finance company investing doesn't have its place in a diversified portfolio.
Look for the rating
Some of the companies still standing have investment-grade credit ratings from
international agencies such as Standard &Poors (S&P), Fitch Ratings and Moodys, whose job it is to analyse credit worthiness.
UDC, for example, is a subsidiary of the ANZ National Bank and has a S&P AA rating. Hanover Finance, has a BB+ rating from Fitch.
That's not to say these ratings are foolproof. But there's a pretty good chance that those with investment-grade ratings will be around for the next generation of investors if they're not bought out.
Sadly, some companies have played on Kiwis' ignorance of the ratings system. Some brag about ratings from second-tier ratings agencies, which begs the question of why they didn't go to S&P, Fitch or Moodys, the world's leading agencies.
Then there are those that don't even figure on the international ratings agencies grading because they're too small, too poor, or too tight to pay for a rating.
Investors can still get an inkling of how safe these companies are by checking out the A-E grade ratings by Kapiti-based stockbroker Chris Lee who runs an
unofficial ratings system on his website Chrislee.co.nz.
Some of those that come in at an Egrade, such as Broadlands, Belgrave, and Lombard have auspicious sounding names. But the names simply play on investor psychology and mean little in reality.
Other fixed interest investments
Investors who want fixed interest investments can go elsewhere. Fund management companies, for xample, offer "cash" funds, which spread your money across a number of fixed income investments and money market securities. These funds should be a relatively safe haven for your money, but of late cracks have appeared in the market.
Products such as the ING Diversified Yield Fund were devised by very clever people to give investors a better return than fixed interest investments. But unfortunately, those people selling them in New Zealand didn't really understand the risk because some of the money in many cases was invested in United States subprime mortgages.
It's likely these funds will recover, but the moral of the tale, as always, is never to put all of your eggs in one basket, no matter how safe it might seem on the surface and all the assurances you get from the person selling you the investment.
As Whakatane-based financial planner and NZ Herald columnist Brent Sheather says: "most advisers get paid more for selling higher-risk investments than for those which are less volatile." That was certainly the case with finance companies where clients were advised to invest large sums of money in Bridgecorp and others.
The rationale, it appears in some instances, was the commission advisers would receive. Then of course, there's the good oldfashioned, high-interest bank account, and the new-fangled version of them: online saver accounts, which were paying as much as 8.25 per cent from RaboPlus, a AAA rated bank, as Money + You went to print.
