Foreign allure rings hollow

By BRENT SHEATHER

As we all know, fashions in the equity markets come and go - previous "strong buys" include emerging markets in 1993, European shares in 1994, technology stocks in 1999 and hedge funds today.

Although investment fads get a lot of press, in practice the collateral damage is usually limited to a minority of investors who are either inveterate followers of fashion or had the bad luck to deal with a particularly excitable adviser.

But underlying the dalliances described above has been a concerted move during the past 20 years or so by institutional and retail investors to invest more of their equity funds overseas.

Until recently, an offshore bias was reinforced by an analysis of past returns - many local equity databases go back only until 1986 or so and, in the 10 years ended 1995, New Zealand shares returned 4 per cent per annum versus 11 per cent for the S&P 500.

But the bad press for local shares didn't stop there. Not only were they underperformers, they were also more risky - the NZ sharemarket's volatility was double that of the United States.

From the perspective of the fund manager in much of the 1990s, local shares offered the worst of both worlds - low returns and high risk.

To really understand New Zealanders' love affair with foreign stockmarkets, one needs to go back in time - in the 80s and 90s our local exchange was dominated by highly leveraged, capital-destroying forestry, property and investment companies often run by megalomaniacs with a death wish.

Furthermore there was free portfolio insurance - even if international shares went nowhere, the New Zealand dollar could be relied upon to fall by 10 per cent a year.

But things have changed - for the better locally and for the worse overseas.

1. The riskiness of New Zealand shares has roughly halved in the past 10 years so the volatility of the NZSE Gross Index is now comparable to that of the World Stockmarket index.

2. The 10-year rolling performance of New Zealand shares has more than doubled from about 4 per cent per annum at the end of 1995 to 10.1 per cent per annum for the 10 years to the end of July and, at the same time, the 10-year historic return of international shares almost halved from 11 per cent per annum to 6.5 per cent per annum in the same time spans.

3. Overseas markets appear to have more than their fair share of dodgy characters.

Today, there is another more fundamental reason to have much more of your equity investments invested locally: higher returns.

New Zealand shares look miles better value than international shares simply on the basis of their outsized dividends - themselves a function of imputation credits and high payout ratios.

Nowhere is the yield story more prominent than in our biggest stock, Telecom, boasting a gross yield of about 10 per cent.

Economics tells us that the future return from shares is equal to the dividend yield plus the rate at which those dividends will grow in the future.

For Telecom, d = 10 per cent and, if inflation averages 2.5 per cent and real growth rates are 1 per cent, we are looking at a 13.5 per cent prospective return from our biggest stock. The dividend yield on the top 50 stocks averages out at about 7.5 per cent.

So what are the same numbers for global stockmarkets?

Rob Arnott, an American and editor of the Financial Analysts Journal, in this year's July issue estimates the numbers for the S & P 500 are as follows: d = 1.5 per cent, i = 2.5 per cent, real growth = 1 per cent. So r = 5 per cent, less than half of that for Telecom.

But did I hear an expert down the back say that "because of their lower dividend yields overseas shares could be expected to grow faster than NZ stocks"?

Reality is different. Arnott (again) published a paper some time ago showing that a strategy of buying shares which distributed a high proportion of their profits as dividends actually produced higher total returns than those which retained their profits for reinvestment.

The explanation being that executives who retained lots of earnings squandered it on silly acquisitions and investments.

Despite the yield advantage, many local investment advisers still allocate 60 per cent to 70 per cent of a retired investor's equity portfolio overseas.

Fund managers, financial planners and consultants have constructed highly profitably businesses selling the "invest-offshore-for-growth" story on the basis that such a portfolio will achieve higher returns and, at the same time, be of lower risk.

Investment experts tell retail clients the obvious things like New Zealand is only 0.2 per cent of the world stockmarket, that the growth sectors of technology, aerospace and energy are virtually unrepresented locally - and advise clients to opt for lots of international fund managers.

That may be but the long-term returns from New Zealand shares since 1931 are similar to those from the US and, the bottom line, for many investors is income.

Mums and Dads need to remember that capital growth, representing more than half of the prospective return from international shares, is about as reliable as an Iraqi policeman whereas dividends, constituting 75 per cent of the return from NZ shares, are much less volatile.

* Brent Sheather is a Whakatane-based investment adviser.