KEY POINTS:
The year 2006 will go down as another extraordinary one for equity investors.
Against the odds of rising interest rates, surging energy prices and continued conflict in the Middle East, not to mention investment theory, both international and New Zealand equities have produced double digit returns far better
than could reasonably be expected in a normal year.
Economics tells us that, over the long term, returns on shares will be equal to the dividend yield plus the rate of dividend growth. International stocks have delivered long term dividend growth of about 4 per cent a year which, with a dividend of 3 per cent or so, supports a normal return of 7 per cent.
Yet in 2006 international shares rose by 19.2 per cent and, after a late rally, the kiwi bourse finished up 18.7 per cent.
The extraordinary nature of returns in 2006 continues a longer term trend of shares achieving higher returns than can be justified by earnings growth alone and which UK economists Dimson Marsh and Staunton have described as a "Triumph of the Optimists".
While it is nice to see one's portfolio move up by 20 per cent the problem with speculative returns - arising as they do as markets become more expensive - is that the resulting lower dividend yields make next year's gains that much more elusive.
At the beginning of the year local experts pointed to the high relative valuations of New Zealand shares and the potential for a weaker dollar and concluded that international shares looked a better bet.
At the halfway stage that looked like an inspired call. New Zealand shares had gone nowhere at 3.2 per cent whereas the weaker kiwi dollar turbocharged international returns to 19.7 per cent.
The second half was a different story with the kiwi rising strongly against the US dollar, international shares range bound and NZ stocks, led by Telecom, soaring. Telecom shares alone rose by 29 per cent in the second half, confounding the sceptics.
In such a bullish environment speculative investments have done especially well. The optimist who at the beginning of the year threw caution to the wind and took a leveraged bet on New Zealand Inc via Kingfish options has enjoyed a total return of around 250 per cent for the year.
As it turned out, over the year local stocks marginally underperformed international shares but since the millennium NZ shares have substantially outperformed global markets, returning 12.75 per cent a year to December 31, 2006 versus a fall of -1.44 per cent a year for the world stockmarket.
In 2006 it was again relatively easy for fund managers to beat the local index: simply by avoiding Telecom. New Zealand's biggest company, which comprises about one-quarter of the market, fell by 7 per cent over the year. The locally listed, computer managed, Midcap Index Fund which has no exposure to Telecom produced a 41 per cent total return for the year, a performance surely worthy of a Fund Manager of the Year Award.
While the broad index of international shares had an excellent 2006 it was possible to do better, and considerably worse.
Early in the year some advisers promoted the Japanese market as having turned the corner, yet reality disappointed with just a 4 per cent return over the year - the poorest result among the larger developed markets.
Actually the place to be was the UK and European stocks which, thanks to strong currencies, weighed in with 31 per cent and 28 per cent returns respectively. Currency was a big factor affecting returns last year but perhaps not as quite anticipated; many of the pundits who forecast a lower kiwi in 2006 were disappointed as the most popular offshore currency, the US dollar, actually weakened by 1 per cent against the kiwi.
While we were marginally weaker against the Australian dollar (-5 per cent) the serious money was made in the pound (-10 per cent) and the Euro (-8 per cent).
Ordinary shares weren't the only place to make money last year - property had one of its best years with the listed property sector rising by 21 per cent as demand for quality office, retail and industrial space kept up the pressure on rents and the new tax changes made investing in listed property more tax effective. Particular beneficiaries of this environment were the AMP NZ Office Trust, up by 39 per cent, and Property for Industry ahead by 33 per cent.
Overseas property markets also ran hard with the Australian and US REIT Indices ahead by 30 per cent and 32.6 per cent respectively. Despite this good result it is hard to see how overseas property markets can continue this momentum as Australian dividend yields are at record lows and have gone well under 4 per cent in the US.
The dullest but safest sector - the Government bond market - had a most unspectacular year with the local index returning only 4.2 per cent as lower bond prices partly offset the 7 per cent or so average interest coupon. Global bonds at 4.7 per cent were similarly restrained and even over 10 years show only a 5.5 per cent return.
With international shares up by 19 per cent it is no surprise that 2006 was a great year for Mum and Dad's superannuation scheme. The average pension fund with a balanced mandate has around 40 per cent of its assets in bonds, 10 per cent in property and 50 per cent in shares, the latter split one-third NZ, two-thirds international. The typical fund with these weightings will be up 13.8 per cent for the year before fees and tax. Knock off 2 per cent for fees and 3.8 per cent in tax leaves about 8 per cent for investors.
A good result but taking a longer term perspective is not so encouraging. Figures for the 10 years ended December 31, 2006 come in at around 7 per cent a year after fees but before tax.
This compares with 6.8 per cent for government bonds, suggesting that, for retail investors without the benefit of employee contributions, fees have eliminated the premium one could reasonably expect for the greater risk of including shares in the portfolio.
Disclosure: Brent Sheather and clients may have an interest in the companies mentioned.
