Brian Gaynor: NZSE fattens up its index values

Investors beware: the Stock Exchange has adopted creative accounting as far as the market's performance is concerned.

The exchange's new benchmark index, the NZSE50 Gross Index, will give an inflated view of the market's performance. Many fund managers will adopt the new index's methodology to report their performance and their clients will be given the impression that they have made more money than they have.

Sharemarket indices are an attempt to measure the market's performance. They are complex and can be constructed in different ways including capital only, adding back dividends, reinvesting dividends paid and reinvesting dividends paid plus their imputation credits.

The best way to explain the different methodologies is to give a simple example of the four main approaches and their returns at the end of a 10 year period.

Our simple index includes just one company, Telecom. Its share price begins at $4.40 and in the middle of each year the company pays a 20c a share dividend, which has a 10c imputation credit. When the company's share price goes ex the 20c dividend each year its share price falls to $4.20 but returns to $4.40 over the next few months. At the end of the 10 year period Telecom's share price is still only $4.40.

The four different measurement systems would give the following theoretical results for Telecom's performance over the 10-year period.

* Capital Index. The capital index takes no account of dividends and it would conclude that Telecom had a zero return over the decade because its share price started at $4.40 and finished at the same price.

* Dividends added back. The 20c a share paid every year would be added back to give total dividends over the 10 year period of $2. Thus the total realisation after the 10 year period would be $4.40 plus $2. This $6.40 represents a gain of 45 per cent over the original share price of $4.40.

* Actual dividends are reinvested. This assumes that the actual dividend, 20c each year, is used to purchase the company's shares. This methodology would produce a return of 55 per cent over the decade.

* Gross dividends, the actual dividend of 20c plus the imputation credit of 10c, are reinvested. At the end of the 10 year period this measurement system would report a return of 93 per cent.

Thus the four different methods produce returns of zero, 45 per cent, 55 per cent and 93 per cent over the decade.

The exchange has jumped from the first methodology to the last, mainly to give a positive view of its performance. (The NZSE40 Gross Index has risen 288 per cent since its inception on July 1, 1986 whereas the NZSE40 Capital Index has fallen 31 per cent over the same period.)

The capital method, which is used to determine most well-known sharemarket indices, understates the performance of the market but the new NZSE50 Gross Index will inflate its returns.

How can our simple Telecom index conclude that the company had a return of 93 per cent over the decade when its share price has remained static at $4.40 and it paid total dividends of only $2 a share?

Many fund managers will adopt the NZSE50 Gross Index as their benchmark and they will also start using its methodology (the reinvestment of dividends plus the imputation credit) to report to clients. Investors should be aware that the reported performance of these managers will be much higher than the cash returns to clients.

WORLD STOCK EXCHANGES

Monday was the third anniversary of the top of the Nasdaq bubble and its decline on the day was a stark reminder that the market is still in a fragile state.

On March 10, 2000 the Nasdaq Composite Index reached its all-time high of 5048.62 and has been in a steady decline since. It closed on Monday at 1278.34, 74.3 per cent below its peak, but 170 points above its post-crash low of 1108.49 last October.

The biggest sharemarket meltdown of all time was the Wall St crash of 1929. As the accompanying table shows it plunged 89.2 per cent in just three years and took 25 years to return to its 1929 high.

The Japanese and Nasdaq markets have been vying for second place. The Tokyo market has been in almost constant decline since it reached its all-time high at the end of 1989 and closed yesterday at another post-crash low.

New Zealand's sharemarket boom and bust of the late 1980s and early 1990s is not far behind.

The NZSE40 Capital index peaked on September 18, 1987 and reached its post-crash low on January 15, 1991.

The index is still 52.6 per cent below its peak at yesterday's close, although under Mark Weldon's gross indices system our market is well above its 1987 level.

US investors hope that the worst of the Nasdaq bear market is over - but the continuing lows in Tokyo are a stark reminder that it can take a long time to purge bubbles.

RUBICON/GENESIS

Wrightson's acquisition of a 15.3 per cent stake in Genesis Research and Development raises a big question about the future direction of Rubicon. Why did Wrightson rather than Rubicon purchase this strategic stake when the latter's stated objective is to expand its biotechnology activities?

Genesis was founded by Dr Jim Watson in early 1994 and Fletcher Challenge Forests was an early shareholder and project partner.

The biotechnology company listed on the Stock Exchange in September 2000 following the issue of 5.75 million shares to the public at $6 each. As part of the Fletcher Challenge Group separation, a process in which Luke Moriarty of Rubicon played a major role, Fletcher Forests' 2.8 per cent (727,273 shares) Genesis holding was transferred to Rubicon. A Grant Samuel report valued these shares at $6.65, the market price on January 22, 2001, but they were transferred to Rubicon at $3.85 a share.

Since then Moriarty has attempted to sell his 17.6 per cent stake in Fletcher Forests at $1.85 a share (37c before a one for five share consolidation). The deal fell over and GPG ended up with a 19.99 per cent stake in Rubicon.

Last month Moriarty raised his Fletcher Forests holding to 19.997 per cent through the purchase of a further 13.1 million ordinary and preference shares at an average price of $1.10 a share.

The big question is why did Moriarty spend $14.4 million to buy a further 2.4 per cent of Fletcher Forests when his stated objective is to sell out of the company and Genesis looked particularly cheap for a long-term corporate investor at $1.31 a share?

Genesis had cash resources of $36.3 million or $1.39 a share at December 31. It had net working capital of $31.9 million or $1.22 a share and some interesting, but speculative, developments in the pipeline. Only time will tell whether Moriarty made the right decision.

* Disclosure of interest: Brian Gaynor is a Fletcher Forests and Rubicon shareholder.

* Email Brian Gaynor