Chris Lee & Partners Ltd

Taking Stock 27 June 2024

THE investigation by the Financial Markets Authority into the market manipulation of the government bond rate-setting is to be welcomed but would be pushing boundaries if an enquiry were to result in prosecutions.

Many, many times market manipulation is observed by old-timers and cynics but explained away as random events, apparently occurring without the influence of a puppeteer. Manipulation is very hard to prove.

Think of those previous investigations in NZ that involved at least two of our largest fund managers, where “settlements” were made instead of prosecutions.

The FMA is right to send another warning shot to market participants.

Without international and retail investor confidence in our finance market behaviour, our markets become ever more brittle. Firm regulatory interventions help to restore confidence. We need offshore money.

The event that raises attention now allegedly involves at least one of our major banks.

The implied accusation is that a bank (or banks) manipulated government stock rates so that the government was duped into paying more interest ($33 million) when it raised $2.1 billion through a recent issue of inflation-adjusted government bonds.

The system should work like this.

The government, through its agencies, appoints a panel of banks to advise on the rates that the market would require, if the market were to invest $2.1 billion in a new issue.

The banks are expected to examine recent trading in the stock, then expected to assess the additional margin that would be needed to incentivise new buyers, some of whom would be international wealth funds. The size of the issue dictates the required margin.

To simplify this concept, imagine the daily trading in similar government bonds had all been at 5.0% yields, volumes in low millions.

To raise $2.1 billion in a day would obviously require a higher rate than the 5.0% average over the preceding days.

So the banks might advise 5.2% to attract much more volume.

If the stock being offered was $2.1 billion, for seven years, a new rate of 5.2% would cost $728m of interest paid out over the seven years.

But if the rate had been only 5.0% the interest cost would have been $700m. Clearly the average daily rate is a crucial benchmark. The margin to attract billions would be easily understood, and a constant.

Imagine that before the government comes along with its question the backrooms of the banks guess that the government will soon have to seek new money to fund the government’s published spending programme and to repay maturing bonds.

So at least one of the banks creates transactions at a higher rate, perhaps the bank selling stock from a fund it manages and buying the stock for the bank itself, generating a new, higher “market” price.

It could easily explain this transaction as being driven by the need of the managed fund to meet “requests for redemption”. It can display fund manager minutes stating the preferred way to meet redemption requests is to sell from its portfolio, the government stock that happens to be similar to the stock that the government will soon be offering.

So the recent transactions occur at 5.0%, rather than 4.8% as might have been the case the previous week. Was the bank cheating? Or was the rate rise coincidental?

I am over-simplifying to make this readable, but the point is fairly obvious.

How could a government, or a court, or the FMA, prove beyond reasonable doubt that the recent “sales” were examples of manipulation?

Effectively, such a judgement would be assuming that the bank should have found some other way of meeting the redemption needs of its managed funds. The banks today are very careful to document their behaviour so that “discovery” produces no surprises.

Think back to the European manipulation of the Libor rates, some years ago.

In that case money market dealers were overheard on tape concocting a swindle that led to higher interest rates. Emails and texts were recorded. The dealers were not just greedy and crooked. They were also stupid.

The Libor swindle was proven.

You can bet your favourite pyjamas that banks today conduct their conversations with great care, ensuring all conversations, emails, texts and minuted decisions will withstand scrutiny.

They know these recordings are discoverable.

They would be moronic to be casual, or to plot swindles in any discoverable way.

My guess is that their documentation will be legally watertight. I guess that any private conversations are held on yachts, fishing expeditions, or golf courses, where there are no recording devices.

However, I would make this observation.

Absurd bonuses, allocated on the basis of day-to-day deals, have historically incentivised the potential beneficiaries of bonuses to cheat. Greed trumps integrity in weak people. 

This current case, alleging manipulation, comes within the general heading of insider trading/market manipulation.

It is similar but not identical to the quarterly window-dressing sales that are seen when fund managers are wanting to meet investor expectations and attract bonuses, in quarterly fund manager reports.

It is similar to those dubious, misleading, Kiwisaver reports that rely on “valuer’s opinions” of the value of unlisted securities. This area is not so much opaque as completely blacked out. It is an area the regulators should penetrate.

But it is quite different from front-running, that egregious behaviour that might more accurately be described as theft.

The best example of front-running in NZ came in the 1990s when a week, greedy young man, working in an institution, collected an order to buy a large number of shares in a particular company, so placed an order to buy for himself a large number, before placing the institutional order. He was “front running” his client.

Let us say he bought 25,000 shares at $4.00, then placed the big order, which drove the share price to $4.50, at which point he sold his 25,000 shares to the new buyer, pocketing (stealing) $12,500, effectively shooting rats in a barrel.

In that well known case, his employer did not prosecute but simply fired him. I regarded this as disgraceful. It let him loose in a market sector that should not employ thieves.

The “fit and proper person” bar in those days was set so low that a one-legged ox could have jumped it.

The cheat was immediately employed by a competitor and has sailed on through life as though he were “fit and proper”.

Market manipulation is insidious.

Weak people – cheats - should not be entrusted with other people’s money.

The FMA is right to test the alleged market manipulation, but I would be amazed if a court could gain certainty about a process that still relies on integrity - the prevalence of fit and proper people.

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DURING the heated debate, never convincingly resolved, about government funding of the media, the temperature rose above comfort levels when anyone alleged that the media was compromising its standards by accepting instructions on what it published.

The media acknowledged that to qualify for grants it had to promote gender and racial diversity in its offerings, it had to support the Crown's initiatives on Maori language and modern interpretations of the Treaty of Waitangi, and it had to promote discussion on government initiatives related to changing weather patterns.

The media insisted it had no obligation to deify Ardern or to gloss up Robertson's image. I came to believe that the media had no such contractual obligation, persuaded by friends in the media.

However, I was never convinced that it had any balance in its coverage of the issues relating to pollution or weather changes. I need to hear both sides of a debate before reaching a conclusion.

In recent days an eminent consultant, widely used by major organisations, sent me a letter he submitted to the Wellington daily paper during the period when the government was funding parts of the media.

His letter was not published.

As it reflects an interesting perspective and refers to scientific research conducted by a Crown agency, I publish below his letter, with the author’s permission, his name redacted.

Why, one wonders, was this letter less relevant than the constant stream of letters that, unlike this letter, simply reflected personal opinion, little of it reflecting any useful evidence?

Surely in such a monumental debate, a NIWA study measuring carbon would have been relevant and should have been presented to the public.

I might assume the refusal to publish the following letter was just the editor’s personal ideology, not fear of losing a share of the public journalism fund. (I have little faith in today’s editors.)

His letter is as follows:

Carbon Dioxide is steadily increasing in the earth’s atmosphere and is now up to around 407 to 410 parts per million.  NZ worries that it may be the fifth worst generator of CO2 equivalent per head of population of any OECD country.

However there is a cycle of CO2 production and absorption, and whilst we worry about our production, we appear to be massively underestimating our CO2 absorption.

The Ministry for the Environment (MFE) estimates that NZ produces around 81million tonnes of CO2equivalent gases per year, but they state that we only absorb around 27 million tonnes.

However on reading their reports this appears to only take into account absorption by pine forests that occupy 6.4% of NZ’s land area. 

 The absorption of CO2 by the other 93.6% of land and its trees, shrubs and grasses are apparently not counted by MFE.  NIWA on the other hand looked at the macro level by measuring how much CO2 is in the atmosphere as it reaches NZ and how much is there as it leaves NZ (the IPCC recommends this approach).

They have produced reports estimating that the total absorption of CO2 by the NZ biosphere is around 98m tonnes a year. Basically NIWA is saying that the 93.6% of land that MFE seems to ignore is responsible for absorbing an extra 71m tonnes of CO2 equivalent (98m minus 27m tonnes).

A large part of NZ land is used for grazing, and via ruminants produces Methane.

Methane is regarded as the big bugbear of agriculture and according to MFE it accounts for 31% of the 81m tonnes of CO2 equivalent, or 25m tonnes per year.

The bulk of this methane comes from cattle and sheep that eat grass to grow, to move, and then belch about 5% to 9% of their food as methane.

Grass growth mainly comes from the absorption of CO2 via the well-known photosynthesis process, which also produces some very useful oxygen.

According to the Department of Statistics 31.4% of the country is used for beef and sheep farming, and a further 9.6% of land is used for dairying.

So we have 41% of the land absorbing CO2 to make the grass grow to produce methane, but this absorption is apparently not considered in the figures used by MFE.

It seems reasonable that if we have 25m tonnes of CO2 equivalent from Methane being counted as emissions, then we should be counting CO2 absorption from 41% of our land used for pasture.

This must be of a similar or greater amount than 25m tonnes (offsetting the methane to CO2.equivalence of about 20:1, with the fact that only 5% of the feed is belched as Methane).

We have still only accounted for 47% of our land area (6.3% pine forest plus 41% of grazing pasture land), the rest of NZ is made up of native forests, scrubland, etc. with a small area of around 1.8% of towns and cities.

It therefore seems reasonable to believe that the figure of 98m tonnes of absorption calculated by NIWA is likely to be correct.

If we are currently absorbing 98m tonnes and producing 81m tonnes of CO2 equivalent then we already are a carbon sink society, and any attempts to make us carbon neutral by 2050 would require us to either produce more CO2, or reduce the biosphere’s ability to absorb CO2.

Neither of which seem to be logical.

Are we chasing shadows?

Will we destroy the NZ economy by focusing on a goal that has already been met?

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THE announcement that Jarden’s long-time figurehead and leader, Bill Trotter, is to retire as chairman provides a suitable occasion to acknowledge his lead role in NZ financial markets.

Trotter, as a young man in the 1980s, joined Jarden at the time his father (Ron Trotter) was playing an influential role in the deregulating of the financial sector, and the clean floating of the NZ dollar.

Ron Trotter, John Anderson, Graeme Scott, Alan Gibbs and one or two others provided the knowledge and impetus that led Roger Douglas to implement his economy-changing policies.

Bill Trotter joined Jarden and would have observed the immorality of many business leaders of that era, one so-called business leader of the time regularly lying to the market, and privately boasting of how many mistresses he kept.

To rise above this, to play a role in representing Maori in its Crown compensation packages, to build what became by some distance NZ’s eminent and most reputable sharebroking firm, and then to become joint chief executive (at 35) and chairman for nearly two decades, was a remarkable achievement.

Trotter, familiar with the Maori language and Maori aspirations, well connected with business and political leaders, and said to be highly skilled at driving people to achieve ambition, has been a unique figure in financial markets. The Jarden alumni of leaders is impressive.

Under his watch, Jarden dominated the market, was rated by market participants as the eminent investment bank virtually every year for more than a decade, and now seems likely to become a truly Australasian financial market participant, achieving profitability within a period much briefer than I would have anticipated.

My expectation is that it will become more Australian than “Kiwi”, having created a profitable presence in NZ.

In recent weeks it has attracted two excellent people, Matt Whineray and Fraser Whineray, to chair the two divisions, Firstscape and Jarden Investment Banking, the Whinerays being genuine market leaders.

 Trotter, in his mid-60s, having worked at Jarden for around 40 years, has had real behind the scenes influence in financial markets and now moves back to being a director of the investment banking division, which surely will have a new ownership structure in the near future.

One suspects Bill Trotter is not one of those sad people who make “donations” to buy a gong. Bill Trotter leader of Jarden for decades, is a pretty decent accolade, in itself.

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Travel

Our advisors will be in the following locations on the dates below:

5 July – Wellington – Edward Lee

11 July – Tauranga – Johnny Lee

12 July – Hamilton – Johnny Lee

19 July – Wairarapa - Fraser

25 July – Auckland (Ellerslie) – Edward Lee

26 July – Auckland (Albany) – Edward Lee

Chris Lee

Chris Lee & Partners Limited

Taking Stock 20 June 2024

IN twelve months’ time New Zealand will begin a new phase of its financial history when it will take away the risk of chasing high returns.

By June next year NZ taxpayers will be guaranteeing up to $100,000 for every finance company, building society, or credit union deposit made by an investor, with very few constraints on the company receiving the money.

NO company will be required to have an investment grade credit rating, its owners, directors and senior staff will be vetted by only the most half-hearted criteria (to pass the “fit and proper” person barrier) and no lending book will be vetted by those familiar with the back streets, where the deals are done.

Most surprisingly the companies glowing from this beneficence will pay the most modest of cost for the taxpayer’s guarantee (0.19%).

The only merit I see in this new guarantee is that the appalling, discredited old trust companies, Perpetual, Guardian, Covenant, and Trustees Executors, will not be allowed to pretend that they are supervising the finance companies, as they did so dreadfully in the last era when non-bank deposit takers were incinerating investor money.

The supervisory role will be performed by the Reserve Bank. It will require around half a dozen streetwise, dedicated staff. To succeed they will need to know where rodents hide and will need to have the creed of “show me, do not tell me”.

Already micro-supervised and subject to heavy regulations, the fully capitalised trading banks will again subsidise the costs of the failure of non-banks. Banks might ponder this injustice and wonder why we learnt so little after the 2008 global financial crisis.

The fees banks will pay for the guarantee will be in hundreds of millions. Bank failure is improbable. Unless some event like a deep depression occurs, or housing becomes uninhabitable in some areas, leaving the banks’ loan security worthless, the likelihood is that the bank guarantee will face no claims.

But finance companies, building societies, and credit unions have pitifully little reserves, and in a depression, or even a prolonged recession when high unemployment exists, claims could easily far outstrip their payments made for the guarantee.

As it is now, a lower-tier lender, for example, General Credit, will be able to offer investors a small margin above bank rates and raise money easily, paying low costs for the guarantee. Why would investors care about additional risk? They are guaranteed by taxpayers!

Indeed, just last week the NZ Herald ran one of its ghastly “guest” items, “sponsored” by a payment from the “guest”, on this occasion by General Capital director, Brent King.

King’s name will resonate as an early owner of Dorchester Pacific, who left and formed Viking Pacific, taking with him the retired politician Bill Birch, whose governance skills were inadequate.

Viking raised money from the public, invested much of it in a junk company, Certified Organics, and when CO self-destructed, Viking Pacific disappeared, its units worthless, the funders of the venture scarred.

King clearly was blameless as he passes the fit and proper bar, at whatever height that is set, and has since taken over the mortgage lender, General Finance, a tiny survivor of the 2008 financial market collapse, its loan book barely exceeding in its total fob pocket coins.

Now owned by General Capital, it has grown its total lending to nearly $160 million, has a sub-investment grade credit rating, and advertises extensively, offering a 1% margin over the bank deposit rates. A company called Equifax awards GC its credit rating of BB, two grades below investment grade, a rating lower than the BB plus that Hanover Finance enjoyed before its collapse.

General Capital has capital of $15.98 million and at 31/3/24 had total assets of $164m of which loans were $136m. It appears to make an annual profit of around $2.6m, and has margins, including loans and nett fees, of around 3%.

To be fair, this margin is low, implying General Capital (trading under the name General Finance) is largely a short-term bridging finance company, similar to how Strategic Finance started out before Strategic morphed into a high-risk property development financier, with all sorts of appalling contrivances that put the risk on its debenture investors, but paid the highest returns to its wholesale partners.

General Credit is therefore not the worst type of finance company. It has a little capital, its lending market is not visibly linked to property development, and it has very few staff. It could be characterised as being dependent on the property market, perhaps able to survive property market gyrations if its small numbers of shareholders have ample personal wealth that would be instantly accessible, if required.

There is nothing obviously inappropriate with any of this.

What is wrong is that it will likely be taxpayer-guaranteed for a miniscule fee (less than 0.20%), enabling it to grow its deposits as fast as it likes, by selling the taxpayer-guaranteed status it might gain in June 2025.

Because there is an implicit Crown guarantee of Kiwibank, and arguably all the main banks, I can see why the Reserve Bank wants a fee to offset the implicit liability to the banks’ depositors.

I may need new specs, but I am squinting, indeed almost blinded, to see past the glare that should be coming from the taxpayers of New Zealand with any sort of recollections of Bridgecorp, Lombard, Money Managers, Capital & Merchant, Hanover, St Laurence, Strategic, Nathans Finance, Mutual, Dominion, MFS, Western Bay, Provincial, Octavia, Allied Nationwide . . . and many others.

Is it too late for a wiser government to undo a dopey idea?

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JUST about equally as ill-advised is the demand to pay the cost of an enquiry into bank lending policies (and lending margins) to rural borrowers.

The rural sector argues that:

1. Rural margins are inexplicably high.

2. Rural lending policies are too restrictive, loans often non-accessible for would-be borrowers.

The banks will respond by saying that the Reserve Bank assesses rural loans as requiring more capital (to offset risk) than is required for vanilla residential loans secured by mortgages.

The banks will say that risk must be rewarded by more return.

The banks will say that their primary duty is to manage responsibly their depositors’ money, and that their secondary duty is to provide their shareholders with a return on their capital.

The banks will argue that these two obvious responsibilities have to be performed while honouring the laws of the land.

The banks will also say that for competitive reasons they like to meet social goals when they can be accommodated without breaching their primary obligations.

The rural sector will seek to prove that lending margins are excessive and seek to demonstrate a history of low bad-debt losses, at least in recent years.

The banks will say that losses are low because, at the banks’ costs, the banks nurture rural borrowers during crises, and discover which of their clients behave honourably during tough times.

The new commission enquiring into rural lending will observe that, at different times, rural lenders like the National Bank (under Sir John Anderson’s leadership), ASB, BNZ, and Rabobank have all had years when they adjusted their standards to grow their rural lending book.

The commission will conclude, must conclude, that the banks have an obligation to operate prudently, and that no government should ever direct them on matters like the pricing of loans, or the selection of those to whom the bank lends.

If the government wants to offer cheaper loans to the rural sector it is entitled to reinvent another iteration of the Rural Bank, and to then service any need it wishes. The last time this occurred, I do not recall an outcome that we would want to repeat.

Banks, like Kiwibank, have no right to take money off clients illegally, or do anything that is illegal, and quite rightly should compensate and be fined whenever they break contracts or break the law. Kiwibank is now facing the issues it caused with illegal practices.

But banks not owned by the government have no legal or social obligation to lend any money to any particular sector, at any particular price.

The enquiry is a waste of time and money and will be another example of negative productivity in the public sector.

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VERY rarely in my career has there been an occasion to applaud a young journalist and acknowledge a special contribution by the journalist to serious financial market players.

So I doff my hat to Madison Reidy, a young woman who produces occasional recorded video interviews with real business leaders in New Zealand.

Her formula is not to pretend that she is “the story”, not to play the silly kids’ game of “gotcha”, not to appear to be worldly by being cynical, feigning knowledge, and not to be disrespectful to the real business leaders who kindly agree to give her an hour of their time.

I first noted her wise approach a year or so ago and asked around, seeking to understand why she seemed a street ahead of the pack. I have never met her.

I learned that she cleverly shifted career as a youngster who had wanted to be a journalist, into a career with a trusted financial market participant with a handful of New Zealand’s smartest financial market leaders, scoring what for her would have been a mind-opening job at Jarden, during a time when markets were humming.

Last week I watched her videoed interview with Ryman Healthcare where a well-balanced, knowledgeable man, Dean Hamilton, with real governance and business experience, now the acting CEO, spoke clearly and honestly for 40 minutes with Reidy, about Ryman.

Hamilton was able to talk for long periods, sometimes on technical subjects, without any smart Alec interruption, but often gently guided into discussing issues that Reidy, quite insightfully, had deemed relevant to her audience.

I should be clear that her audience is not those who might be described as the lowest common denominator, those who are casual, uninterested people seeking quick entertainment to help them confirm their own meaningless opinions.

Reidy arranged her time with Hamilton so that it would be of interest to real investors, not those in the public bar at closing time.

New Zealand now has a few business reporters, mostly older, some hard-working, some of them sufficiently familiar with the real business world to be useful conduits of the knowledge of those who work in the business world. We have a few who in the context of our immature media cast longer shadows than most.

Until Reidy’s career shift to Jarden some years ago, none, to my knowledge, have actually worked in the heart of our financial markets. That is logical. The remuneration in the business world, for excellent people, would make a transition to journalism improbable.

On reflection, the highly-regarded Pattrick Smellie who worked for Contact Energy, is another who reverted to journalism from an important company.

Ideally, investors are served up “business” news by people who write (usually, well), behave politely enough to ensure their phone calls/emails to business leaders are answered, and who, over time, soak up the business language.

None would evolve into being a credible thought-leader or provider of advice except at the most casual level, for the obvious reason that their knowledge is superficial. Business leaders would not share knowledge of the often difficult issues that, if published, might lead to delays or even stoppages, while negotiated solutions are being developed or executed.

Businesses have no obligation to engage with the media. Many leaders do not. Businesses are obliged to engage with their investors.

Yet Ryman engaged wholeheartedly with Reidy.

I suggest this reflected her courtesy, her insightfulness, and her genuine understanding of the general issues Hamilton discussed.

The pinnacle for every business journalist is a role as presenter at CNBC, the US-based television business programme that is trusted and is regular viewing for many business leaders. Its back office journalists and its studio performers are generally outstanding.

It has high standards and such a huge audience that it can afford to cover a wide range of subjects in detail, its presenters generally telegenic, knowledgeable and respectful, yet not feigning to be a source of “advice” to business.

Reidy, I guess, could be a rare NZ contender for such a role if she can maintain the standards so far displayed. I might add many of our influential business leaders have noted her approach and have welcomed it.

Leaders rarely appear in “sponsored newspaper supplements” and do not receive “bonus points” from their board for engaging in clickbait trivia (in contrast to the universities, and those in other academic roles).

They probably will engage with Reidy.

Footnote: Ryman provides a high-quality service (usually) to around 17,000 people. It must rethink its balance between capital and debt, rethink its pricing formula, and uncover a new chief executive who combines property development skills with corporate skills and with empathy for the care of its residents.

_ _ _ _ _ _ _ _ _ _

Infratil understands capital management and debt management better than any other NZ listed company.

Its wholesale placement to raise another billion of capital is yet another example of its balance sheet care.

It will use most of the funds to feed into data capacity and data protection, areas where artificial intelligence will produce elevated demand.

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Mercury Energy Capital Bonds

Mercury has announced that it is considering making an offer of capital bonds.

MCY is a 100% renewable electricity company, generating electricity from nine hydro stations, five wind farms, and five geothermal power plants. It is also 51% owned by the NZ government.

The bonds will have a set maturity date of 30 years but will offer an election (repayment) process after 5 or 6 years, enabling Mercury to repay early.

It is worth noting that Mercury is likely to repay investors on the election date.

The interest rate has not been set yet, but based on current market conditions, we expect the interest rate to be above 6.00% per annum.

MCY will cover the transaction costs for this offer; therefore, clients will not have to pay brokerage.

If you would like to be pencilled on the list for these bonds, please contact us promptly with an amount and the CSN you wish to use.

We will be sending a follow-up email next week to anyone who has been pencilled on our list once the interest rate and terms have been confirmed.

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Travel

Our advisors will be in the following locations on the dates below:

25 June – Napier – Chris Lee

5 July – Wellington – Edward Lee

11 July – Tauranga – Johnny Lee

12 July – Hamilton – Johnny Lee

Chris Lee

Chris Lee & Partners Limited

Taking Stock 13 June 2024

THE destruction of investor value in the modern milk processor Synlait Milk will surely signal convincing evidence of many failings of governance in Synlait, and in others.

In no particular order, investors will be processing their own thoughts on:

1. The repeated, widespread failure of companies to replace debt with either new capital or retained earnings. 

2. The suitability as directors of many, including former politicians and lawyers, with no history of building businesses, managing risk, or understanding return-for-risk, or even the importance of cash flow.

3. The far greater importance of NETT PROFIT AFTER TAX than RETURN ON EQUITY.

4. The difference between Asian and European attitudes towards retail shareholders.

5. The distortionary effect of index funds on share prices, resulting from their robotic buying that so often ignores underlying true value.

History

Synlait was listed in July 2013, at $2.20 per share, using the money raised to settle debt.

It had first processed milk in 2008 and had a plan to sell milk powders to the global market, with infant nutritional food sold mostly to China. A “daigou” means of selling to China later evolved. This involved Chinese residents buying Synlait’s dried milk in small quantities while overseas and carrying the milk containers back into China. The practice ended when Covid interrupted travel.

From the beginning Bright Dairy, effectively a Chinese government entity, became a 39% shareholder in Synlait Milk. It now has four directors on Synlait’s board, having replaced its NZ nominee, Ruth Richardson, who Bright had earlier selected to help represent the Chinese investors. China has a view of the relevance and power of former politicians that differs greatly from reality in NZ where most politicians have no or little power over (or knowledge of) commercial entities or people. (The regulators and the law retain this power.) By contrast, political figureheads are almost omnipotent in China.

Synlait soon grew its product range to process the A2 milk product, with the listed company A2 Milk becoming a 20% shareholder.

From day one Synlait’s policy was to compete with Fonterra for dairy farmer support by paying the same price as the giant cooperative Fonterra, but without any requirement for suppliers to hold shares in Synlait. Fonterra's suppliers had to invest in Fonterra shares at a level commensurate with their daily volumes. This tied up farmer capital. Synlait’s model did not.

However Synlait required its suppliers to be easily accessible and to meet certain standards of farming practices. For example, it had rules about water qualities, including proof that there was no link to old pesticides like 245T, a pesticide banned in the 1990s because of its link to cancer. Its shelf life in water tables is extreme. (Of course, Fonterra also has quality controls.)

Synlait reported growing sales, growing numbers of suppliers, and growing nett profit but also growing use of debt.

Criticism by outsiders raised the issue of Synlait being solely reliant on the South Island suppliers and its Dunsandel plant (just south of Christchurch).

Synlait responded by building a magnificent state-of-the-art plant at Pokeno, north Waikato, and diversifying its product range by buying Dairyworks in 2020, a cheese maker, for $112 million, having earlier bought the NZ Dairy Company in 2017 for an announced final price of around $56m. NZDC is based in Auckland.

The new plant at Pokeno was a problem from day one, a neighbour greenmailing Synlait, through a covenant on the land, arguing that the neighbour had a plan to build a dairy factory that would compete with Synlait’s planned factory.

The contrived argument cost an unknown number of tens of millions to resolve, led to extreme time delays, and no doubt contributed to the ultimate absurd cost of Pokeno, apparently reaching $400 million. Pokeno's plant has never had the volumes of milk to justify its cost.

During this period Synlait’s progress led to it being admitted into a global index that predictably resulted in various index funds being forced to buy Synlait shares.

Alert active fund managers foresaw this and acquired as many of the available shares in Synlait as they could access.

Accordingly, the robotic, rule-bound index funds were pressed by their own promises to track the index. The index funds eventually acquired the shares they needed for the ludicrous price of $14, or slightly more, a price that exceeded the underlying value of Synlait by at least double, and caused hidden losses for the index investors of more than $100 million.

Synlait could have sought to place shares with the index funds at a much fairer price, raising capital, reducing debt, and helping the index funds. It either had no wish to see its shares price settle at a stable level, or it did not have the wit to seize the opportunity to increase capital. Perhaps the Chinese and its board representives preferred to rely on extreme debt.

When Covid arrived the “daigou” trade ended, sales and exports fell, the licensing (by China) was painfully delayed, the company lost its close relationship with A2 Milk by selling competing products, all of this leading to farmer supplier discontent, revenue falls, losses, poor board decisions, director and executive departures and, now, a penny dreadful share price with no obvious ability to service its bank debt or its bond debt.

The Present

Synlait Milk may survive its dreadful governance, though in my opinion it is more likely that investors will observe its major shareholders (Bright and ATM) dividing up its assets and privatising the company.

To survive might mean ATM must pay a proper price for the Dunsandel plant (with its licence to export milk powder to China), enabling the banks to be satisfied, and the bondholders to be repaid within a mutually-agreed time frame.

New Zealand would be heavily disadvantaged if Synlait Milk were allowed to fall into the hands of receivers appointed by banks. Such a collapse would mean receivers would sell assets to return money to the banks, probably at bonfire sale prices.

Receivers and liquidators in New Zealand have a dreadful record of failing to achieve pricing tension, instead focusing on satisfying the banks with little or no respect for other creditors or shareholders.

Synlait Milk provides pricing tension for farm gate milk and is one of the few milk buyers with the power to keep our now blossoming milk cooperative Fonterra on its single group mission to maximise returns to farmers. It is ironic that Fonterra is displaying better governance whilst Synlait’s directors are failing.

Yet Synlait might survive, with the help of its two major shareholders, the larger holder being, in effect, a Chinese government corporate.

Conclusion

This is a terrible story of a company that has had the potential to be a modern exporter of value-added commodities, achieving superior margins with niche products. NZ needs value-add commodity exporters.

My expectation is that Synlait will survive but I expect the shares held by the public and by very few fund managers will be close to worthless, the company probably privatised after a Russian roulette game between Bright Dairy and A2 Milk.

An enormous rights issue, raising more than $250 million, might help Synlait repay bonds and restore banking relationships (with Chinese bankers) but would likely result in Bright and A2 Milk owning 90% of the company, leading to a compulsory takeover at a price equivalent to a single glass of milk. No external party would underwrite such a capital raise.

There is no obvious happy ending for all parties.

The best outcome is that bondholders are repaid, perhaps over an extended time, and that A2 Milk pays a proper price for Dunsandel, leaving Bright to develop a business model for Pokeno, and to sell or manage Dairyworks and other subsidiaries.

In my opinion it is fair to place the blame for this dreadful outcome on Synlait’s directors. Had Synlait raised equity when its share price was absurdly north of $10, none of these problems would be unsolvable today.

When, one must ask, will New Zealand directors come to understand the truth that capital underwrites survival, while extreme debt threatens survival?

_ _ _ _ _ _ _ _ _ _

SO at this point I referred to the five questions raised:

1) Why do NZ directors not foresee the need to raise external capital? Might you ask Ryman, Fletchers, Sky City, Air New Zealand, Metro Performance Glass, or Accordant this question, as well as Synlait Milk?

The great, long-lasting public companies have all survived cyclical or event-based setbacks, perhaps blessed with wealthy, wise directors with a vested family interest in survival, and a genuine understanding of the company's products/services and its markets. 

The biggest mistake commonly made has been to grant excessive power to short-stay chief executives, grossly over-rewarded, the only risk for these people being underperformance and dismissal, with the resulting costs falling on shareholders. 

Think Fletcher Building and Mark Adamson.

I once heard a commercial buffoon in court allege that cash was never “king” and argued, by implication, that capital was less important than future cash flows. Tell that to Synlait’s directors and watch their reaction.

2) The crass NZ practice of loading up boards with politicians and lawyers.

Shipley and her friend Richardson are by no means the only politicians whose suitability for board positions is unconvincing. I think also of Douglas/Wild (Brierley), Talboys (Night Harness Racing), Graham/Jeffries/Templeton (Lombard Finance), Birch (Viking Pacific) and, of course, Shipley and Richardson.

Shipley was chair of a Chinese-owned construction company (Mainzeal). Her errors were documented in court, resulting in a successful claim against her of $6.6 million, ironically paid for by an insurance company whose policy premium was paid for by . . . Mainzeal public company investors.

Richardson, a long-time director of Synlait Milk, has collected good coin for many years, using her political experience and a 1980s law degree to fashion a profile as a director/chairwoman.

She was first brought to my attention in her role as chairwoman of two companies created by the late Roger Moses in the early 1990s, IP Mezzanine Finance and I-Cap Equity Fund. Moses was a highly self-focused financial salesman with a great willingness to promote high-commission, high-risk, investment products.

Richardson became a director of Jade, which converted to Wynyard, the failed security software company, and of Syft Technologies, which endured a number of indignities.

IP Mezzanine Finance eventually returned around 80c in the dollar to its investors, I-Cap Equity Fund had a bleak record, yet Richardson was paid extravagantly as the figurehead who presided over these entities.

The Chinese have great fear of, and respect for, politicians. They come from a land where political office carries immense power. Indeed, readers of Mr. China, an excellent book about China’s commercial development, would recall how politicians had the power to unilaterally deny companies electricity should the company cause any offence, such as dismissing the dishonest nephew of a politician.

China's assumption that retired NZ politicians retain a mana that would help a public company, or perhaps that their career implies commercial and strategic wisdom, would find little support amongst New Zealand’s real commercial leaders.

To be fair Richardson has also chaired without obvious controversy such companies as NZ Merino Wool and been a director of the NZ subsidiary of the Bank of China.

She is, of course, not Synlait’s only director. However, she would be by some distance Synlait’s most recognisable director. She has recently retired from the board, replaced by a Chinese appointee.

My point is really that what investors need from directors is evidence of relevant expertise, wisdom, strategic commercial skills, understanding of risk return and knowledge, not just of governance procedures but of governance skills.

I do not know Richardson but those investors, who cited her presence on the board as being, by dint of her political power in the 1990s, relevant and a source of comfort, need to conduct much deeper research.

In my view Synlait’s failure has much to do with the failure of its directors to take the required responsibility of displaying skill and good judgement.

Lawyers occasionally make useful directors but often have a skill set and a sense of importance that detracts from governance success.

Lawyers who were also politicians - Graham, Jeffries etc. - might be a double hazard.

3. During my 50-year career, the mindset that defines company success has changed dangerously. The new focus is on short-term quarterly profit announcements, on the need to meet short-term guidance, on the fawning hat tipping to passing fund managers, on the prioritising of Return on Equity, and on the focus on Earnings Before Interest, Tax, Depreciation and Amortisation.

I observe the increasing indifference to comparative advantage, strategic long-term initiatives, cash flow, survival and, most oddly, the old fashioned Nett Profit After Tax.

Capital is what enables companies to think about long term success and what frees it from the erratic moods of bankers whose short-term bonuses are often collected before long-term outcomes are clear.

Years ago, a man I know well was asked to chair an organisation that was by any definition insolvent and had negative cash flows, thus being entirely dependent on its bankers’ trust in the board to survive.

 Amongst his first initiatives was to find an excellent chief executive, followed by a switch away from bank debt to a funding model that was provided by the real stakeholders.

He cancelled capital expenditure, ran on low octane budgets, and after seven years the organisation had no debt to anyone, and was thus free of covenants, able to manage $150 million of assets and 130 staff without any constraints on decision making.

No board member ever heard anyone mention EBITDAF or ROE. Survival, cash flow, and NPAT were often discussed.

Will the failing fortunes of Fletchers, Ryman, Metro Glass, Synlait Milk etc. lead to a return to the basics that seem to be too “old-fashioned” to enter today's governance textbooks?

4. Throughout the early decades, we of a certain age will recall the problems caused by the difference in attitudes between Asian and European directors, in respect of the relevance and rights of minority retail shareholders.

I greatly admire New Zealand’s Asian population, but I am very wary of the behaviour of off-shore Asian investors.

The grey haired will remember London Pacific, and how it took its NZ investors for a ride when it fell into Asian control.

They will recall how Equiticorp was gamed by Asian borrowers.

They may recall how UEB ended up with Paladin in Hong Kong, no value left for New Zealanders.

The book Asian Eclipse records how in many Asian companies the directors favour family and friends over retail shareholders. It records how various transactions syphoned profits to “consultants”, who might be family.

Synlait Milk has displayed no evidence of this type of behaviour, but I would expect that Bright Dairy will not be lending $130million to SML because it wants to protect the bondholders or restore the company to its previous status.

The terms of the $130m loan have not been published at the time of writing, but I would expect the terms to be what the Bright Dairy people would call “commercial”.

There may be a high coupon attached to the loan; there might be a demand on the banks to release an asset as security for the loan; there might be a requirement that bondholders agree to a deferred payment date.

Nobody knows. Shareholders will have to approve the loan, given it comes from a related party.

Do not expect the loan to be a moral offset for the abject failures of governance.

5. In the days before robotic index-tracing a mindful decision was made each time a fund purchased a share. There was no way of forecasting other people's minds.

When Synlait had a business model that, given ongoing success, meant its share price might find fair value at $6, the mindless buying of index funds, by their own published rules, required the purchase of millions of shares at whatever it took to acquire the required volume.

The price rose to $14, and a few cents more. Virtually all our clients sold all or most of their shares at highly elevated prices.

The likes of the index tracing KiwiSaver funds were the buyers.

The smart fellows in the broking world, and some active fund managers, stockpiled Synlait shares early on and make a hundred million or more at the expense of the clients of the index fund KiwiSaver investors.

You might ponder how a clever board of directors might have reacted during this anomalous period.

Might they have approached the index fund people and offered a new placement of, say, 30 million shares at $9, thereby precluding any need to offer subordinated notes with an interest rate responsibility, or accept more covenant-heavy bank loans?

Might an alert board, with an overriding commitment to a survival mentality, have seen such a capital increase as derisking the business?

Or might a board have been intoxicated by the rising share price and imagined the company had an open ended contract to enter Fort Knox whenever it wished, for ever?

In summary, Synlait’s governance has been disgraceful, in my language.

Its directors have broken no laws, and no doubt will have had a rationale for the asset splurge based on the use of debt, rather than equity.

Perhaps we need to know their explanation for the war they declared on their own shareholder (ATM).

Whatever, my summary is this.

We have an admittedly subjectively chosen list of never again directors. When their names pop up on a board, the red flag flutters noisily and vigorously.

The Synlait directors, including the just retired Richardson, are indelibly inked onto the list.

Synlait, properly governed, should have had a permanent competitive advantage, it should have grown to be an example of how to add value to a commodity.

Synlait now is at the mercy of its Chinese and ATM shareholders.

What an appalling outcome for investors and New Zealand.

_ _ _ _ _ _ _ _ _ _

Travel

Our advisors will be in the following locations on the dates below:

19 June – Lower Hutt – David Colman

19 June – Christchurch – Johnny Lee

25 June – Napier – Chris Lee

11 July – Tauranga – Johnny Lee

12 July – Hamilton – Johnny Lee

Chris Lee

Chris Lee & Partners Limited

Taking Stock 6 June 2024

AS signalled by the government, Nicola Willis’ presentation of the Crown's budget contained no surprises except for the cynical decision to renege on the funding of modern cancer drugs.

One imagines the public response will see this decision reversed shortly.

What the budget did was to confirm the somewhat grim direction of our current economy, as discussed at our recent seminars. (The seminar notes will be available next week should any client not already on our list wish to receive these.)

Our tax receipts are, and will be, far leaner than our expectation of government spending. 

We will be borrowing far more than any government has wanted to signal, indefinitely (some $19 billion more over the next five years).

We will be reliant on immigration to fill the growing skill gaps in areas like education, health, policing, and construction.

The budget did not tell us anything we did not know.

For investors, the message is to seek your capital growth aspirations by investing in a tiny number of ambitious NZ initiatives, but mostly by heading offshore, looking at the sectors that attract government subsidies and wealth fund “free” money in stronger economies.

AI, technology in general, health treatment, decarbonisation, renewables, data protection, and prefabricated housing seemed to be sectors that have widespread support.

Good luck to those who anticipate free trade agreements, seamless globalisation, an end to wealth and life destroying wars, and good luck to those who invest in the belief that the 2050 climate change commitments will be met.

Good luck also to those who expect a less divided NZ society or any early sign of the necessary tax reform.

One very obvious recent response to the new era came from our retail sector.

Accepting that we have always, like Britain, been absurdly oversupplied with retail shops, we must now acknowledge the recent retail survey that concluded:

- Two-thirds of retailers are pessimistic about their future.

- One-seventh believe they will have closed within a year. 

An observation on the hospitality and accommodation sectors is simply anecdotal.

Both hotels in which I stayed last week advised their conference rooms were increasingly idle, affecting guest numbers, dining room and bar revenue, and thus employment security. Both hotels were using their empty car parks to generate parking revenue from non-guests.

Both noted the business level felt a little like the Covid days, companies and domestic travellers intimidated by the forecasts of diminishing household disposable income and reduced revenues.

The issues for those people who have savings and who rely on passive income are not all one-sided.

Their returns from bank deposits and from corporate bonds remain at levels between 6% and 7.5%. Investors are entitled to believe that the major banks will be shoring up their capital ratios with Tier One securities at rates that could exceed 8%. High rates looked to be entrenched for years.

Investors will know that the overhanging question that related to the 10% of our national electricity generation has been solved.

The Bluff aluminium smelter, quite predictably, has contracted to commit to our renewable energy for more than two decades, meaning there is no hope of electricity cost reductions.

One useful aspect of this agreement is that the smelter will adjust its usage during droughts, meaning Lake Manapouri is effectively a storage lake capable of feeding the grid when there are short-term demand problems.

The power companies will be reliable suppliers of dividends to their investors. Contact Energy is soon to review its dividends, probably upwards.

New Zealand still has a handful of well-governed ambitious companies succeeding on a global scale, and a sawmillers number of fingers representing aspirational companies that might succeed in coming years and enjoy higher share prices.

The budget has done nothing to suppress such ambition or achievement, though social dysfunction will still remain a part of the threat that deters the essential offshore wealth funds needed to paper over our deficits and to pump up the prices and liquidity of our listed securities.

Offshore money is also essential to underwrite, at some sort of level, our property prices and the value of our retirement villages, as well as providing tension in the pricing of our agricultural, horticultural, silvicultural, and aquacultural assets.

The NZ apple grower, picker, packer and exporter, Scales, which also produces pet food, has recently committed very large sums to buy orchards in Hawkes Bay, presumably exploiting the pessimism there after Cyclone Gabrielle.

I suspect the prices paid reflected the willingness of the vendor to sell.

Whether the vendor has been smarter than the purchaser will be clear only in coming years.

The budget confirmed that we will have sticky inflation and relatively high mortgage rates by declaring NZ will be a long-term large borrower and is resisting tax reform.

In so doing the government handed all the aces and the joker to the offshore funders of our deficits, who now know that we must buy their money. That sounds like a sellers’ market dream.

The cheerful abandonment of credible financial management by Robertson cannot be fixed quickly, nor are there any credible solutions other than “winning Lotto” or miraculously improving productivity and growing the economy.

The plan to use mining to obtain growth is clear. Mining may produce a billion or two in exports, hundreds of millions in taxes and royalties, and provide 1000 or two of new jobs.

We need tens of billions of new exports.

The hope that global demand for commodities and rising prices will solve the problems is akin to hoping that Lotto will provide.

Retired investors with competent advisers will be reviewing their risk appetite, focusing on reliable passive income, mindful of persistent inflation, wary of exchange rates, and willing to expose some of any surplus capital to the offshore markets, even if prices there are completely unrelated to discernible value.

They will also now know that a serial defaulter and liar, sex predator and now convicted criminal is likely to be the next president of the world's largest economy.

_ _ _ _ _ _ _ _ _ _

INVESTORS looking to cope with market trends will likely face at least two further changes within the next year or two.

The second will be related to the first.

The US is now moving to contract settlement requirements of what is known as “T+1”, a pithy phrase meaning any American buying a security will need to pay the vendor (or broker) one day after arranging the purchase.

This needs to be put into context.

In the 1970s and 80s, settlements here and everywhere were haphazard, brokers here often using the funds of their selling clients, not to pay those who had sold, but to pay the bills for those other clients who had bought shares, but not paid the broker.

The settlement practices then were illogical, dangerous, and relied on the integrity of the brokers’ directors and shareholders, and on the juggling skills of the back office.

During bull rushes, most parties were winning, especially in the early and mid-1980s, so slow settlements were tolerated.

By 1987, many brokers were using large overdrafts to survive.

The worst managed firms by 1987 were a sneeze away from creating widespread pneumonia, many collapsing, some quite disgracefully having stolen funds from their clients to pay out “more important” clients.

I recall virtually none of these corporate crooks went to jail, and few, if any, ever compensated their victims. I cannot explain that lenience. One or two had nervous breakdowns, maybe one or two were bankrupted, but the dreadful dishonest behaviour was condoned by a legal framework that was inadequate.

A good friend, and now retired investment banker, worked diligently on introducing new market disciplines, resulting in today’s good standards where investors’ money is siloed, and paid to the appropriate person or broker within two days.

Brokers now must have access to funds to cover any defaulting client and will be fined heavily for breaches of settlement rules.

T plus 2 has worked well.

The Americans are now introducing T plus 1.

This will affect investors here, eventually.

Almost certainly, it will lead to investors having to hold credit accounts with their broker at the time the order is placed, as is the case already with various electronic platforms.

Once the US has embedded its new policy, Australia will follow, probably next year, and I guess NZ will follow by 2026.

Instant settlement is also likely to lead to a second trend, making custodial services the most logical consequence of the new settlement requirement. Indeed, for transactions with offshore shares, a custodial service will soon be essential, later this year.

The pricing of this custodial service will be struck by each provider, and no doubt reflected in the costs of broking services.

The benefit to clients might be much easier personal administration. Clients will have electronic access to their personal holdings at the speed of lightning.

Any new standards that minimise the possibility of broker defaults, or broker dishonesty, are to be applauded.

Heaven knows the degree of incompetence and/or dishonesty that led to so many broker failures around 1987, a year when brokers routinely charged 2.5% on each transaction and allowed share traders to settle their nett purchases and sales at month end!

_ _ _ _ _ _ _ _ _ _

ONE growing opportunity for investors is higher deposit rates by funding “private credit”, the global move away from borrowing from highly regulated banks, to borrowing from what I would describe as grossly under-regulated managed funds.

To recap, banks today are required to hold high levels of capital to underwrite lending errors and risk.

The riskier loans require more capital than less risky loans, like home mortgages.

Accordingly, the banks are reluctant lenders to the type of loan that involves little or no security or has no certain means of loan repayment.  For example, property developers now must have real personal substance to access bank funding for developments.

Lending by hedge funds to facilitate share market speculation is an example of risky lending the private credit funds will use in pursuit of high returns.

Because private credit funds have traditionally been funded by pension funds and institutions playing with other people's money, global regulators have stepped aside, accepting that this is a big boys’ game, effectively ruled by “buyer beware”.

However, retail investors are now drifting into this unregulated area, just as they have fumbled their way into other wholesale activities, like unlisted property syndicates, and highly speculative managed funds trading in cryptocurrencies or non-fungible tokens.

Because the private credit funds need to hold no capital, their nett margins are high, enabling them to share higher returns with their funders.

The private credit sector is growing rapidly.

When times are stressed, when our media has been savagely downgraded by lack of revenue, resulting in a flight to the lowest common denominator, some investors pretend that the sugar rush of high returns overwhelms the fear of capital loss.

Indeed, it does have this effect; until it doesn't.

Investors need to reflect on the protective value of the well-conceived regulations that force banks to behave responsibly.

Retail access to high-risk private credit funding should be under the subheading of “oxymoron”.

_ _ _ _ _ _ _ _ _ _ _ _

Travel

Our advisors will be in the following locations on the dates below:

11 June – Tauranga – Chris Lee

13 June – Auckland (Ellerslie) - Edward Lee

19 June – Lower Hutt – David Colman

19 June – Christchurch – Johnny Lee

25 June – Napier – Chris Lee

11 July – Tauranga– Johnny Lee

12 July – Hamilton– Johnny Lee

Please contact us to arrange a meeting office@chrislee.co.nz   

Chris Lee

Chris Lee & Partners Limited