The O'Brien Column: Investors must assess if stocks' earnings justify price re-ratings

Friday 16th March 2001

The idea that the sharemarket will boom on reinvestment of funds freed up from the sale of Fletcher Energy needs to be tempered with a dose of realism.

Investors pushed share prices last week after Fletcher Challenge shareholders approved the sale of Energy to Shell and some to the market's leading companies could go further in the near future. Several of them are still off their highs for the past year as a result of price weakness in the past six months.

Others are pressing their 2000-2001 highs, so investors have to assess the current prices and decide whether the stocks' earnings records and potential profit growth are sufficient to support price re-ratings.

That is, or should be, normal procedure when deciding to buy shares. It is occasionally ignored when euphoria sweeps through a market or a new fad industry attracts attention.

The latter occurred last year when people bought into technology-based stocks, several of which had no earnings record and doubtful short-term prospects.

There will obviously be a flow-on effect to equity investment when the big payout for the Fletcher Energy sale is made, particularly from institutional investors who are likely to change the weightings in their portfolios.

Fund managers usually have a different approach to investment compared to individuals.

Risk management principles lead to a spread of money across the main investment categories of shares, fixed interest securities and property with another division between local and overseas investments.

The funds allotted for local equity investment are then placed in companies based on their relationship to composition of leading indices, with plus or minus questions from the index depending on particular managers' views of the individual company.

Managers might decide to have no funds in a company if they consider the stock is a dog. There is nothing ironcast about the split of money across assets classes, nor about the amount put into a specific equity investment.

Portfolio management is a fluid business because economic and industrial and sharemarket conditions change constantly and need to be monitored regularly to minimise risk.

Management of passive funds differs from the general rules but is still based on a stock weighting principle.

That brings us back to reinvestment of funds from Fletcher Energy.

No competent fund manager should be chasing stock at higher and higher prices merely to preserve a relationship with the index weighting, after allowance for averaging the total cost of the holding in a company.

The manager of a non-passive fund eventually has to look at a share's "intrinsic" value based on the company's operational and earnings potential.

Opponents of that view often base their argument on the point that it is difficult to beat the market regularly without increasing the portfolio's risk profile. Investing passively on the basis of companies' weightings in an index lowers risk because you will always get at least the index return.

Assuming more money is invested in active funds than in the passive variety, it seems to follow that management will eventually reach a point where they consider the market, and/or prices of some individual shares have gone too far.

They will then either stop buying, hold what they have or sell down.

The alternative is to keep lifting share prices until the inevitable reaction sets in and prices ease, or in extreme cases crash, as happened in 1987.

New Zealand shares did well last week, particularly among the leaders, and could continue to rise for some time, although there is likely to be unevenness in terms of rises, falls and "no changes."

It would be a brave person (certainly not a sensible fund manager) who decided to give the raft of technology and e-commerce stocks another run across the board.

There are some solidly-based concerns operating in the sector but most will take time to prove themselves, if they ever reach a stage to justify the price levels of late 1999 and early 2000.

The general outlook for the market appears reasonable, apart from the Fletcher Energy factor. Rural service and tourism companies have lifted their earnings, subject to a few that had difficulties in Australian operations, the local economy has picked up generally and the dollar is showing more stability than it had towards the end of last year.

There are other elements to be considered in relation to the Fletcher Challenge breakup and its effect on the sharemarket.

The listing of Rubicon will be watched with interest.

Rubicon is supposed to "commercialise new technologies that have the potential to capture high-growth, high-margin opportunities in emerging industries," according to FCL publicity.

That may eventuate but the inclusion of a network of retail petrol operations and a 14% holding in NZ Refining looks a bit out of place under that business definition.

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