The one-egg Kiwi basket

By Michael Coote

Friday 13th December 2002

The new year will usher in a new Stock Exchange. To give its reform the benefit of the doubt, we should suppose a reinvigorated, entrepreneurial bourse will bring new vitality to capital markets. The NZSE should be wished well in its great leap forward.

A challenge for the NZSE, one its proposed AX board might go some way to address, will be to offer a range of listings that more accurately reflect the structure of the economy.

For example, despite heavy economic dependence on export earnings from agriculture, there is little choice for investment in listed companies in that sector.

One way for the NZSE to drive listing sales would be to aim to replicate as nearly as possible the actual percentage composition of industry sectors. The range of listings shows a substantial disjunction between the real economy and the make-up of the sharemarket.

Investors are exposed to undue risk where their choices are confined to a narrow range of industries. They are deprived of the opportunity to diversify out of a limited number of business cycles. The more industry-specific cycles that can be bought into, the better.

Modern portfolio theory (MPT) teaches that investors should pick investments that have low correlation with each other. That is, the cycles peculiar to each investment should be as independent as possible from the cycles of the others. The result is to smooth out overall average returns and manage down risk.

Conversely, to hold investments with high correlation is to have a portfolio that will behave like a school of fish always swimming together in convoy, whatever their overall direction.

Great volatility results, with the whole portfolio swinging widely between highs and lows.

It never fails to surprise, when looking at private share portfolios, how poorly the low correlation concept is understood by investors and their sharebrokers.

It is not unusual to see a significant proportion of capital loaded into, say, a mix of brewers and forestry stocks. Nor do those shares generally appear to be bought in relation to the size of the underlying industrial sector they represent.

Of course, not all industrial sectors would be desirable for such weighting if, for example, they represent sunset industries. And a bias toward growth industries would be sensible.

But there seems to be little logic in the way many direct investors acquire their shares. The NZSE could go some way toward improving the position by making its listing range more rational in structure and balance across the economy.

If the NZSE did, hypothetically, achieve the suggested "look through" into the real economy, New Zealanders would be shocked by what they saw. The truth would emerge that, on an MPT basis, the economy is a badly designed portfolio.

Far too much is weighted in the primary sector and dependent on price-taking export markets. And far too little exports at all; most export-orientated capital is concentrated in mega-firms such as Fonterra.

This is a high-risk, lop-sided, adversely concentrated, high-correlation economy. It needs an MPT-style analysis and overhaul to diminish industrial sector concentration and enhance overall low correlation.

One glaring example is agriculture. Australia is locked in drought and we are told this will be good for our farmers as we replace Australian suppliers. But agriculture in Australia makes up only 3% of GDP and the drought will shave just 1% off economic growth.

Similar conditions in New Zealand would knock the economy for a six. The same applies to a disease outbreak such as foot-and-mouth.

The Australians could shut down their agriculture tomorrow with barely a blip in GDP but for the social and political ramifications. If that was done here, the last one out could turn off the lights. The economy has a fragile, unstable base.

New Zealand Inc could go bust tomorrow if there was an agricultural catastrophe, or for that matter a major seismic event in Auckland or Wellington.

However well the NZSE does with its revamp, the fact remains that Kiwi investors should get a large chunk of their funds offshore if they want to keep their shirts.

The NZSE could help them do this and profit into the bargain if it could increase the number of dual-listings, as Australia's ASX has done in agreements with exchanges in the US and Singapore.

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