This article originally appeared in the NZ Herald.
As 2016 comes to a close there are a number of issues that continue to have an adverse impact on the country’s investment markets.
These include: overpriced IPOs, NZX trading rules that favour stockbrokers over investors, the increasing use of “adjusted” or “normalised” profit figures and the director appointment process.
These are recurring themes yet little has been done to resolve them. Confidence in the NZX won’t be fully restored until these issues are addressed.
The overpricing of IPOs is a major problem that erodes investor confidence in the domestic sharemarket.
The partial sale of the Crown’s electricity generators went well but the performance of a large number of private sector IPOs has been poor.
These include: Wynyard (down 100 per cent from its IPO price and no longer trading after being placed into voluntary administration), Intueri Education (off 98 per cent), Energy Mad (96 per cent), Serko (74 per cent), SLI Systems (73 per cent), ikeGPS (65 per cent), Orion Health (64 per cent), Eroad (44 per cent), Moa (38 per cent) and Tegel (6 per cent).
However, it is important to note that a number of IPOs have performed extremely well while a third group have had positive returns but have underperformed the overall market.
IPOs are overpriced for a number of reasons including: companies are not ready to list, directors are far too optimistic and private equity promoted IPOs often have overvalued share prices.
In addition, existing controlling shareholders are incentivised to have high offer prices because this reduces the dilutionary impact of capital raisings on their shareholdings.
It is a shame that controlling shareholders and independent directors don’t take a longer-term view when setting the IPO price. Many controlling shareholders don’t realise that if an issue is overpriced, and the share price falls post listing, they will have limited ability to sell shares.
They would be far better advised to pitch the IPO price at a lower level, thereby creating strong after-listing demand. This would give them the opportunity to realise value by selling shares into a rising market.
New ASX IPO rules introduced this week will curtail the listing of immature companies across the Tasman. The NZX should consider adopting these new rules.
The second item is the NZX, particularly its structure and trading rules.
One of the unique features of the NZX is that 66 per cent of trading, by value, is done off market compared with only 11 per cent in Australia and 2 per cent in the Asia-Pacific region.
These crossings or off-market trades are where brokers match buy and sell orders without putting them through the market.
The vast majority of trading, by value, is done off market in New Zealand because NZX rules do not encourage brokers to place orders through the market.
This puts market participants at a huge disadvantage compared with brokers for a number of reasons including:
The NZX has no market makers (firms or individuals that provide market liquidity by agreeing to buy or sell shares in certain companies). This means that a handful of brokers completely dominate the New Zealand sharemarket.
Most of these broking firms have substantial private wealth operations. Consequently, brokers can cross orders from their private wealth clients with orders from external clients without putting these transactions through the market.
Brokers often have proprietary books, whereby they buy and sell shares on their own account.
This is common practice offshore but individual New Zealand brokers can receive orders from external clients while simultaneously managing a proprietary book whereas these two operations are clearly separated offshore through Chinese wall requirements.
These proprietary books represent a clear conflict of interest for brokers, in the same way real estate agents are conflicted when they buy and sell properties on their own account.
Lax NZX off-market transaction rules mean that NZX market liquidity is extremely poor, as is price discovery. Brokers want to maintain the status quo because they receive commission on both sides of a crossing or off-market transaction.
A predominance of off-market crossing also discourages the establishment of new broking firms.
The upcoming appointment of a new stock exchange CEO is extremely important because he or she will have to focus on changing the crossing and proprietary book rules to ensure that market rules are fair to all participants. An increase in on-market trading would give a huge boost to the NZX.
There is a strong probability that the NZX will be absorbed by a foreign exchange, probably the ASX, within the next decade unless its market rules are changed.
Another issue is the increasing use of “adjusted” or “normalised” earnings rather than official IFRS (International Financial Reporting Standards) earnings.
Most of these adjustments are made by listed companies while the vast majority of 100 per cent Crown-owned entities continue to emphasise IFRS figures.
A New Zealand academic paper, “Pro forma earnings, adjustments and IFRS adoption”, published by John Crowley, David Lont and Tom Scott earlier this year noted that changes “in accounting standards can have unintended consequences through shaping the non-statutory information that firms provide”.
The Financial Markets Authority (FMA) has a guidance note advising that these adjusted earnings figures should not be given undue prominence, emphasis or authority.
The Crowley, Lont and Scott study showed that 47 per cent of NZX-listed companies reported adjusted earning in 2004, increasing to 57.8 per cent in 2013. A Deloitte report found that 34 of the 50 largest companies report adjusted earnings.
The academic report illustrated that adjusted figures are usually higher than IFRS figures and companies have the remarkable ability to turn IFRS losses into adjusted profits.
The Crowley/Lont/Scott study does not seem to be concerned about these adjusted earnings figures, as long as firms provide a clear reconciliation between the two figures.
This column takes a more cynical view of adjusted profit figures, mainly because of the ability of rogue companies to make inappropriate and flattering adjustments that are not subject to audit certification.
Last, but not least, is the director appointment process.
The modern trend is for companies to engage an executive search company to lead the director search process.
These executive search firms are incentivised to recommend individuals that will be familiar to board members.
These are usually conservative choices because it takes much longer to convince a board to accept a left-field choice, particularly a younger person who is not well known.
The most frustrating aspect of this process is that companies, executive search firms and potential directors rarely engage with shareholders during the process. The existing board, with the help of a conservative executive search firm, appoints new directors without shareholder input.
In addition, there is clear evidence that some chief executives play an important role in the director selection process.
The CEO interviews potential candidates with one or two existing directors and the recommendation of this small group goes to the main board. The appointment is made without the new director being interviewed by the full board or the chairman.
The unwillingness of companies to engage with shareholders during the director selection process is unfortunate because this column is aware of at least one company that had a highly successful board refreshment following shareholder consultation. This organisation is now one of the NZX’s best performing companies.
Progress in New Zealand is often painfully slow because of the entrenchment of the old boys network, particularly at the NZX and as far as director selection process is concerned.
Next year could be a watershed year if we could start dismantling these entrenched positions.
Milford Funds Ltd. holds shares of Orion Health and Serko on behalf of clients.
Disclaimer: This article originally appeared in the NZ Herald and is intended to provide general information only. It does not take into account your investment needs or personal circumstances and so should not be viewed as investment or financial advice. Ifyou require financial advice we recommend that you speak to an Authorised Financial Adviser.