Prime Minister John Key’s partial privatisation programme was dealt a major blow this week when the Labour Party announced proposals to regulate the electricity industry. It is too early to assess the impact of these proposals on demand for Mighty River Power shares but, if implemented, they would be a major backward step for the economy. There are a number of reasons for this, including:

• The recent rise in electricity prices has occurred while the sector has been majority government-owned. The best way to create a competitive environment would be to have all of the electricity generation companies listed on the NZX.

• Telecommunication and airline prices have declined substantially since Telecom and Air New Zealand were privatised. Would tele-communication prices be low today if Telecom was still government-owned?

• Figures released this week show that New Zealand’s annual inflation is only 0.9 per cent but central and local government charges rose by 4.5 per cent. Prices for government-controlled services, including health, education and electricity, continue to rise at a far more rapid rate than private sector prices.

• Labour’s announcement will probably reduce the price the Crown receives for Mighty River Power. This will have a negative impact on all taxpayers.

• KiwiSaver now has 2.1 million members, many of whom will have holdings in the existing listed electricity companies. Labour’s proposals will adversely affect the retirement savings of these KiwiSaver members.

The best way to keep prices down is to ensure there is a competitive market rather than heavy-handed price regulation that is more reminiscent of the Muldoon era.

It is highly unlikely we would have had the massive advances in technology in the telecommunications industry, and substantially lower prices, if the Government had introduced heavy-handed price regulation to this sector in the early 1990s.

Meanwhile, sharemarket indices and their composition are back in the headlines again as markets hit record highs and the Mighty River Power (MRP) share issue opens.

Indices are important because they will have a big influence on the demand and issue price of MRP shares. They also influence day to day market trading and investors’ perception of the NZX’s performance.

There are two types of sharemarket indices; capital indices and gross or accumulation indices. The former takes into account capital movements only whereas the latter includes dividends and assumes the reinvestment of these dividends.

The world’s most widely quoted sharemarket indices, with the notable exception of the NZX, are capital only. Former NZX CEO Mark Weldon changed the benchmark NZX index from capital to gross in the early 2000s. The effect of this change was to give the impression that the New Zealand market was performing much better than it was, particularly compared with overseas sharemarkets which generally used capital-only indices.

The benchmark NZX index was established in January 1957 with a base of 100. It was originally known as the NZUC Index, then the Barclays Index and NZSE40 Capital Index.

The original index allowed us to assess the performance of the domestic stock exchange on a consistent basis from 1957 until the early 2000s and to compare it with other markets.

Between January 1957 and September 18, 1987, the market’s all-time high, the benchmark capital index surged from 100 to 3969 whereas the Dow Jones Industrial Average (DJIA), a capital index, increased from 479 to just 2525 over the same period.

In other words, the NZX outperformed Wall Street over this 30-year period, albeit most of the outperformance was in the 1984 to 1987 period.

Since then it has been completely the other way around with the DJIA going from 2525 on September 18, 1987 to 14,540 this week while NZX’s main capital index, now called the NZX50 Capital Index, has fallen from 3969 to 2483 over the same period.

The NZX introduced gross indices in 1986 but they were not widely accepted because of a number of inherent flaws, including:

• Gross indices assume that dividends and capital repayments are always reinvested when this is usually not the case.

• Dividends and capital repayments are assumed to be reinvested across the index at closing prices on the ex date, not the date the dividend or capital is distributed. If the market has moved up by the time the dividend or capital is distributed then investors can only reinvest the money in shares that are more expensive than they were on the ex date.

• The gross index assumes that no tax is paid on dividends even though some companies pay taxable dividends.

The assumed reinvestment of all shareholder distributions on the ex date gives a gross index a huge upward bias compared with a capital index. This is particularly true over the longer term because of the compounding influence of reinvested dividends and capital distributions.

This is clearly demonstrated in the accompanying table.

In the 20 years ended March 31, 2013 the NZX50 Capital Index was up 55.3 per cent whereas the NZX50 Gross Index soared by 412.3 per cent. These figures clearly demonstrate why Weldon encouraged the media to treat the NZX50 Gross Index as the stock exchange’s benchmark index instead of the NZX50 Capital Index.

Thus media reports now refer to the NZX hitting an all-time high whereas the capital index is still more then 35 per cent below its September 1987 peak.

One of the interesting features of the NZX is that smallcap companies have comprehensively outperformed the market’s 10 largest companies included in the NZX10 Index.

These 10 companies are Auckland International Airport, Contact Energy, Chorus, Fletcher Building, Fisher & Paykel Healthcare, Infratil, Ryman Healthcare, SkyCity, Telecom and Trade Me.

In the 20 years ended March 31, 2013 the smallcaps outperformed the top 10 by 197 per cent to 37.5 per cent on a capital basis and by 825.6 per cent to 352.4 per cent on a gross basis.

Another feature of modern sharemarkets is the large number of passive funds or funds that are required to stick very closely to the weightings of a benchmark index. This is particularly relevant as far as the Mighty River Power IPO is concerned.

Company weightings in the NZX50 Gross Index range from Fletcher Building with 12.53 per cent to Telstra with an index weighting of just 0.34 per cent.

In other words, a passive fund, which is required to totally replicate the NZX50 Gross Index, will have to weight its portfolio identically to the benchmark index, with Fletcher Building representing 12.53 per cent and Telstra 0.34 per cent.

Mighty River Power will have an estimated weighting of around 3.5 per cent in the index.

Therefore a $300 million passive fund will have to purchase $10.5 million worth of shares to ensure it meets its index weighting requirements.

Its ability to achieve this will depend on the level of individual applications. If there is strong individual demand then there may not be enough shares available through the IPO to satisfy index benchmarked funds and they will have to purchase shares on market when MRP lists.

If individual demand is low then these index oriented portfolios may be able to acquire all the shares they wish through the IPO and will not have to purchase shares on market after listing.

The movement of companies in and out of an index has an important influence on their share price performance as index aware funds have to purchase companies that are added to an index and sell those that are removed.

These index weightings should also have an impact on the demand for Mighty River Power shares, although Labour’s regulatory proposals may now overwhelm this consideration as far as institutional investors are concerned.

Gross Indices – Doctoring up the NZX’s performance


Ten years ending

Twenty years ending 31/3/13




NZX50 Capital Index




NZX50 Gross Index








NZX10 Capital Index




NZX10 Gross Index








NZX Smallcap Capital Index




NZX Smallcap Gross Index




Brian Gaynor

Portfolio Manager

Disclosure of Interest: Milford Asset Management will be participating in the Mighty River Power bookbuild process. Milford holds Telecom, Air New Zealand, Auckland International Airport, Contact Energy, Chorus, Fletcher Building, Fisher & Paykel Healthcare, Infratil, Ryman Healthcare, Sky City, Trade Me and Telstra shares on behalf of clients.