Are NZ equities a buy?

29 Jan 2021 was an important date if you were an asset allocator. That was the date when the US equity market went on a tear relative to the domestic NZ market.  A strengthening US Dollar has made the differential even more pronounced.

Over the last 5 years [1], the US [2] market has generated returns of 17.3%, compared with only 2.2% for the domestic index [3] (both annualised in NZD). That 17% annualised is well above the 30-year average of 10.7%.  However, in July, the domestic market has staged a bit of a fight back. Last month, Kiwi stocks were up 5.9% whereas the US gained 3.3%.

Rather than focus on the one-month outperformance, we believe it is instructive to first reflect on why NZ has been such a desultory place to invest over the past three and a bit years.

We see two key reasons why NZ stocks have underperformed:

1.      The structure of our market relative to offshore and,

2.      A weak domestic economic environment

1.      Market Structure

Tech Exposure

Technology stocks make up over 30% of the S&P 500 – contrast that with less than 2% in the S&P/NZX 50 Index. For several years, technology stocks have been the main drivers of US (and global) market performance. We wrote in January about the ascendancy of the ‘Magnificent 7.’ Over the last couple of years, these stocks with their links to the Artificial Intelligence (AI) thematic, have generated outsized returns and fuelled much of the broad market rally.

Here at home, Serko is one of the largest technology names in the NZ index. It has a market cap of NZ$500m (for context, Microsoft has a market cap of NZ$5+ trillion) and is a travel management company with no direct AI links. It is down 57% over the last 3 years because of concerns around the discretionary nature of travel and the renegotiation of the Booking.com contract.  

Yield sensitivity

Aside from tech exposure, the other big difference between the NZ Index and the offshore markets, is our exposure to real estate investment trusts (REIT’s) and utilities.  27% of our index is in these two sectors while the S&P 500 has less than 5%.

These sectors tend to be particularly sensitive to changes in interest rates. Higher rates usually lead to stock price declines. This is because these stocks typically pay large dividends and are more highly geared. In an environment where the yield on term deposits is commensurate with the yields on these stocks (and if you perceive the potential for capital gains to be low), you would naturally want to take the ‘safe’ cash yield rather than the stock risk. In addition, more leveraged entities face a higher interest cost burden than companies with large moats.

Given the large utility and real estate weighting in our index, our market is disproportionately impacted by higher rates.

Small cap versus large cap

Globally, small cap [4] stocks have materially underperformed large cap stocks. This underperformance has been significant. In the three years to June 2024, global large cap [5] stocks have delivered a 21% total return while global small cap [6] stocks have fallen 2%.

The underperformance is an outcome from some of the reasons mentioned above (the dominance of large cap technology stocks). But there is a myriad of other plausible reasons for the underperformance of small caps. Some possibilities include the growth of passive investing, ongoing concerns about a recession, higher levels of leverage or the greater vulnerability of smaller businesses.

The median market cap [7] of the S&P/NZX 50 Index is c. $640m whereas the median market cap of the S&P 500 is $35bn. Even Australia’s (ASX 200) median market cap is almost four times larger at $2.5bn.

Flows into larger companies have squeezed out smaller companies and reduced their liquidity. This filters through to our market - the NZ market is at a low ebb in terms of flows with transaction volumes reaching multi-year lows at the start of this year.

NZ is under owned, even domestically

According to the Reserve Bank of New Zealand, the amount of NZD in term deposits reached almost $220bn in May 2024. That is the highest level since the start of the data series in 2016.

Looking at the split between international assets and domestic assets within KiwiSaver portfolios, back in 2008, it used to be c. 60% local 40% international. Today, that ratio has flipped where 60% is international and 40% is invested locally.

Cash is on the sidelines earning high yields in term deposits and investors have followed performance – moving out of NZ assets and into offshore assets.

Domestic Economic Environment

New Zealand was one of the first countries to start its rate hiking cycle, others followed suit. Our central bank rates now match those of the US, but our GDP certainly doesn’t!

While our growth rate has bumbled along near 0%, dipping in and out of recessionary territory, the US has remained resilient with its last GDP print coming in just above 3%.

Higher interest rates have impacted our consumer base more meaningfully than the US because the pass through of central bank policy into mortgage rates is more direct.

US homeowners tend to have 30-year fixed mortgages, so you only feel the sting of the rate hikes when you move house. Here, we have shorter loan terms (often 2 year fixed) and a bigger proportion of floating rate mortgages. The rate hikes here feed directly to the consumer which in turn has caused house prices to drop and consumption to decline. Those without mortgages have endured a much higher cost of living in recent years.

In addition, the new government has been on a cost cutting exercise, actively retrenching jobs in the public sector. Private sector job losses have also picked up. Tight monetary policy, tight fiscal policy and a cost-of-living crisis is an unpleasant cocktail and New Zealanders are certainly not enjoying drinking it!

 With all of this as the backdrop, how on earth does one begin to get excited about domestic stocks?    

Looking forward

The first point to note, is that the NZ stock market is not the NZ economy. The stock market is largely utilities and healthcare, it has very little domestic consumer exposure. What domestic consumer exposure is in the index, has been significantly repriced[8]. Markets are forward looking – much of the economic weakness we as consumers are now feeling has been recognised and priced into the market.

The second point to note, is that the weak NZ economy will force the RBNZ to act, particularly now that inflationary pressures have waned. We think the RBNZ will be forced to cut interest rates quicker and more deeply than they have been projecting. In addition, the RBNZ takes an extended summer break from December through February. There may therefore be a lot of pressure on them to make the November cut count and see them through to 2025.

And, as we have articulated above, we are a yield sensitive market. In fact, we have become an even more yield sensitive market. The proportion of ‘cyclical’ stocks has declined significantly and what is in place now, is a market with ‘structural growth’ characteristics and ‘defensive yield’ characteristics. A rate cutting cycle, both domestic and international could be more of a positive for the NZ market than others.

The third item, and probably the most important one, is that valuations do not look expensive. The 12-month median price-to-earning (P/E) ratio of the index was 14.6x at the end of June – back to levels seen c. 10 years ago. The market weighted forward P/E is higher, skewed by the large weight in Fisher & Paykel Healthcare. But this is a stock which deserves a higher valuation given its low debt levels and high growth rate. In addition, FY 2025 expectations with respect to sales growth, earnings per share growth and gross yield all look very positive and attractive.

July saw a reversal in sentiment – NZ versus the US, small caps versus large caps. Will this persist? One swallow doesn’t make a summer, but what it does indicate, is that a reversal in some of the themes that have been in place for an extended period should benefit NZ equities. It was also interesting to see that the recent capital raise by Infratil (upsized to $1.2bn) was easily absorbed by the market which implies that there is cash ready to be committed to the market for the right transaction at the right price.

In addition, much of the negative economic sentiment has now been priced into our market. We can never know for sure if there is more pain to come or when interest rate cuts will materialise, but what we do know from a stock picking perspective, is that there are plenty of interesting domestic opportunities to include in our NZ focused portfolios.  

[1] To 30 June 2024
[2] S&P 500 Total Return Index
[3] S&P/NZX 50 Index (Gross)
[4] Cap refers to the market capitalization i.e. the value of a company traded on the stock market with small cap being  stocks with a market cap of <US$2bn, large cap >US$10bn.
[5] MSCI All Country World Index Large Net Total Return Index
[6] MSCI All Country World Index Small Net Total Return
[7] Median is the middle number in a sorted list of numbers. We use the median when large numbers might disproportionately skew the average. The median market cap is the midpoint market cap of the index.
[8] SkyCity is down a third, Kathmandu has halved, as had the Warehouse Group until its recent bid.