Significant financial events can influence more than the profitability of individual businesses. They can alter the investment attitudes of a generation. The Depression was such an event. In New Zealand the share market collapse of 1987 significantly affected investment attitudes. This decade, and more particularly the last two years, is likely to create a similar outcome.

Where to from here for investment?

That impact is not evenly spread however. Investment into shares will take time to bounce back. Property less so. And despite the failure, freezing or closure of numerous income based organisations such as finance companies and mortgage funds, enthusiasm for the latest good rate appears undiminished. Or at least that conclusion could be intuited from the enthusiasm shown in recent months for company fund raising. Recent issues include Auckland Airport, Fonterra, NZ Post, Tower, Contact Energy and AMP.

Corporate Bonds appear to be an attractive investment currently

This form of debt is generally known as a Corporate Bond (higher security) or a Capital Note (lesser security). The rationale is that the company needs to raise funds. Since the world wide credit crisis began in September 2007, it has become increasingly difficult for New Zealand companies to borrow offshore. The international market is not as keen as it was to lend to small companies on the other side of the world.

When an investor purchases a Bond or a Note they are providing a loan to a company. In exchange for the loan, the company promises to pay interest (called a ‘coupon’) to the investor over the life of the investment. The company will pay either a fixed interest rate (for example, Contact Energy’s recent offer of 7.75%) or a variable interest rate, which is usually pegged to cash rates. In the case of a variable rate, if interest rates rise the company will pay a higher rate of interest and vice versa if they fall (a recent example being Westpac’s government-guaranteed floating rate bond, which returns 0.6% over cash rates). Fixed coupon bonds are more popular with retail investors because they create the illusion of security. But just because the company is a household name and offers a fixed return does not make it a safe investment. Household names do strike trouble from time to time.

Are all bonds created equal?

It has been said that the ability of a company to honour its promise of income should be measured under conditions of depression and not of prosperity. It is also necessary to understand that they are not all created equal. In purchasing this investment we should want to be as high up the security ladder as we can. Unfortunately that space is generally already taken by the bank. That Capital Notes differ in security terms to Corporate Bonds is not readily understood by consumers. Some recent Capital Note issues include Fletcher Building, Infratil and Sky City.

Diversification, security and an adequate return for risk taken

Whether times are good or bad the basics of diversification, security and an adequate return for the risk being taken are key. But in income investing those rules are often ignored. One of the worlds’ great investors Benjamin Graham wrote: “It appears to be a financial axiom that whenever there is money to invest, it is invested; and if the owner cannot find a good security yielding a fair return, he will invariably buy a poor one. A prudent and intelligent investor should be able to avoid this temptation, and reconcile himself to accepting an unattractive yield from the best bonds, in preference to risking his principal in second-grade issues for the sake of a larger coupon return.” Food for thought.

Stephen McFarlane is a Chartered Accountant and Certified Financial Planner. He is an adviser with the One to One Group and Triplejump both of whom are based in Timaru. A Disclosure Statement is available on request and free of charge at www.one-to-one.co.nz.

Life just isn’t coming together at the moment (certainly in the imaginary world I’m existing in as I write this article). For starters I had a significant heart attack just over two months ago. I was in a coma for almost a week. I’m going to need surgery but I need to regain my strength first. Then there is the recovery period. I’m told that it could be close to 6 months before I am back at work full time. That is where my problem arises.

My business partner doesn’t seem keen to wait for my return. We had insurance covers on each other should this issue arise. Unfortunately we don’t seem to have completed the paperwork as well as we might. The insurance on my health was owned by him and he has now received the money – in his own name. Thanks very much he said. And by the way “I would like to own the whole business. There is too much uncertainty around your return date and if it is six months then why should I carry the pressure for that long. Sorry mate, but we need to move on”. But my business is a big part of my life. I don’t want to sell.

My make-believe business owner’s situation is unfortunate. In my own business that problem is not going to arise. For starters we considered the possibility that the owners of the policy proceeds are not bound to use them to purchase the shares of the business and that the funds could be applied to a purpose other than that which was intended.  So the insurance proceeds will be received by an independent entity.

And we have signed off a Buy Sell Agreement. This is a legal document which specifies how and under what conditions a shareholder will be required to transfer their shares and the process for doing so.

In the event of my death the transfer to the other business owners is automatic – they won’t end up doing business, or negotiating, with my wife or my solicitor. If I am disabled I get 12 months to get myself back to work. That is a period agreed by all the parties and the cash will be created through insurance to keep the business trading. The risk that we might recover but find that our ownership in the business has gone led us all to see 12 months as a fair outcome.

We have documented a valuation formula for the shares. I don’t want to be negotiating from my sick bed. The agreement specifies that my salary will continue for 3 months. My current account will be repaid after 12 months. I am only entitled to drawings in the interim if the bank balance is at a pre-set level. To the extent that the insurance proceeds have been received I can choose to trigger the buy sell agreement and sell my shares prior to the 12 month deadline if I want.

If there is insufficient insurance funding to buy my shares when the time comes then the agreement allows for the balance to be paid in three equal annual instalments. Interest will be paid on the outstanding amount at the prevailing ASB three month term deposit rate. If there is a surplus then it is to be distributed to shareholders in proportion to their shareholding. The remaining shareholders are required to indemnify me from the date of sale in regard to obligations to which I am a party.

Certainly of outcome is important, particularly at a time of ill health. A Buy Sell Agreement and an independent entity to hold the insurance proceeds are crucial to that.

By Stephen McFarlane

One of the owner’s roles is to be the manager. This is an operational or management hat. Another hat is to be a Director. This is a Board or governance role. Governance and management are two different and separate focuses.

Governance is about determining the vision for the organisation, defining where the organisation is to go. It is about developing strategy and then monitoring performance and progress. It is about delivering value for shareholders. As part of their role a Board may well develop an annual plan including financial and human resources, operational strategies and performance objectives as well as the longer term goals.

If the owner, having completed that task, possibly with the help of independent directors or facilitators, puts his management hat back on his role changes. Having been made aware of the board’s requirements he must now harness the financial and people resources of the organisation. This includes financial planning, accounting, cash flow management, solvency, investment, financial reporting and communication with financing organisations, team building, public relations, marketing, technology and so on.

In allocating and managing resources the owner is guided by the strategic goals delivered to him by the board. Because specific goals are known resource allocation should be more focused and effective. The requirement to report back progress to the Board maintains a focus on the plan and allows the strategy to be monitored and tweaked if necessary.

In a small business the governance and management functions generally meld together. Often the owner is too busy doing the day to day work to think about the longer term in a structured way or to measure progress. By not allocating separate time to each role, the owner risks not completing the governance role effectively. The focus of the business may therefore not be as sharp as it could be at an operational level.

An organisation that has taken the time to plan where it wants to go and to measure progress against that plan is more likely to be successful. The odds are certainly improved. The challenge for the owner of a small business is to recognise the variety of roles that need to be filled and to allocate sufficient time to each to ensure that the business reaches its potential. To wear all the necessary hats, but not at the same time.

By Stephen McFarlane