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Five point plan for investing in finance companies

This article provides a summary of the Five point plan Philip Macalister outlined on Campbell Live tonight. For more information sign up for the free depositrates.co.nz newsletter. Links are at the bottom of the article.

Wednesday, 22 August 2007

by Philip Macalister

It is totally understandable that investors are worried about the state of the finance company sector following the run of recent collapses.

I think it is important that these events and this sector are kept in perspective. Firstly finance companies play an important part in the New Zealand economy. Their role is to provide funding to businesses which may not necessarily be available through other organisations such as banks.

The nature of this sector means it is higher risk lending, therefore investors should expect better returns than from bank-based investments. Also it is imperative investors don't put all their money into one organisation.

Another point to remember is that the finance company sector has been around for decades. It's not one of these new sectors which tend to offer innovative, creative and "engineered" financial products.

Investors need to be vigilant and ask questions. Abandoning the sector in droves will only inflict more damage and pain on investors.

What is their credit rating and what does this mean?
Not all ratings are created equal. Also a rating does not guarantee a company's success or failure.

There are three major, international rating firms; Standard and Poor's, Fitch and Moodys. The first two have rated a number of finance companies in New Zealand, while Moody's has only rated banks. The ratings they give provide a probability of default.

Many people draw a line halfway down their ratings scales and deem those above it to be "investment grade" and those below to be "junk" or more speculative in nature. I believe this is somewhat misleading and not necessarily helpful to investors. It can be quite sensible to invest in some "speculative" grade companies.

Depositrates.co.nz will explain this concept some more in a separate article. (Sign up for the newsletter using the link below so we can tell you when the article is live).

There are a number of other rating and ranking services available including: Grosvenor, FinanceWatch, Axis, a service from sharebroker Chris Lee and the SQP ranking system. These will be explained in the next article. However, I beleive SQP is something which should be ignored by investors for a number of reasons. The most obvious is that it provides misleading perceptions. For instance at one stage Bridgecorp had a AAA ranking, while Nathans had a CAB.

Who is running the company and what is their history?
Financial services firms are as much about people as well as numbers. My key point is that investors should check out the backgrounds of people involved in companies and decide whether they want these people to look after their money. Again more on this later.

What is being said about the company?
After the Bridgecorp collapse I asked myself this question: Was there sufficient publicly available information which would have led me to choose another company over Bridgecorp. While there was positive as well as negative news, I believe there was enough information, and that the media had done a good job here. For instance Bridgecorp's problems with loans in Fiji, a run in with the Australian Securities and Investment Commission and the Westpoint collapse in Australia were reported.

Investors need to read about what is happening. Depositrates.co.nz is one source of news to watch.

Do you understand what the company does?
Look at what your prospective finance company does. Do you understand it? If not walk away. Nathans' listed parent company VTL is a good example. Read the NZX releases (available on ShareChat.co.nz
here) and see if you understand them.

Likewise Bridgecorp disclosed sufficient information to raise a warning flag. Provincial Finance entered into an area where its management had no expertise.

Do the returns justify the level of risk?
Finance companies, as mentioned earlier, are higher risk than banks. Look at what a bank offers as a benchmark then measure the finance company against that. For instance a two-year bank term deposit is sitting around 8.00%, and a good finance company is offering around 9.50%. Are you happy that that extra 1.5% is enough to cover the extra risk. You can compare rates using our calculator

Keep up to date with the latest rate changes and news and further "How to Invest" articles by subscribing to the depositrates.co.nz Newsletter. Join here.

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