Mark Lister, 6 June 2016

The domestic sharemarket has continued its relentless march ahead, with the headline S&P/NZX50 Index moving through 7000 points recently for the first time ever.

I wouldn’t have picked NZ shares to be up 11 per cent five months into the year, especially after the preceding four years, when annual returns averaged 18 per cent.

Few will deny the market is looking stretched, but at the same time there are some logical reasons for just how solid it has been.

For a start, the NZX 50 is a gross index, which means cash dividends are included when returns are calculated. All of the other major indices track share price movements only, and ignore dividend payments.

This might sound like we’re cheating, but it makes some sense. Dividends are much higher in New Zealand than other countries, and contrary to popular belief, dividends represent the vast majority of returns to share investors here (approximately two thirds since 1992).

Over the last decade, NZ shares are up 109.2 per cent, whereas the S&P 500 in the US is up 64 per cent. However, if we remove dividends the local return falls to 28.1 per cent. Similarly, if we add back dividends to US shares, the return rises to 103.1 per cent.

As luck would have it, the make-up of our market also happens to suit the current environment. In recent years, the weakest sectors globally have been those related to commodities, oil and financials.

The NZX has very little exposure to these types of companies, but we are over-exposed to the most popular trades, which have been defensive, lower risk, high-dividend paying companies. Our market is dominated by these utilities, property, infrastructure and healthcare companies with more predictable earnings.

The weak link for us is the dairy sector, which ironically isn’t represented on our market. Fonterra is, of course, but it’s a processor rather than a producer so it doesn’t feel the ups and down the way landowners do.

Still, on some measures the local market looks very expensive. The price-earnings (PE) ratio of 18-20 (depending on how you measure it) is close to the highest it’s ever been, and is well above the average of the last 20 years, which is around 15.

However, in a small market like ours, historic comparisons are less useful. New companies change the make-up of the index more so than internationally, where there is more depth. We have seen this with the emergence of high-growth technology companies, and even the newer electricity listings have skewed the numbers.

At 5.8 per cent, the current gross dividend yield is only slightly below the historic average of 6.3 per cent. So on a dividend yield basis, the market appears a lot closer to where it belongs.

None of these valuation measures are perfect, and I suspect the truth is somewhere in the middle. The local market is pricey, just like everything at the moment, but maybe not at extreme levels.

Even so, investors would be wise to acknowledge just what a stellar run it’s been, and to keep their feet on the ground regarding where it goes from here.

This article was originally published in the New Zealand Herald on 3 June 2016