This is the sixth of a series of monthly articles compiled by Curmi & Partners Ltd, that cover a mixture of educational topics, general market commentary on both local and foreign markets as well as topical subjects that impact your wealth.
In mathematical terms the answer is simple - 0%. While this is a staggering concept, it is unfortunately not too far from reality. History books are being revisited and rewritten in many an area.
The financial industry is no exception. Only last Tuesday the Federal Open Market Committee of the United States cut interest rates by 0.25% to 1%. The last time interest rates were this low was in 1958.
For many investors this is a very worrying thought, especially for those who are retired and looking forward to living a decent life off their hard-earned savings.
Interest rates are used as a monetary tool, almost like an accelerator and a brake in a car - to slow the economy and to help speed up economic activity.
Interest rates in Europe, the UK and the US have been on a downward trend for nearly three years now. Malta has also followed this trend with the most recent cut coming last Tuesday when the Central Bank lowered its central intervention rate from 3.5% to 3.25%.
While the prime objective for reducing interest rates remains that of stoking the fire of economic activity, it also has a knock-on effect for investors, especially investors seeking income.
In today's world of investment it is becoming increasingly difficult to find investments that offer attractive yields. Bonds that were once giving investors returns of 6, 7 and 8% are now yielding 2, 3 and 4%.
And this is before tax is brought into the equation. Is this trend going to continue? This is another one of those 64,000-dollar questions. Nobody knows the answer but one can look at what is happening in the world for guidance to draw conclusions.
Currently there are two major schools of thought in the marketplace and it is unclear which one has the upper hand. There are those who believe that the turmoil the world economies have been through is going to send us into a spiral not unlike the Japanese experience of the Nineties.
Interest rates there are at 0.5% and the economy has been in a state of deflation for some time now. This means that as consumer demand is not strong enough and companies remain with substantial underutilised capacity, the general price level of goods and services is likely to fall instead of rise. Broadly, this means that interest rates will continue to fall and bond prices rise.
The other main school of thought points at the more positive economic indicators flickering away and concludes that the recovery in confidence of the spending public - albeit from a low level - together with the sustained demand for housing and its knock-on effects within the economy will help pull out the economies from their current state of limbo. If this is the case then interest rates throughout the world will rise again.
Our view is that economic growth will come. But not for now. 2003 will be very much a flat year and we expect some real signs of growth to appear in the first half of 2004. If we are correct then interest rates will stop falling at about this time, possibly in the first quarter of 2004.
In the meantime there is plenty of scope for rates in Europe, the UK and the US to fall further, especially in Europe and the UK. Thus, for the time being, it is safe to continue buying bonds in these countries, but not for much longer and not very long-dated ones. Though long-dated bonds offer the highest coupon, they are most at risk when interest rates rise, so investors should watch out for this. Our favoured strategy is to stay short-term - five to seven years - for the next few years.
Malta, on the other hand is slightly different as interest rates here offer a healthy premium of some 1% to those available in Europe. Let's take a look at the new Malta Government Bond issue announced last week.
The government is proposing to raise Lm30 million through the issue of 5.1% bonds due in 2014 and a further Lm33.8 million through the issue of 5.5% bonds due in 2023. Both are being issued at par.
While we agree that Malta offers its own peculiarities in terms of its move towards the Eurozone, one can easily assume that interest rates in Malta will converge with those in Europe. Currently, 10-year bonds in Europe offer yields of approximately 3.8 to 4% in euros.
With the Malta lira having a weighting of 70% to the euro it is easy to see where the price of such bonds should head in the near term. Consequently I have no doubt that once again these two bond issues will be heavily subscribed.
Risk/reward
Take two investments. Company A goes up 10% in one year, Company B goes up 15%. Which was the better investment? Intuitively, many would say that Company B was the better investment since it had the higher return, and with 20/20 hindsight they would be correct.
In truth, there is more to it than that. One cannot simply look at returns when assessing performance; one should also take account of the level of risk that was carried in generating those returns.
We all know that certain shares have the potential of growing profits faster than others. For example, one would expect that in the long run ARM Holdings (UK-listed chip designer) will grow profits faster than Severn Trent (UK-listed water utility) - ARM is in a growth sector. Severn Trent is not.
Not surprisingly, the market has recognised this and has applied a higher rating to ARM. The market is therefore betting that ARM will indeed be able to overcome current industry problems and revert to historic growth rates. The extent to which ARM will manage to do this will determine whether the shares offer value at the current 69p.
There is a wide range of possible outcomes in this respect, and this will lead to volatility in the share price going forward. Severn Trent, on the other hand, has none of the excitement associated with ARM, but its income stream is much more predictable.
Having looked at the two companies, we conclude that we would be more than happy to generate a total return (i.e. capital gains + dividends) of 10% over the next 12 months in Severn Trent, but would require an expected return of greater than 15% to be tempted into ARM, given the level of risk.
Therefore, on a risk-adjusted basis we believe that a potential 10% return on Severn Trent is a superior investment proposition to a potential 15% return in ARM.
Is it too greedy to go for 15% in respect of ARM? Perhaps, and many equity analysts would argue that we should be prepared to accept a 10% return - that is the cost of capital that they might apply to their discounted cash flow models which are used to generate price targets.
That's all well and good; all opinions are welcome in the investment world. Yet we cannot help but look on with incredulity when these same analysts pontificate on TV that a raft of shares are a definite buy and in the interests of disclosure they also tell us that they have no vested interest in any of them!
Why not, you may ask? They obviously do not believe that there is compelling value in the shares they are talking about, yet to fill up airtime they expect viewers to part with their hard-earned cash. Either that or they have no money to invest...
It may transpire that ARM returns 15% or more over the coming 12 months, in which case we would have foregone the extra return. However, successful long-term investing is a marathon event, not a 100-metre dash.
The key point is that if you consistently select investments which offer the most attractive risk/reward ratios, you are investing when the odds are in your favour. And if the odds are in your favour, the law of probability dictates that your portfolio will outperform in the long run.
Hornby - up from 540p to 802p since our January recommendation
Naturally, the Holy Grail in the investment world is low risk/high return. Everybody wants this ideal combination, so you rarely find it! But if you are patient and are prepared to put the time and effort into it, it is possible to unearth jewels which the market has not yet recognised.
Evidence of the validity of this approach is our investment in Hornby. When we wrote out first article in January, we wanted to select a stock which best encapsulated our stock- picking strategy. Back then the markets could see no light at the end of the tunnel. We particularly wanted to pick a stock at a time like that, to reflect our belief that you should not be swayed by wider market issues if you believe in the stock you are investing in.
But which stock to pick? The one with the most upside potential? The one with the least risk? Many investors adopt a highly polarised strategy: maximum reward or minimum risk. We believe this is a fundamentally flawed one-dimensional approach to investing, for the reasons outlined above.
Hornby offered the best risk/reward ratio we knew of back in January, so that is the one we selected. Since then some shares have outperformed Hornby, many others have not. We are clearly pleased that the shares have risen 49%, but we are equally pleased that we carried relatively low levels of risk while generating that return.
Is it now time to sell? A fair portion of the previously unrecognised value has now been recognised by the market. Therefore, the gap to our perceived fair value has been partially closed as the price has risen. Investors with short- term horizons may wish to take their profits at this stage - we would advise them not to adopt short-term strategies and to enjoy their winnings!
Congratulations on having the courage to invest in equities when many were too fearful and stuck to bonds - it will take some time for bonds to generate a 49% return. Long- term investors should ignore unwarranted falls in Hornby's price and hold on for more as the remarkable story continues to unfold.
Readers' comments and suggestions may be sent by e-mail to info@curmiandpartners.com (tel: 2134-7331)
Curmi & Partners Ltd are licensed to conduct investment services business by the MFSA and are members of the MSE. The value of investments and the income derived therefrom may rise as well as fall. Past performance is no guarantee of the future. Any opinions expressed are those of the authors and are subject to change without notice.