A recent development in the taxation of investment income in terms of article 41 (a) (iv) of the Income Tax Act has dramatically changed the tax environment for investing in foreign bonds. From our point of view this is viewed as a highly positive development.
To start with, here is a short explanation of what these new rules entail. Prior to this new tax ruling, investors who bought foreign bonds were obliged to include the income earned from this investment in their annual tax return.
For many individuals this meant that this income was taxed at their top rate of 35%. The new interpretation issued by the Inland Revenue now allows individuals to have this same investment income taxed at the withholding tax rate of 15%.
Furthermore, since it is a final withholding tax, and similar to the income that is earned on bank deposits where tax is deducted at source, no further tax is deducted nor is there a requirement for this investment income to be declared in your annual income tax return.
Investors who therefore have investments where they are currently paying 35% should consider contacting their investment consultant to ensure that their investment is held in the most tax-efficient manner. This may entail holding the same investment through an investment service provider but this should not cost much and the benefit received from doing this should be substantial and recurring.
It also means that if individuals have funds on bank deposits overseas it is worth considering, where they are earning less than 3%, placing these funds in AAA-rated short-dated investments. This has the dual benefit of: a) improving the returns being earned since yields on these investments are much higher than deposits; and b) taking advantage of the 15% final withholding tax ruling.
World equity markets
2002 was a tough year for equity investors. The third year of the bear market saw the FTSE All-Share have 25% of its value wiped off. At the end of 2001 many commentators suggested that the worst was over.
The same strain of optimism is apparent at the moment, albeit promoted by different commentators - many of last year's prophets are conspicuous by their absence. The end-of-year festivities seem to induce people to drop their guard temporarily and take a more optimistic view of the world than would otherwise be the case.
The truth of the matter is that the future is inherently unpredictable, and the current future seems to be more unpredictable than past futures! Geo-political concerns are preying on investors' minds, North Korea having recently added fuel to the fire. The spectre of terrorism is not going to go away any time soon.
Against this backdrop, poor corporate profitability coupled with question marks over the reliability and transparency of financial statements have left equity investors reeling and seeking a safe harbour in the form of bonds. This safety first approach was a winning strategy in 2002.
Will bonds continue to outperform equities in 2003? Many feel that with interest rates and bond yields at multi-decade lows, the bond market is starting to look toppy. However, it is still too early to call time on the bond rally.
If one looks at the various sectors in the economy, it is hard to find areas where companies are enjoying an element of pricing power. In other words, inflationary pressures are weak. In this scenario, high quality medium-term yields of say 4% can look relatively attractive.
This statement would have been inconceivable at the turn of the century and is testament to just how dramatically things have changed since then. Where does this leave the equity investor? Many equities still do not look compellingly cheap and it is quite conceivable that the equity market will not turn around until the market as a whole is demonstrably and undeniably cheap.
However, it is worth remembering that even in the midst of the doom and gloom, some long only equity investors have made handsome returns, which easily outstrip those of the bond market.
Over 10% of the constituents of the FTSE All-Share returned more than 10% in 2002. Incredibly, Lastminute.com was the top performer, rewarding investors with a 244% return. The bears will point out that over three-quarters of the constituents lost ground in 2002.
We take the view that selective stock-picking, rather than blind index tracking, has the best chance of reaping rewards and simultaneously reducing risk. In this column we will not restrict ourselves to general market comment - this is a means to an end, not the end in itself. The ultimate objective is to make money.
We will attempt to do this by trawling through the UK market and selecting stocks which we believe offer real value and have a good chance of outperforming both the equity and bond markets.
Our first selection for 2003 is Hornby. Hornby designs, manufactures and markets model railways under the Hornby brand and slot car sets under the Scalextric brand. Until recently the outlook for this company was dull, but new management has completely transformed the fortunes of the business by transferring production to low-cost China, simultaneously implementing a quantum leap in quality and increasing the product offering and number of distribution channels.
The financial turnaround has been stunning. Pre-tax profit has risen from £1.1 million in 1999 to £3.7 million for the year ended March 31, 2002. Analysis of the profit and loss (P/L) shows that relatively modest gains in turnover result in disproportionately large gains in profits.
Year-on-year comparisons show that turnover increased 16%, while pre-tax profit increased by 149%. At the interim stage, pre-tax profit was up 108%. At this rate of growth, earnings per share (eps) will hit 52p for the full year.
At the current share price of £5.40, the prospective price/earning (P/E) is 10.4 - hardly demanding for a company which is experiencing such explosive growth. The rating is more akin to that of a mundane utility.
So the valuation looks promising. But will the growth continue? The outlook looks good, judging from the interim accounts: "Looking to the future, the longer term prospects for the Group are excellent. We are continuing to develop exciting and innovative products, many of which will be launched during 2003."
No director could ever be accused of selling his company short, but previous declarations from Hornby have turned out to be realistic and prudent, and there is no reason to suspect that it will be different this time around.
Anecdotal evidence suggests that Hornby products are selling extremely well, and this year we have the added benefit of the Harry Potter train set helping out on the sales front. Furthermore, the product range for 2003 looks promising.
With a solid balance sheet and strongly rising profits, the shares are attractive for growth investors. Income investors will also be attracted by a prospective yield of 4.8%, assuming that the 52p eps is achieved and the payout ratio is 50% (2002: 52%).
Readers who would like to contact Curmi & Partners Ltd or make suggestions can send an e-mail to info@curmiandpartners.com or contact them on 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.