Financial forum

On January 21 EU finance ministers did what many thought was unthinkable, or at least unachievable. After ten years of haggling they finally came to an agreement on the harmonisation of taxation of savings across Europe.

One of the stated objectives of the European Council of Finance Ministers (Ecofin) was to eliminate "harmful" tax competition across the single European market. Hidden within this statement, though, were a number of different forces at play representing various national interests.

On the one hand England argued vehemently against any form of withholding tax. Its objective was to protect the City of London's commanding commercial lead in the Eurobond market.

On the other hand countries such as Austria, Belgium and Luxembourg refused to give in to the demands of the UK to settle the matter by way of exchange of information. This stance was not surprising given that all three countries earn significant revenues from their financial services industry.

To give an example Luxembourg earns some 40% of its GDP from financial services while it is estimated that Germans alone have some $320 billion deposited in offshore bank accounts. The thought of having to give up their banking secrecy was simply unacceptable. Given these diverging interests it is not surprising that it has taken ten years to get any sort of agreement. Add in to this the Swiss position on the protection of their banking industry and the cocktail becomes even more complicated.

However, after Britain dropped its insistence on exchange of information across Europe a deal became possible. In fact the final outcome shown below reflects a hotpotch of the various positions adopted by the main players. These are the main points of the deal.

All EU countries except Austria, Belgium and Luxembourg are to exchange information with other EU countries on savings accounts and interest received from investments such as domestic and international bonds.

Austria, Belgium and Luxembourg, though, are to operate a withholding tax on savings and interest at the following rates: 15% from January 1, 2004 to December 31, 2006; 20% from January 1, 2007 to December 31 2009 and 35% from January 1 thereafter.

The withholding tax is to be split with 75% going to the member state where the beneficial owner of the savings is resident, 25% to remain in the place where the account is held.

So where do Switzerland and the Channel Islands come into all of this? Not surprisingly Switzerland still holds the key here as Austria, Belgium and Luxembourg have also agreed to lift their banking secrecy if the EU can persuade Switzerland to do the same. Presently this looks highly unlikely but in the meantime Switzerland has also agreed to withhold tax on the same basis as detailed above.

What about the Channel Islands? Well UK Chancellor Gordon Brown, has given assurances that the UK's dependent territories (which include Jersey, Isle of Man and Guernsey) will also conform to this directive. On the other hand statements made by these territories also indicate that it is their intention to maintain a "level playing field" with the likes of Switzerland and Luxembourg. Yet a statement made by the States of Jersey Policy and Resources Department last April also indicated that "Jersey is and cannot be a place where EU citizens can avoid paying their taxes". Believable?

So where do we stand at the moment? Clearly the tax environment prevalent in Europe is changing but at this moment many points remain unclear. For a start, the position that the Channel Islands adopt has not yet been established. From the Swiss angle many practical issues remain unsolved and hence it is possible (read probable) that any final agreement may not be in place by next January.

For example it is not a requirement of the 'know your customer rule" to have on file the tax residency of a client. This would therefore need to be established before any country can comply. Also prudent policy making would require that a complete study of the type of financial assets held in a country be conducted to assess the likely impact of capital flight in the event that either one or the other option is chosen as this may create risks of financial instability at either a national level or for particular financial institutions.

On the other hand though a report just issued by Standard and Poors discounts these risks keeping its AAA status on countries like Switzerland, Liechtenstein, and the Isle of Man.

A meeting to be held this month is aimed at solving some of these issues and finalising what are still draft proposals. It is unlikely that before then the picture will become any clearer. Only after this meeting and once the dust begins to settle can investors reassess their position in the light of the final outcome.

Investing in equity markets

As stock markets continue to struggle, some commentators have begun to question whether equities will ever be viable investments. The simple answer is that they will... at the right price. The skilful investor will always seek to ascertain what the right price is. Let us re-visit the basics of investing.

If John has Lm100 hidden under the mattress, he is foregoing the opportunity to earn interest in a cash account. Banks are willing to pay interest on cash in order to attract deposits. This capital can then be lent, at a higher rate than the bank pays its depositors, to enterprises which will (hopefully) put it to good use. (We can say that a business has put the capital entrusted to it to good use if its return on that capital is greater than its cost. For a company with 100% debt financing, the cost of the capital will simply be the bank's interest). Cash, however, is the most attractive asset since it is the least risky, and returns are correspondingly low.

John may be tempted to lend directly to ABC Ltd in order to receive a higher return. In other words, John could buy a bond issued by ABC. This is a riskier strategy than leaving the cash on deposit, since ABC may not generate returns in excess if its cost of capital and consequently it will be unable to pay the interest on its debts as it falls due.

In a worst case scenario, ABC may incur losses to the extent that it will be unable to repay John's capital. John must decide whether it is worth taking on the extra risk in order to generate the extra return. John decides that the risk is worth taking, and he purchases ABC's bonds.

Demand for ABC's products is constantly increasing, and ABC wishes to build a second factory in order to increase capacity. How will ABC raise the money it needs in order to expand? If it borrows more money it may be unable to pay the interest until the new factory becomes operational. Therefore ABC does not have the option of issuing more bonds. (In theory it could issue zero coupon bonds, but this type of instrument is outside the scope of this article).

However, there is reason to believe that the factory will eventually yield attractive returns which are sufficient to justify the investment. ABC therefore decides to issue equity. John now has a new decision to make. Does he keep his bonds in ABC or does he sell them in order to buy shares with the proceeds?

If he sells his bonds he foregoes the interest he would have received. On the other hand, if he buys the shares he will be entitled to share (hence the word "shares") in the profits which ABC generates. That's the lure, but what is the risk in this context? In simple terms, it is the risk that his share of the profits will be less than the returns on the bonds. He knows that bondholders have to be paid first, and shareholders are only entitled to what is left in the event that the venture fails. Our intrepid investor decides that the factory could prove successful, and the extra return he could make from the shares outweighs the risks. So he sells the bonds and buys the shares.

There are a number of observations which can be made about the scenario above. When faced with investing alternatives, John considered two variables: risk and reward. Like everyone else, he prefers not to take risks unless it pays him to. We have therefore established that there is a positive correlation between risk and return: the higher the perceived risk, the higher the expected return.

When John chose to sell his bonds in order to purchase shares and become entitled to a share of ABC's profits, he was prepared to wait until the second factory became operational. This illustrates the fact that shareholders must be prepared to commit their capital, be patient and bide their time until the business plan is executed. It follows that investors should only purchase shares with patient money, i.e. money that will not be needed in the time period during which the business is executing the business plan which has formed the basis of the original investment decision.

As a shareholder, John's relationship with ABC has now fundamentally changed from creditor to part owner. Whether the shares are quoted or not is irrelevant to the investment decision in the first instance. John is buying into ABC's future income stream and it is the size and quality of that income stream which will eventually determine the future value of his shareholding.

This brings us to the importance of determining the right price that an investor should pay for an investment. Investing can essentially be broken down into three steps: input, process and output. The input is the investor's hard earned cash. The process is the use to which that cash is put. The output is the investor's return. The objective of risk, reward and time horizon assessment is to try and estimate this output. Once this has been estimated, the next crucial step is to determine a fair price.

It is pointless, and downright dangerous, to simply buy into "quality" or "solid" companies, without going the extra mile and assessing whether the price you have been offered is less than your estimated value. This is why we decided to recommend avoiding MIA shares: great company, expensive price. Next month we shall take this line of thought one step further.

Further to our column last month where we pointed out that lastminute.com was the best performer in the FTSE All-Share in 2002, readers asked us whether we have come across any beaten down dotcoms which actually do have a promising business model. Dotcoms are definitely not for widows and orphans, but we shall research this area and report back in the next article. We shall also review Hornby's recent trading statement.

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.