The New Armada

Grave news: A Spanish armada landed on the shores of Britain and conquered, inter alia, a mobile phone network, several airports, some power assets and a mortgage company. These invaders were not armed with anything other than a few spreadsheets and some incredibly cheap finance. No-one was harmed, indeed many shareholders were seen looking rather happy! What can the New Armada tell us about the state of financial markets and can we use it to enhance investment returns in the future?

Essentially, it shows us that liquidity is still abundant in the financial system. If you are a Spanish company, you can currently borrow at 4% (or less). If you pay 30% tax, you will only effectively pay 70% of that 4% interest rate, so the net cost of debt may be only 2.8%! That is true for many companies across the Eurozone, but the Spanish were ahead of the big mergers and acquisitions (M&A) boom because for some time now they have also had one of the highest inflation rates in Europe. Even now, inflation is only expected to fall from 3.6% in 2006 to 2.8% in 2007. So, even in 2007 the real after tax cost of debt will be zero for a Spanish company. What doesn't look attractive when you can borrow for free?

The key issue is that net real interest rates in many parts of the world are extremely low. Spanish companies are simply adopting the financial structures that have proved so incredibly lucrative to the private equity and venture capital industries.

A bemused UK investor sitting with real interest rates at nearly 3% may wonder at this. But the UK is affected as well:consider why sterling has been so strong this past year. It's not because of trade surpluses (we run deficits) - it is because financial players (often banks as well as hedge funds) can't resist borrowing in low rate currencies like the Euro, Swiss Franc and the Yen to buy high yield currencies like Sterling. Variations of this "carry trade" go on throughout the world, distorting currencies, driving down bond yields, property yields, corporate bond spreads and, eventually, dividend yields on equities. In the process, the prices of these income-yielding assets are driven up.

How can we benefit from this? From January 2007 we will be launching a Newton European Higher Income Fund where we will only select companies that offer at least 15% more yield than that of their market. From this group we will then pick companies that are attractive fundamentally and which offer growth in dividends over time.

Clearly, there is the possibility that any stock fitting the bill will probably also appeal to other companies that fund themselves at next to no after-tax, after-inflation cost.

It is not just other corporates that may be interested. Let us not forget the ever-increasing proportions of Europe's leveraged buyout, venture capital and private equity funds all desperate to find investments that can give them a positive spread over their unfeasibly low cost of debt. Also worth remembering are the growing ranks of infrastructure funds and indeed the huge pools of capital tied up in the world's pension funds, that need to generate income streams to meet their liabilities. Even private investors, brought up in an era of high interest rates, find themselves starved of sources of income.

Hence, this fund should appeal to any investor heeding Jane Austen's wise words about the value of an income stream, as well as holding out the potential for more conventional capital gains.

Janus - the god of two faces: the Roman god of gates and new beginnings is shown with two faces to symbolize looking backwards and forwards simultaneously.

Looking back, 2006 began very strongly for the European funds as we benefited from some very strong capital goods and restructuring stocks, only to sell them and move to a more defensive stance ahead of the Q2 sell-off. But then performance faltered in the second half of the year. We were substantially underweight in the utility sector. We focused on the valuation of Continental European utilities (which are yielding much less relative to the market than they normally do) and the difficulties of getting M&A done. The market only had to get the merest whiff of M&A to re-rate the cash flows and dividend streams of the entire sector. Is it too late to buy the sector? We would be more humble now and say that valuations (absolute and against the market) scream "yes - far too late" but against interest rates the answer is far less clear.

Looking forwards, we think that there will be better opportunities elsewhere. The trends discussed above will support the overall market. M&A, leveraged buyouts, venture capitalists, re-leveraging and the hunt for yield may continue to drive markets for some time. What currently seems a very Spanish practice could become common currency by the end of the year.

So which areas will enjoy the limelight in 2007?

We think the telecoms sector offers interesting opportunities. Yields far in excess of the market and even government bonds seem to substantially embed the strategic and technological threats the sector clearly faces…they could become the "utilities of 2007". More controversially perhaps, we find the oil sector quite interesting. Again high yields and good cash flows are the starting point, with the market quite clearly pricing the sector as if we have passed the peak in energy prices. Whilst we may not see crude prices exceed US$70 per barrel again any time soon, we almost certainly don't need to in order to drive higher stock prices. Thematically we believe that the industrialisation of countries like China and India is a secular trend that will underpin global energy prices. If that's the case and oil companies continue throwing off huge cash flows and returning them to shareholders it may only be a matter of time before someone with a negligible cost of debt decides to make a move.