BT: Bear in mind shifting equity risk premiums (09 Sep 2006)

Business Times - 09 Sep 2006


Bear in mind shifting equity risk premiums

By TEH HOOI LING
SENIOR CORRESPONDENT

THE Straits Times Index is currently trading at between 11 and 12 times its historical earnings. Based on weekly data from Thomson Financial Datastream, in the last two decades the index traded to a high of 35 times and to a low of nine. The average is 18 times and the median 16.

So we are at the low end of the historical PE range. Going by past patterns, there should be significant room for the STI to move up. That is true if conditions prevailing today and those expected going forward are similar to what we've seen in the past 20 years. But, the world has changed a lot since the 1980s.

In a report two months ago, UOB Kay Hian said Singapore stocks may be trading at valuations lower than historical figures, but that does not necessarily mean that the market has become cheaper. While it is quite a common practice for investors to look at the fair price-earnings (PE) ratio of the market using the historical valuation range, this could be misleading as the historical PE band could have shifted, it said.

Based on the findings of its study, UOB Kay Hian said market players have implicitly accorded a higher risk rating on Singapore equities in the post-2000 period. 'The main guiding parameter is in the higher equity risk premium (ERP) of the market in the post-2000 period vs the pre-2000 period,' it said.

The higher risk rating could be attributed to the maturity of listed Singapore companies now seeking new growth avenues by expanding their exposure to the overseas markets where risks are normally higher.

Among the stocks which have seen risk premiums rated upwards since as far back as 1997 are Keppel Corp, Keppel Land, OCBC, Neptune Orient Lines and SingTel. Stocks which have a shorter history were not included in the study.

Based on the risk premiums accorded to the market, the trading range in PE terms could now have shifted to between 10 times and 14 times, from between 16 times and 25 times previously. 'Hence, it would be quite misleading to talk about the market being cheap from a historical perspective,' said UOB Kay Hian, Singapore's largest broking house. 'Because of this, we believe the next historic low for the Straits Times Index could be at a PE of as low as 10 times.'

Indeed, regular readers of this column would have seen the chart showing the rough estimation of historical equity risk premium (ERP), which I derived from market PE and the one-year interbank rate as a proxy for risk-free rate. The chart - which I updated yesterday - clearly showed that since 2001, the ERP has shifted upwards to 5 per cent and above. The average and median in the last 20 years are between 2 and 3 per cent.

The movement of equity prices is determined by the expected future equity risk premium or investors' expected appetite for risky assets, the expected level of interest rate, and the expected earnings of companies.

Larger returns

A study by Dimson, Marsh and Staunton from London Business School found that the mean annual real return on equities in 16 major economies in the first half of the 20th century was 5.1 per cent, versus 9 per cent over the next 53 years.

The larger equity returns earned during the second half of the 20th century are attributable to at least four factors, the authors said.

First, there was rapid technological change, unprecedented growth in productivity and efficiency, and enhancements to the quality of management and corporate governance.

'As Europe, North America, and the Asia-Pacific region emerged from the turmoil of the Second World War, expectations for improvement were limited to what could be imagined. Reality almost certainly exceeded investor expectations,' they said.

Corporate cash flows grew faster than investors anticipated, and this higher growth is now known to the market and reflected in higher stock prices.

Second, transaction and monitoring costs fell over the course of the century, and this underpinned rising stock prices. Third, in the last two decades of the century, inflation rates generally declined and real interest rates rose, and this had a further impact on the stock market.

Finally, stock prices have also risen because of a fall in the required rate of return due to diminished business and investment risk. Business risk declined as the economic and political lessons of the 20th century were absorbed, international trade flows increased, and the Cold War ended.

Investment risk diminished over time as investors gained from the benefits of diversification, both domestically (through a wider range of quoted securities and industries, and through intermediaries such as mutual funds) and internationally (with the disappearance of impediments to foreign investment).

Diversification, said the authors, allowed investors to lower their risk exposure without detriment to expected returns. Factors such as these, which led to a reduction in the required risk premium, have contributed further to the upward re-rating of stock prices.

So, in other words, one way to determine the future direction of a market is to predict how the equity risk premium will change. And the first step is to ascertain the implied premium currently reflected in the prices.

Using the discounted cash flow model, we can also derive the implied equity premiums of the various markets if we have their price levels, their dividend yields, and also an assumption of their growth. If we assume that dividend payout will grow at a constant X per cent to eternity, the discount rate is simply the dividend yield of the market plus that dividend growth rate. And the equity premium is that discount rate minus the risk-free rate.

I made the calculations two months ago. Based on a conservative 3 per cent dividend growth rate till eternity, among the markets I looked at, Taiwan had the highest equity premium, followed by the Nikkei, the Kuala Lumpur Composite Index, and Singapore. But since then, it was the two markets with negative implied equity risk premium - India's Sensex and Indonesia's Jakarta Composite Index - which chalked up the biggest gains, in excess of 12 per cent.

Strong gains

Others with low implied risk premiums and yet managed to post strong gains are Hong Kong's Hang Seng Index and South Korea's Kospi Index. In most of these markets, the risk-free rates were on the high side. It was the easing of the risk-free rates which helped in raising the valuations of equities.

So in the case of Indonesia, if you expect the general interest rates to continue on a downward trend, its companies to show continued improvement in their bottomlines, and that there be no change or a decline in investors' aversion to equity risks, there may be room for prices to climb.

Still, buying a one-year government bond will yield a near-12 per cent return in rupiah terms. Equities definitely have to promise a return of much more to be attractive to investors. In Taiwan's case, its implied equity risk premium actually rose in the last two months, no doubt due to the uncertain political situation there.

As for Singapore, has equity risk premium moved permanently higher as a result of companies seeking new growth from overseas market as argued by UOB Kay Hian? Perhaps that's one of the reasons. Another could be the insecurity of a guaranteed regular income. It has been shown that attitudes towards risk can be affected by the prospect of being liquidity-constrained and by the presence of additional uninsurable risks.

Thus, individuals facing high labour income risk - which is normally uninsurable - will be more risk-averse and thus avoid exposure to portfolio risk by holding fewer risky assets, or none. The insecurity of jobs has been one of the main features of the new economy.

This could be another reason for the higher ERPs since 2001. (It should be noted that the ERPs shown in the chart are historical ones derived from earnings yield, while those in the table are implied premiums based on current price levels and certain levels of expected dividend yields.)

So will the ERP in Singapore expand or diminish? Politically, the risks appear low. Meanwhile, the domestic economy and job security are continuing to improve. Corporate Singapore is expanding into fast growing countries in the region. And as most companies have paid 'tuition fees' in their initial forays into foreign countries, arguably those lessons and experience will put them in good stead in future projects. If the US manages a soft landing in its economy, and as long as the earnings growth outlook can be maintained at a healthy pace, there is no reason why domestic equities will not get re-rated.

The danger is a US recession leading to a global recession and some unexpected nasty surprises lurking in some dark corners of the world.

The writer is a CFA charterholder, and can be reached on hooiling@sph.com.sg

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