Pricing equity risk appetite
Historic excess returns from equities tell us little about the risk premium embedded in valuations at any given time. Toby Nangle and Hartwig Kos explain how a forward earnings-based model allows them to take account of extreme economic scenarios that could disrupt those earnings
Warren Buffett famously said that investors, if they were to insist on trying to time equity investments, "should try to be fearful when others are greedy and greedy when others are fearful". This wonderful aphorism raises the issue as to how much fear or greed is priced into markets.
While fixed income investors will differ in their risk assessments of a given bond but agree on its yield, equity investors tend to disagree on both risk assessment and valuation methodology. Equity ownership is a claim on the earnings of an enterprise or set of enterprises, the path of which are unknown and unknowable. Because the equity risk premium (ERP) is both unobservable and volatile, it is unsurprising that portfolio allocations and investor estimates for risk premia differ wildly.
The ERP is defined as both the risk premium available from equities and the excess return delivered over the ‘risk free rate' delivered by equities in the long run. Historically, one can simply take the average excess return of equities over bonds over a certain time horizon. However, without making heroic assumptions, this approach tells us little about how equities might perform in the future.
The main challenge is constructing a fundamental valuation model. There are three principal model specifications: dividend discount models, free cash flow models and residual income models. These differ in their interpretation of corporate profitability and shareholder value. We have applied a forward-looking dividend discount approach to estimating the ERP, which has the merit of being relatively simple, and is sufficiently robust to facilitate stress-testing.
We assume that the only cash flows associated with equity ownership in the long term are dividends. An equity market, like a single company, will have a current dividend level, and to calculate the value of the market we need to project payments into the future. Dividend payments are a product of the level of earnings and the proportion of earnings paid to shareholders. We have observed that payout ratios are mean-reverting over the medium term, and for the purposes of our ERP model, we project them to mean revert on a five-year horizon. This leaves us with the thorny issue of prospective earnings growth.
Barings has access to the full set of investment bank analyst earnings forecasts data. We aggregate these earnings forecasts for individual stocks to arrive at a consensus forecast for the market. The wisdom of adopting these forecasts to establish equity market cheapness or dearness is, however, questionable. We have found that earnings forecasts put together by company equity analysts tend to lag actual earnings revisions, have a meaningful positive bias, and are poorly correlated with actual earnings trends.
Rather than rely on consensus earnings forecasts, or even issuing our own forecast, we have constructed a multi-period dividend discount model that facilitates our interrogation of the impact of changing two short-term growth rates (for year one and year two), one intermediate growth rate (for years three to five), and one long-term growth rate (for the period beyond year five). We use the 10-year government bond yield as a proxy for the risk free rate. Our estimate for the path of the payout ratio is determined by taking the current level and gradually adjusting it towards the long-term payout ratio.
Each point on the trade-off curve (shown in figure 1) shows the level of ERP associated with a different level of compound annualised earnings growth. For example, if you think that earnings will remain flat for the next two years, the ERP would be just over 4% (an average return of 4% over the risk-free rate). It can be seen that the blue dot (the consensus-derived estimate of the ERP) sits above the blue ERP-EPS trade-off line. This is because the consensus among investment bank analysts is that the profit share as a percentage of GDP will rise meaningfully between 2012-2015, although will fall by around 13% per annum for the next two years. Without the expectation of higher profit share, the ERP associated with consensus earnings would fall back down to the trade-off curve level.
In this way, the ERP associated with differing growth scenarios can be assessed very easily. Figure 2 shows this in practice. If corporate profitability is expected to grow by 18% annualised over the next two years - significantly ahead of consensus - this would equate to an ERP of about 6% (green dotted lines). However, if corporate earnings were to fall by 26% annualised for the next two years, about twice the fall consensus factors in, then the ERP level would be around 2% (red dotted lines).
We re-run this analysis on a monthly basis across a variety of markets to discover the degree of mis-pricing between equities and bonds. Two years ago the ERP, using an earnings estimate of -10% per annum, was only 0.9% - a wafer-thin cushion that illustrated the degree to which the market had priced perfection into markets. By contrast, in March 2009 an ERP of more than 4% was available to investors even if they expected aggregate earnings to fall by 40% per annum in 2009 and 2010, illustrating the degree of value available in the market. We have used this framework to enable us to allocate with confidence away from equities during 2007 and 2008 when risk premia were low and towards equities at the end of 2008 and through 2009 when risk premia have been high. In other words, we have found a means of implementing Buffett's famous aphorism using more than just intuition.
The term ‘equity risk premium' is sometimes used as though it is an observable and absolute variable. We hope that we have explained why this is not the case, and shown how the approach that we take allows us to assess the attractiveness of a given equity market on an absolute or relative basis for a given earnings outlook. The model presented is simple and straightforward, and this is what makes it so useful.
Toby Nangle and Hartwig Kos are director and investment manager, respectively, in the multi-asset team at Baring Asset Management