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Thursday, November 30, 2023

Negative Risk Premium Signals Investors to Underweight Stocks for Longer

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The Equity Risk Premium (ERP) is the additional return that a reasonable investor expects to receive on an equity investment above a risk free investment like Federal Government of Nigeria (FGN) bonds. The ERP is a major component of the cost of equity.
In theory, stocks should provide a greater return than safer investments such as Treasury Bills and FGN Bonds. The difference in return is called the equity risk premium, and it is what you can expect from the overall stock market above a risk-free return in bonds.
One method for calculating ERP is the backward-looking historical approach, in which the ERP is estimated using actual equity returns of a stock index and the risk-free rate of return for a given time period.
Nigerian stocks have a negative Equity Risk Premium when comparing the 5- year historical return of the main equity index the NSE All share index, to the 10 year FGN Bond yield.
Stocks have returned an average of -2.79 percent over the past 5 years with returns of -17.36 percent in 2015, -6.17 percent in 2016, +42 percent in 2017, -17.81 percent in 2018, and -14.60 percent in 2019.
The 10 year FGN Bond due 2030 has a yield of 10.99 percent by comparison, according to FMDQ data.
This means the ERP for Nigerian stocks is -13.98 percent.
The equity risk premium often helps to set portfolio return expectations and determine asset allocation. A higher premium implies that investors would invest a greater share of their portfolio into stocks.
It is no wonder then that investors are largely underweight Nigerian Stocks with retail investors still yet to return 12 years after the 2008 stock market crash.
Pension funds exposure to stocks are also some of the lowest in recent years, with allocations to domestic equities at a low 4.62 percent as at April 2020, according to Pencom data.
Since the ERP is a forward-looking concept that is meant to quantify the expected market risk associated with future cash flows of an equity investment, the negative premium suggests to investors that it is better to invest in and receive a guaranteed return from bonds than volatile Nigerian equity markets that have returned nothing to investors over the past 5 years.
This explains the shrinking volumes traded on the Nigerian Stock Exchange and lack of broad based excitement from domestic institutional and retail investors, which may be set to continue for a while longer, absent of a better macro story that underpins much greater move higher for stocks.

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