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Wednesday, February 21, 2024

Nigeria’s Equity Risk Premium Returns with a Vengeance, But How Sustainable Is It?

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In Finance the concept of an equity risk premium is not really difficult to grasp.

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.

As bonds are considered safer investments than equity, the rate of return offered by bonds is typically expected to be lower than the rate of return offered by equity.

For instance, If a company that has borrowed money from a bank goes bankrupt or has difficulty continuing as a going concern due to illiquidity, the debt (bond) holders are near the top of the list to get paid when assets of the firm are sold, while equity investors (shareholders) should expect to be wiped out.

This means that 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.

As usual with all things Nigeria, it has not been quite so simple or straightforward.

Nigerian stocks have had (until this year) 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.

The main stock market index the NSE-ASI has 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 had an average yield of 12.8 percent by comparison in that time period (2015 – 2019), according to FMDQ data.

However, a number of regulatory actions taken by the Central Bank of Nigeria (CBN) to push banks into increasing lending to the real sector of the economy has helped to reverse the anomaly of negative ERP for stock investors compared to bonds.

The CBN banned Pension Funds and most non-bank corporates from participating in its open market operations (OMO), which moved a wall of liquidity into FGN Bonds and Treasury Bills helping to depress yields.

The CBN also has elevated Cash Reserve Ratio (CRR) requirements for banks, as well as minimum Loan to Deposit ratio levels for lenders.

The policies have helped to push the risk free rate from a high of close to 14 percent over the past five years to a low of 3.65 percent for benchmark 10-year FGN bonds due March 2027.

Nigerian stocks have belatedly soared in response to the CBN engineered collapse of fixed income yields.

Stocks in Africa’s largest economy have returned +30.5 percent year to date and +15 percent just in November. The S&P FMDQ Nigeria Sovereign Bond Index has returned 0.46 percent by comparison in November.

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.

So it is not a surprise that investors especially Pension Funds Administrators (who are struggling to find alpha amid beaten down yields), Insurance Companies and other institutional investors have begun to rotate into domestic stocks.

Share prices reflect not just the expected future stream of company earnings but also the rate at which the profits are discounted to present value.

Equity risk premium and the level of risk are therefore directly correlated. The higher the risk, the higher is the gap between stock returns and the risk-free rate and hence, a higher premium is expected by investors.

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 that heralded most of the Nigerian capital markets for the past 5 years was suggesting to investors that it was better to invest in and receive a guaranteed return from bonds than volatile Nigerian equity markets that had returned nothing to investors over that time period (past 5 years).

So a major question for investors is how sustainable is the current move up in equities vis a vis rock bottom yields?

We believe it is not quite sustainable unless some confirmation is had in the form of multiple expansion, positive movement in the real economy via higher GDP growth rates and an unwinding of the CBN balance sheet which has helped to flood liquidity into the system.

Multiple expansion refers to the expansion of a stock’s price/earnings (P.E) ratio based on investor willingness to place more value on each naira of the company’s earnings.

Nigerian stocks as a whole currently trade at 12.47x earnings. This compares to 21x earnings for South African Equities. Investors would need to see sustained levels of multiple expansion across sectors to really buy into a normalized risk premium.

The specter of stocks rallying while the real economy is rolling over is also not a good sign. The Nigerian economy is forecast by the IMF to contract this year by up to 8.9 percent this year, after contracting by -6.1 percent in the second quarter of the year.

Inflation rate is currently at the highest level in nearly three years at 14.2 percent while unemployment rate hit a six year high of 27.1 percent this year.

Lastly the CBN would have to in our opinion unwind its bloated balance sheet which has funded all manner of interventions, as well as monetizing of the Federal Government debt via ways and Means financing and overdrafts to the FG which have served to depress yields.

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