Monthly Archives: September 2010

Why you’re mis-estimating the Equity Risk Premium #3

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You’ve used the ‘wrong’ risk free rate

Your ERP estimate can be incorrect if you’re not applying it in the same manner in which you estimated it. This isn’t as much an issue of there being a ‘right’ risk-free rate, but we have to compare apples with apples.

The ERP estimated with risk-free as T-Bills or short term rates will be different from that estimated using long (10 year or longer) bonds as risk-free.

If we want the ERP to reflect the additional return for bearing equity risk only, then arguably it is better to compare it to a long government bond with more comparable term and liquidity rather than the very short-dated T-Bill.

When using the ERP in your valuations, you should be clear whether it is added to T-Bill or bond rates, and whether the liquidity and term characteristics of the cash flows are consistent with this choice.

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Clear, Simple and Wrong

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The reason opinions are so cheap is that everyone has one and nobody wants to buy anyone else’s. I’m no different.

I’m not going to try to sell you mine. I would like to present you with some ideas to think about before you overpay for someone else’s though.

Jon commented on a recent post of mine and, guessing I’d be interested, directed me to a fascinating opinion piece by Mark Gilbert on Bloomberg covering a range of current economic issues. I suggest you read it now. It’s ok, I’ll wait.

Right, some pretty compelling points are made there. I disagree with many of them, but they are pretty compelling at first read. Here’s my rebuttal to those I’ve heard discussed most commonly in recent times (typically with head nodding all around).

Gold is not the answer to all our currency problems

All of a sudden it’s popular to talk about how fiat currencies are not worth the paper they’re printed on, how it’s a scam, how we’d be better off with a metal-backed currency. They’re wrong. This is a complex area so I’ll only touch on the points rather than try to explain each of them in detail.

Broken promises and speculator spectacles

A metal-backed currency is only as good as the government’s promise to stick to the standard. History shows this promise has been broken regularly. By attempting to stick to a standard, it’s like waving a red, pheromone-doused flag to an amorous bull (a.k.a. currency speculators. The Bank of England was hit by this in the 1930s and again, albeit with a different kind of peg, in the early 1990s by Soros). Continue reading →

Why you’re mis-estimating the Equity Risk Premium #2

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You’ve used too short a period

Your ERP estimate can be way too high or way too low.  The standard errors of estimates of the ERP are typically huge since the variability in equity returns is so high. To get a solid estimate within a narrow confidence interval requires many decades of data.

It’s true that the ERP itself may change over time, but estimates of very short periods are not reliable.

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Just because you don’t like the definition

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A recession is usually defined as two consecutive quarters of a decrease in real GDP.

A better definition would be two consecutive quarters of a decrease in real GDP per capita, since the economy is only really moving forward it is adding value per person in the economy. Over a short period like two quarters, given the relatively low net population increase over time, it probably doesn’t make much difference.

In the US, the National Bureau of Economic Research sets the definition of recession more broadly to include factors like employment, incomes, production and sales.

There are some who choose different definitions of recession, focussing more on employment and less on real GDP. Depending on the distribution of changes in unemployment, this may “feel” more or less to citizens like a recession that an more abstract decline in real GDP. Positive growth in real GDP can still occur alongside job losses, often termed “jobless growth” which reflects the mix of factors of production between labour and capital (amongst other things).

The problem I have is that many people seem to argue about “whether we’re still in recession” or not, based on different definitions of recession. Since it isn’t universally, precisely defined, arguing over whether we are or not in recession is pointless.

We should stick to deciding what the best policy decisions are to influence the economy, jobs and growth.

Our currency isn’t alone (get Real)

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The Rand is much stronger against the US Dollar now than any time in the last 18 months. Aside from a brief blip at the end of 2007, it’s actually back to 2006 for the Rand to be stronger.

Given that our inflation has been higher than US inflation by some margin at every point in the last decade (and probably more, but I haven’t confirmed) and that our interest rates have been higher too, both Relative Purchasing Price Parity and Absolute Purchasing Price Parity would suggest that our currency should weaken against the US Dollar over time. Continue reading →

Why you’re mis-estimating the Equity Risk Premium #1

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You base your estimates of the ERP on US history alone

Your ERP estimate is too high because your calculation suffers from survivorship bias and errs by including the largest economy for which the most data is currently available rather than a random sample.

The US has been a spectacularly successful economy over the last hundred years. At the turn of the previous century, Imperial Russia and the US were at about the same level of economic development. Investing in Imperial Russia would have given you a -100% return. If we estimate the ERP from Imperial Russia, we get a very different answer than if we calculate it based on US data.

The US is the largest economy today. It is not a good place to estimate an average, prospective ERP.

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Mis-estimating the Equity Risk Premium

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The Equity Risk Premium (ERP) is the expected excess return priced into equities as reward for bearing risk. Equities are expected to provide greater returns because they are riskier than, say, government bonds.

The historical ERP experienced (and prospectively estimated by some) is higher than many theoretical assessments of what it should be based on the average investor’s risk aversion. There are many problems with estimating both the ERP itself and the risk aversion of an average investor. This discrepancy has been known as the Equity Risk Premium Puzzle since the 1980s when it was first popularised.

The ERP is an important assumption in many valuations and as such, getting it right is also important.

This post serves as an introduction into a series of posts on mis-estimating the ERP.  It needs a series of posts because there are so many different mistakes than can be made.

For the record, my own assessment (based on meta research and drawing heavily from the fantastic book Triumph of the Optimists – 101 years of Global Investment Returns that considers the problem very rigorously) is between 3% and 5%. Continue reading →

Lower interconnect not the promised panacea

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Decreasing interconnect fees was supposed to lower telecoms costs, promote competition and create world peace.

It’s done none of these because the logic underlying it was flawed. Analysts focused on interconnect as an expense, happily ignoring the revenue side (since it was a fee paid to another company within the industry). Never has a telecoms issue been so badly hijacked by lack of understanding.

Now, in a press release that is a little vague, BMI TechKnowledge reflect concerns that telecoms growth rates may be lower as a result of falling mobile termination rates.