I reader asked why so many practitioners use high Equity Risk Premiums in their valuations and fairness opinions.
In particular, he mentioned a specific assumption set he had seen including:
ERP of 6.8%
company specific risk premium of 4%
He also commented on how haphazard the use of risk premiums can be and referenced a few sources I’ve used myself.
The ERP of 6.8% does seem high. However, it really isn’t possible to comment on the specifics of the company specific risk premium without knowing the company.
Although I haven’t updated my research on this in a few years, in my own work I still generally stick with a range of 3% to 5% for an ERP, before considering company specific factors, liquidity, and so on. Historically / empirically estimated ERPs shouldn’t change frequently since the time series used is long. Another few years on a 20 year estimation period shouldn’t have much impact.
Why some practitioners persist in using too-high ERP estimates
Of course, it does beg the question, why doesn’t Saudi just change the supply to achieve the price that want?
If the price is too low, they might want to increase the price without reducing supply, to increase their revenues even more.
If the price is too high (as it is now) they actually might prefer to increase supply without the price declining from a pure revenue perspective. This might require some Jedi Mind Tricks since natural supply and demand would move it to other way. It seems they actually want something different now – they want a lower price to moderate economic stresses in the global economy (and presumably limit the incentive for research into oil alternatives and US offshore drilling etc.). It should be easy then to increase supply, make more profit and slowly watch the oil price decline. Win-win.
So why are they announcing this to the market? Clearly something is not working in the supply-demand theory for oil, suggesting sentiment plays a far bigger role in the day to day, month to month oil price than fundamentals do.
Paulson and Soros still think Gold is a buy, adding to their stakes as the price declines. It’s also not very brave of me to blog about this now as gold has declined when for much of the financial crisis it was increasing in price. I’ve been watching other things.
The idea that the gold price must increase because of massive monetary easing reflects a broken understanding of the economy and a liquidity trap. The money isn’t going anywhere. It is being hoarded in bank vaults. Very few people want to borrow, and aside from banks buying up gold with their excess cash (which would effectively be a massive speculative prop-trading bet on the direction of the gold price) there are few reasons for gold to be spiking massively.
One possibility is the simple safety argument. If you don’t know where else to put your money, put it into gold because it’s gold and it’s safe. Except why should gold be safe? The price swings all over the place like many commodities, but unlike most commodities it has limited industrial uses. Gold arguably has very little intrinsic value.
I’m not saying gold is going to tank. I really don’t know. I also don’t think anybody else really has a good idea of where the gold price is going to and much of the speculation is by people who think it’s going to rise. Therefore it may have been overbought already (whatever that means when it comes to gold, that is).
Hyperinflation is not here. Gold price increases are not guaranteed. If your entire investment view is centered on monetary policy giving rise to massive inflation, you’re in for a painful ride.
(The one risk that does remain is that when the economy starts turning, and I’m thinking maybe as far away as 5 or 10 years out, if the liquidity isn’t quickly pulled back, we might have high inflation and increases in gold prices. I don’t see this as a major part of the view of current gold bugs. There are too many ifs and too much time and far too much uncertainty.)
Listen I know John Paulson made an enormous amount of money betting against the housing markets in 2007. He made some excellent calls and made a tonne of cash.
As Nassim Taleb would say though, that doesn’t necessarily mean he has skill or insight. He could just have been lucky. Most people lost money in that market; it would be almost impossible if nobody had the opposite positions and made large amounts of money.
I’m also not saying Paulson doesn’t have skills or insight.
But I am saying that there is no reason to listen to hedge fund managers as a guide to the economy.
Gold has had a fantastic run, getting to within sight of $2,000 recently. Many see this as a clear indication of hyper inflationary pressures arising out of loose monetary policy. The informed recognise that you can’t have hyperinflation if all sensible measures of actual prices other than a particular, volatile commodity are showing very low inflation.
Now I don’t spend much time on gold as an investment, but these stories are certainly interesting.
I’ll leave you with one thought (for the OMG! Inflation! of my readers). If the gold price is a measure of “real prices” in the economy, but prices of actual goods and services are more or less unchanged in dollar terms, this means the price of these items in gold terms has plummeted massively. Do you really think that a scenario where all prices are half of what they were two years ago is workable? What should have to wages? What needs to happen to wages? What will likely actually happen to wages? Does any part of this scenario seem like a Good Thing?
[Update: for some incomprehensible reason the embedded video clips below only work on YouTube. Click the image for a link to the YouTube page]
Andrew Canter (of Future Growth) makes some strong statements about the “phone and dealer” approach to the South African bond market. When one of the arguments against Andrew’s preferred centralised, electronic order book is “we like the information we get from deal flow” I have to say I agree with Andrew.