GCC Sovereign Equity Risk Premium Q4 12 Update

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1 Kuwait Financial Centre Markaz R E S E A R C H Markaz Research is available on Bloomberg - Type MRKZ <Go> Thomson Research, Reuters Knowledge Nooz Zawya Investor ISI Emerging markets Capital IQ FactSet Research Connect TheMarkets.com M.R. Raghu CFA, FRM Head of Research rmandagolathur@markaz.com Sowmya Dorai Senior Research Analyst ext.4603 SDorai@markaz.com GCC Sovereign Equity Risk Premium Q4 12 Update Subsequent to our note published in October we now publish an updated calculation for various equity risk premiums. Key findings include: The equity risk premium based on ratings has remained more or less unaltered. The ERP based on CDS spreads have declined almost across all GCC countries. The CDS spreads are used to measure the default risk. Higher CDS spread indicate that there is greater default risk of the contract. The adjusted CDS has declined and this has brought down the ERP for all the GCC countries. This comes as a positive relief after a prolonged period of stress and pressure. The ERP for Bahrain fell from 9.1% in Oct-12 to 7.2% while for Oman it has decreased from 7.8% to 6.7%. The implied ERP based on stock indices is influenced to a very great extent by the corporate earnings. Most of the GCC companies have witnessed a subdued performance in The Q3 results have remained muted on the back of economic slowdown world over and waning demand for commodities. The political instability in the region has added to the woes. The political challenges have an adverse impact on the health of these nations. These resulted in muted stock market performance and in turn increase the riskiness of the stocks. The long term growth estimates have been cut due to these factors. Equity Risk Premium for GCC Countries Kuwait Financial Centre S.A.K. Markaz P.O. Box 23444, Safat 13095, Kuwait Tel: Fax: markaz.com Country Implied ERP ERP based on Rating ERP based on CDS Spread Oct-12 Dec-12 Oct-12 Dec-12 Oct-12 Dec-12 Bahrain 7.6% 7.9% 7.6% 7.3% 9.1% 7.2% Kuwait 7.8% 5.7% 6.6% 6.3% NA NA Oman 8.1% 7.9% 7.0% 6.7% 7.8% 6.7% Qatar 7.1% 8.6% 6.6% 6.3% 6.8% 5.9% KSA 7.4% 7.2% 6.8% 6.5% 6.8% 5.8% Abu Dhabi 8.0% 7.8% 6.6% 6.3% 6.8% 5.9% Dubai 6.8% 6.0% NA NA 6.8% 5.9% Source: Markaz Research

2 Equity Risk Premium - Findings Estimating ERP using Default Spreads Method 1 - Sovereign Rating: Taking the latest US market equity risk premium of 5.8% 1, the ERP of GCC countries are arrived at by adding the default spread based on their credit rating. Rating agencies are generally considered to be slow in updating their ratings. So, we can use CDS spreads as a proxy. ERP for GCC Countries based on Credit Rating Country US Eq. Risk Premium Rating Default Spread Total Equity Risk Premium Bahrain 5.8% Baa1 1.5% 7.3% Kuwait 5.8% Aa2 0.5% 6.3% Oman 5.8% A1 0.9% 6.7% Qatar 5.8% Aa2 0.5% 6.3% KSA 5.8% Aa3 0.7% 6.5% UAE 5.8% Aa2 0.5% 6.3% Abu Dhabi 5.8% Aa2 0.5% 6.3% Source: Moody s, Aswath Damodaran, Markaz Research Method 2 Estimating ERP using CDS spreads: Rating agencies are generally considered to be slow in updating their ratings. So, instead of arriving at default spread based on rating, we can use CDS spreads as a proxy. In this method, the CDS spread of a country s bond (adjusted for spread of risk free country) is considered as default spread instead of looking at the yield differentials of similarly rated bonds. ERP for GCC Countries based on CDS Spread Country US Eq. Risk Premium 5Yr CDS Adjusted CDS Total Equity Risk Premium Bahrain 5.8% 2.0% 1.4% 7.2% Oman 5.8% 1.5% 0.9% 6.7% Qatar 5.8% 0.8% 0.1% 5.9% KSA 5.8% 0.7% 0.0% 5.8% Abu Dhabi 5.8% 0.8% 0.1% 5.9% Dubai 5.8% 2.3% 1.6% 7.4% United States 0.7% Source: Thomson Reuters Eikon, Markaz Research Inputs required for calculation of Implied ERP were not readily available for GCC countries. Method 3: Implied Equity Risk Premium Implied equity risk premium is an alternative approach to estimating risk premiums. Assuming that stocks are correctly priced in, if we can estimate the expected cash flows from buying stocks, then we can estimate the expected rate of return on stocks by computing an internal rate of return (IRR). Subtracting out the risk free rate from IRR should yield an implied equity risk premium. 1 Aswath Damodaran Kuwait Financial Centre Markaz 2

3 The inputs required for calculation of Implied ERP were not readily available for GCC countries. Absence of sovereign bonds for some countries made the estimation of risk free rate and perpetual growth rate difficult. Also, the lack of consensus earnings growth estimate makes it hard to determine the market s view on growth for the next 5 years. Implied Risk Premium for GCC Countries Country Index Level * Implied Equity Risk Premium KSA 6, % Kuwait 5, % Qatar 8, % Abu Dhabi 2, % Dubai 1, % Oman 5, % Bahrain 1, % Source: Thomson Reuters Eikon, Zawya, Markaz Research * As of 31-Dec-2012 Kuwait Financial Centre Markaz 3

4 Appendix 1: Historical Risk Premiums - Premium vs Bonds (% p.a.) Country Australia Belgium Canada Denmark Finland France Germany Ireland Italy Japan Netherlands New Zealand Norway South Africa Spain Sweden Switzerland U.K U.S World-ex U.S World Europe Source: Credit Suisse Global Investment Returns Yearbook 2012 Kuwait Financial Centre Markaz 4

5 Appendix 2: Market Risk Premium used for 82 countries Survey Results Country Average Median Number of answers Country Average Median Number of answers USA ,223 Pakistan Spain Egypt Germany Singapore United Kingdom Thailand Italy Malaysia Canada Saudi Arabia Mexico Kazakhstan Brazil Philippines France Kuwait China Nigeria Australia Romania South Africa UAE Netherlands Ecuador Russia Bahrain Switzerland Croatia India Oman Chile Bulgaria Norway Qatar Sweden Bolivia Austria Lebanon Colombia Morocco Belgium Senegal Portugal Vietnam Argentina Panama Greece Venezuela Poland Malta Denmark Slovenia Japan Zimbabwe Peru Costa Rica New Zealand Cyprus Czech Republic Iran Finland Kenya Turkey Slovakia Luxembourg Uruguay Taiwan Zambia Ireland Albania Israel Trinidad&Tobago Korea (South) Guatemala Indonesia Honduras Hungary Lituania Hong Kong Ghana Source: Fernandez et al (2012) - Market Risk Premium used in 82 countries in 2012: a survey with 7,192 answers Kuwait Financial Centre Markaz 5

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