Kuwait Financial Centre “Markaz” RESEARCH

October 2012

Markaz Research is available on Bloomberg - Type “MRKZ” 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 +965 2224 8280 [email protected]

Kuwait Financial Centre S.A.K. “Markaz” P.O. Box 23444, Safat 13095, Kuwait Tel: +965 2224 8000 Fax: +965 2242 5828 markaz.com

GCC Sovereign Equity Risk Premium

A Search for the Elusive Proxy Number

Valuation in emerging markets is mostly considered as a futile exercise due to several difficulties which include data availability, regulatory & political risks, and a totally different capital market in terms of efficiency, liquidity, and participants. Due to the absence of financial models developed specifically for emerging markets, models which work in the West are adopted in the developing countries as well. One key input in such models is the Cost of Equity which is arrived at using the Equity risk premium (ERP). Equity risk premium is the extra return that investors collectively demand for investing in stocks instead of holding it in a risk less investment. Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation1. Credit Suisse Research Institute compiles historical equity risk premium from the year 1900 to 2011 for 19 markets across the world. Due to the volatile nature of equities, historical returns are not a reliable measure of equity risk premiums. It becomes doubly challenging in emerging markets where such a long history is not available. The challenge for GCC is all the more glaring in the absence of a yield curve. This note is an attempt to contemplate different ways of calculating equity risk premium for GCC markets which can be used in valuation and capital budgeting. We acknowledge that each of the methods discussed in the report has its own merits & demerits, and there is no foolproof method to find out equity risk premium. The method to be practiced depends really on the purpose and availability of data points. We intend to have this report updated on a quarterly basis so that regional investors are kept informed about the changing market dynamics. Equity Risk Premium for GCC Countries ERP based on Rating ERP based on Country Spreads CDS Spreads Bahrain 7.6% 9.1% Kuwait 6.6% NA Oman 7.0% 7.8% Qatar 6.6% 6.8% Saudi Arabia 6.8% 6.8% Abu Dhabi 6.6% 6.8% Dubai NA 6.8% Source: Markaz Research

1

Aswath Damodaran - Equity Risk Premium Report

Implied ERP based on Stock Indices 7.6% 7.8% 8.1% 7.1% 7.4% 8.0% 6.8%

MARKAZ RESEARCH October 2012

Equity Risk Premium - Findings

The simplest way to compute ERP is to calculate the long term returns earned by stocks over risk free investments

The simplest way to compute Equity risk premium is to calculate the actual long term returns earned by the country‟s stocks over risk free investments (probably Sovereign bonds). At first sight, this calculation seems easy. But the method has inherent problems (discussed below) especially for markets like the GCC. 

Not all GCC countries have instruments which can be considered risk free. This is either because sovereign bonds were not issued (Ex. Kuwait) or because governments may have default risk (Ex. Dubai).



Most GCC indices are still below their levels reached in 2004 implying negative historical equity returns for an 8 year period. And even if returns improve, the risk premiums may not be large enough to reflect the true picture accounting for volatility of the regional equities.



The oldest stock market in the GCC was established a little more than 30 years ago (Kuwait) and the recent one (UAE) being only 12 years old. Almost all GCC exchanges are still undergoing a lot of transformation in terms of regulations, trading platforms, instrument availability, and corporate disclosures. This coupled with nascent secondary market for bonds will make the risk premiums calculated with historical numbers inaccurate.



Equity markets are volatile and risk premiums calculated with short historical data experience significant estimation errors

Estimating ERP using Default Spreads Method 1 - Sovereign Rating: Taking the latest US market equity risk premium of 6.1%2, the ERP of GCC countries are arrived at by adding the default spread based on their credit rating. Not all GCC countries have instruments which can be considered risk free

ERP for GCC Countries based on Credit Rating Country Bahrain Kuwait Oman Qatar Saudi Arabia Abu Dhabi

Rating Baa1 Aa2 A1 Aa2 Aa3 Aa2

Total Equity Risk Premium 7.6% 6.6% 7.0% 6.6% 6.8% 6.6%

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.

2

Aswath Damodaran

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MARKAZ RESEARCH October 2012

Implied equity risk premium is an alternative approach to estimating risk premiums

ERP for GCC Countries based on CDS Spread 5Yr Adjusted Country CDS CDS Bahrain 3.5% 3.0% Oman 2.2% 1.7% Qatar 1.2% 0.7% Saudi Arabia 1.1% 0.7% Abu Dhabi Dubai United States

1.1% 3.4% 0.5%

Total Equity Risk Premium 9.1% 7.8% 6.8% 6.8%

0.7% 2.9%

6.8% 9.0%

Source: Thomson Reuters Eikon, Markaz Research Note: Refer Methodology section for explanation

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. 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 Saudi Arabia 6,952 7.36% Inputs required for calculation of Implied ERP were not readily available for GCC countries.

Kuwait Qatar Abu Dhabi Dubai Oman Bahrain

5,724 8,332 2,508 1,551 5,465 1,098

7.81% 7.08% 8.04% 6.79% 8.11% 7.64%

Source: Thomson Reuters Eikon, Zawya, Markaz Research * As of 04-Aug-2012

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MARKAZ RESEARCH October 2012

Concepts & Methodology Weighted Average Cost of Capital (WACC) CAPM is used to theoretically determine the required rate of return or cost of equity

Normally a company‟s assets are financed by debt or equity or a combination of both. WACC is the company's cost in which, every source of capital is weighted in proportion to how much capital it contributes to the company. A firm's WACC gives an idea about the overall return that the firm as a whole needs to generate in order to pay its sources of capital. Hence, this is normally the hurdle rate which is used by the company‟s management for capital budgeting decisions. WACC is also used for discounting the firm‟s cash flows so as to arrive at the firm‟s overall value. For a company with only debt and equity funding, WACC will be calculated as WACC = (After Tax Cost of Debt * (Debt/(Debt + Equity))) + (Cost of Equity (Equity/(Debt + Equity))) In the above equation, practitioners normally use the terms „Cost of Equity‟ and „Required Return to Equity‟ interchangeably. Although there is a subtle difference between the terms, it is usually computed using the Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) CAPM is often used to theoretically determine the required rate of return or cost of equity. While CAPM is often criticized for its assumptions and flaws, it is still the most widely used model for calculating cost of equity. Usually government bond rates are used as risk free rates but not all government bonds are risk free

Cost of Equity = Risk free Rate + Equity Beta * (Equity Risk Premium) Government bond yields are used as risk free rates Historical risk premiums are used for Equity risk premium Beta is estimated by regressing stock returns against market returns

Risk Free Rate On a risk free asset, the actual return should be the same as expected return. Usually government bond rates are used as risk free rates but not all government securities are risk free. Some governments face default risk and hence their bonds are priced so as to include the default risk premium. In such cases, we need to negate out the effect of default risk premium to find out the local currency risk free rate.

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MARKAZ RESEARCH October 2012 Calculating Risk Free Rate

Beta is a measure of a company‟s systematic risk (non-diversifiable risk)

Beta Beta is a measure of a company‟s systematic risk (non-diversifiable risk). It is often computed by regressing stock returns against market returns. Usually, the most followed equity market index is used as a proxy for market returns. Beta is easily available from most database providers. Beta is difficult to calculate for emerging market companies where the market is illiquid and often lacks depth. Restrictions on historical data also pose a problem. One way to mitigate the errors in beta computation is to take the global industry beta based on the firm‟s business and adjust it according to firm‟s operating leverage and capital structure.

Equity Risk Premium Equity risk premium is the extra return that investors demand for investing in stocks instead of holding it in a risk less investment

Equity risk premium is the extra return that investors collectively demand for investing in stocks instead of holding it in a risk less investment. To put it differently, equity risk premium reflects what investors expect to earn on equities over and above the risk free rate. Equity risk premium (ERP) is one of the most important factor in any investment decision and yet it is the most elusive as well. The reasons being – practitioners use different methods for calculating ERP, it is affected by investor sentiments which are not always rational and there is an element of approximation especially for emerging market countries due to problems of data availability. Pablo Fernandez reviewed 150 textbooks on corporate finance and valuation and noted that equity risk premiums varied widely across books from 3% to 10%3. Equity risk premium can be determined based on either historical data, assuming that the future will be like the past or by using estimates that attempt to forecast the future. Both methods have their proponents and critics.

3

Pablo Fernandez, 2010, The Equity Premium in 150 Textbooks

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MARKAZ RESEARCH October 2012 Equity Risk Premium – Uses Equity risk premium finds usage in several important steps of investing. ERP ascertains the expected return on all risky investments and consequently affects the value of those investments. ERP is used in asset allocation decisions to determine how much is allocated to different asset classes

At a broader level, ERP is used in asset allocation decisions to determine how much of the portfolio is allocated to different asset classes. ERP is also used to determine how much is allocated to various geographies. After narrowing down on asset allocation, risk premiums come into play for valuing individual companies. The most common method for valuing financial assets is to discount the expected cash flows from the asset to determine its present value. Since the expected cash flows carry some risk, the discount rate is adjusted to account for the risk. ERP is an important component of the determining the discount rate. When investors perceive higher risk, equity risk premiums rise, and will therefore lead to lower prices. Equity risk premium also plays a part in capital budgeting decisions. The worthiness of a new investment / expansion is determined by whether the project can generate higher returns than the cost that is attached to the invested capital. Equity risk premium moves the cost of equity and cost of capital which are used for project evaluations. Corporations and governments set aside contributions for future pension and health care obligations based on their expectations of equity market returns. Assuming a higher equity risk premium will lead to smaller amounts being set aside to cover future obligations and vice versa.

Country Risk Premium

Equity risk premium also plays a part in capital budgeting decisions

Doing valuation in emerging markets is a bit difficult as investors have to deal with additional risks which include macroeconomic volatility, capital controls, regulatory changes, and political risks. There are two ways in which these emerging market risks can be captured while valuing companies or evaluating projects. The first is to incorporate the risks in cash flow projections and the other is to add the extra risk premium to the discount rate. There are arguments favouring both the methods and selecting which one to use really depends on the purpose and availability of data points. Arguments FOR adjusting cash flows: 1. The basic argument against adding country risk premium to the discount rate is that country risks are diversifiable and theory indicates that the cost of capital should reflect only non-diversifiable risk. So by holding a geographically diversified portfolio, country risks can be eliminated. Also, diversifiable risks are better handled in cash flows.

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MARKAZ RESEARCH October 2012

Emerging market investors have to deal with additional risks while doing valuation

2. Many risks in a country don‟t apply equally to all the industries in that country. So using the same country risk premium for all the companies in a country leads to incorrect valuations. Arguments AGAINST adjusting cash flows: 1. Geographical diversification might reduce some country specific risk but as correlation between markets increase, country risk becomes nondiversifiable and can hence command a premium. 2. Accounting for country risk in the cash flows through probabilityweighted scenarios may be difficult to do because many of the risks are not quantifiable and hence requires a lot of qualitative inputs. It is hard for someone doing valuation to estimate GDP growth, inflation, forex rates etc and assign probabilities so as to find out its effect on the company‟s cash flows. There is also a problem of accounting for low probability, high impact „Black Swan‟ events.

Estimating ERP using Default Spreads In this section, we will discuss about computing equity risk premium using the country default spreads, for markets which have data limitations. This method keeps the mature market premium (say US) as a base, and then augments it by adding a country risk premium (default spread) for the country. ERP Emerging market = ERP Mature market + Country risk premium That country risk premium can be computed using the following methods: Dollar denominated sovereign bond: If a country has a US dollar denominated bond, then the bond‟s spread over US treasuries will give an indication about the country‟s default risk. Sovereign Rating: If the country doesn‟t have a USD denominated bond, then the default spread can be estimated from the country‟s sovereign rating. Using similarly rated countries as a proxy; we can get the spread of the proxy country‟s dollar denominated bond (against US Treasuries) and use it as an approximate measure of country risk. There are two ways in which emerging market risks can be captured while valuing companies

The pitfall with this method is that: 1. Rating agencies are generally considered to be slow in updating their ratings. 2. Using credit risk of a country as a proxy for the risk faced by equity investors overlooks the fact that equity investments can often be more risky than bonds. CDS spreads: The inaccuracy caused due to delayed rating action can be rectified using the country‟s CDS spread as a proxy for default risk. Credit default swap market allows one to buy insurance against default risk of the bond. The values are market-driven and current thus reflecting a more accurate picture. Taking the CDS spread of the country in question and

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MARKAZ RESEARCH October 2012 adjusting it with the CDS spread of a country like US or Germany will give us the default risk specific to that country. Implied equity risk premium approach assumes that stocks are correctly priced in

The problem of credit risk not being a good indicator of riskiness of a country‟s equities can be tackled by multiplying the default spread of a country by relative volatility of equities over bonds. Adjusted Default Spread

=

Default Spread

X

S.D. of Country's Equities S.D. of Country's Bonds

S.D. = Standard Deviation

Implied Equity Risk Premium Implied equity risk premium is an alternative approach to estimating risk premiums that does not require historical data or corrections for country risk but assumes that the market, overall, is correctly priced. If we assume that stocks are correctly priced in and 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. Subtracting out the risk free rate should yield an implied equity risk premium. We can use a simple one stage dividend discount model or can extend the model to allow for dividends to grow at high rates for short periods and then make assumptions for perpetual growth rate. The advantage of implied premium approach is that it is market-driven and current, and it does not really require historical data except for making estimates about the future.

Implied ERP - Methodology & Calculation The advantage of implied premium approach is that it is market-driven and current

 





Average dividend yield over the last 7 years was considered for calculations. Yield on 10 year government bonds adjusted for default risk is taken as risk free rate. For countries without sovereign bonds, yield on quasisovereign issues or yield of countries with similar credit rating is considered as a proxy for arriving at risk free rate. Expected growth rate over the next 5 years is computed by a combination of earnings growth over the last few years and our expectations for the next 5 years. Perpetual growth rate is deduced using IMF‟s growth forecast, interest rate and our assessment of the economy.

Let us     

consider the following information for the Saudi Arabian market: TASI index level = 6,952 Dividend Yield = DY% Expected dividend growth rate for next 5 years = 17.6% Expected perpetual growth rate = 4% Local currency risk free rate = 2.4%

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MARKAZ RESEARCH October 2012 6952

D1 (1+R)

D2 (1+R)

D3 2

(1+R)

D4 3

(1+R)

D5 4

(1+R)

D5 /(R - 0.04) 5

(1+R)5

Solving for R, we get R = 9.8% Implied Risk Premium = 7.4% = (9.8% – 2.4%)

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MARKAZ RESEARCH October 2012

Appendix 1: Historical Risk Premiums - Premium vs Bonds (% p.a.) Country

2002–2011

1987–2011

1962–2011

1900–2011

Australia Belgium Canada Denmark Finland France

-1.2 -5.4 -1.8 -0.9 -7.4 -5.7

-1.7 -1.2 -1.5 -0.4 1.5 -2.0

2.8 0.6 0.8 0.2 3.8 -1.6

5.6 2.5 3.4 1.6 5.2 3.0

Germany Ireland Italy Japan Netherlands New Zealand

-5.0 -6.7 -6.3 -4.9 -6.9 -2.0

-2.0 -1.3 -5.2 -7.3 0.7 -7.1

-0.5 3.0 -2.5 -2.3 2.8 2.0

5.1 2.8 3.5 4.7 3.3 3.6

Norway South Africa Spain Sweden Switzerland U.K.

2.5 3.9 0.7 -1.1 -3.3 -2.4

0.8 0.7 1.7 0.9 1.5 -0.6

2.2 6.5 2.6 4.1 1.0 2.7

2.2 5.3 2.1 3.5 1.9 3.6

U.S. World-ex U.S. World Europe

-4.7 -4.5 -3.5 -3.9

0.2 -1.9 -3.1 -0.7

1.7 0.4 -0.1 0.6

4.1 3.5 3.5 3.7

Source: Credit Suisse Global Investment Returns Yearbook 2012

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MARKAZ RESEARCH October 2012

Appendix 2: Market Risk Premium used for 82 countries – Survey Results Number of Country Average Median answers Country Average Median USA 5.5 5.4 2,223 Pakistan 9.5 9.5 Spain 6.0 5.5 958 Egypt 9.2 8.0 Germany 5.5 5.0 281 Singapore 6.0 5.7 United Kingdom 5.5 5.0 171 Thailand 8.1 8.1 Italy 5.6 5.5 120 Malaysia 5.9 6.4 Canada 5.4 5.5 94 Saudi Arabia 6.5 6.5 Mexico 7.5 6.8 87 Kazakhstan 7.5 8.0 Brazil 7.9 7.0 86 Philippines 7.4 6.1 France 5.9 6.0 85 Kuwait 6.8 6.6 China 8.7 7.1 82 Nigeria 10.1 8.5 Australia 5.9 6.0 73 Romania 7.7 8.0 South Africa 6.5 6.0 73 UAE 8.0 8.0 Netherlands 5.4 5.5 72 Ecuador 13.5 15.9 Russia 7.6 7.0 70 Bahrain 7.3 8.3 Switzerland 5.4 5.3 68 Croatia 7.8 9.0 India 8.0 8.0 66 Oman 6.6 7.3 Chile 6.1 5.6 63 Bulgaria 8.3 8.6 Norway 5.8 5.5 58 Qatar 7.1 7.0 Sweden 5.9 6.0 58 Bolivia 10.2 10.5 Austria 5.7 6.0 57 Lebanon 9.0 9.0 Colombia 7.9 7.5 57 Morocco 7.3 7.3 Belgium 6.0 6.0 54 Senegal 11.0 11.0 Portugal 7.2 6.5 53 Vietnam 10.8 12.0 Argentina 10.9 10.0 50 Panama 9.2 9.0 Greece 9.6 7.4 47 Venezuela 12.2 12.0 Poland 6.4 6.0 45 Malta 6.6 7.5 Denmark 5.5 5.0 43 Slovenia 6.5 7.3 Japan 5.5 5.0 41 Zimbabwe 10.5 12.5 Peru 8.1 8.0 41 Costa Rica 8.5 9.0 New Zealand 6.2 6.0 40 Cyprus 7.9 9.0 Czech Republic 6.8 7.0 38 Iran 17.2 19.5 Finland 6.0 6.0 37 Kenya 6.2 7.0 Turkey 8.4 9.0 37 Slovakia 6.9 7.3 Luxembourg 6.0 6.0 35 Uruguay 9.3 9.6 Taiwan 7.7 7.1 32 Zambia 7.2 7.0 Ireland 6.6 6.0 31 Albania 11.1 12.0 Israel 6.0 5.8 30 Trinidad&Tobago 9.8 8.3 Korea (South) 6.7 7.3 30 Guatemala 10.1 9.6 Indonesia 8.1 8.0 28 Honduras 13.9 13.5 Hungary 7.4 7.0 26 Lituania 7.9 8.3 Hong Kong 6.4 6.2 24 Ghana 9.6 10.0 Source: Fernandez et al (2012) - Market Risk Premium used in 82 countries in 2012: a survey with 7,192 answers

Number of answers 24 23 23 22 21 21 20 18 17 17 17 17 16 14 14 14 13 13 12 12 12 12 12 11 11 10 10 10 9 9 9 9 9 9 9 8 8 7 7 7 5

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MARKAZ RESEARCH October 2012

Disclaimer This report has been prepared and issued by Kuwait Financial Centre S.A.K (Markaz), which is regulated by the Central Bank of Kuwait. The report is owned by Markaz and is privileged and proprietary and is subject to copyrights. Sale of any copies of this report is strictly prohibited. This report cannot be quoted without the prior written consent of Markaz. Any user after obtaining Markaz permission to use this report must clearly mention the source as “Markaz “.This Report is intended to be circulated for general information only and should not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. The information and statistical data herein have been obtained from sources we believe to be reliable but in no way are warranted by us as to its accuracy or completeness. Markaz has no obligation to update, modify or amend this report. This report does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors are urged to seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and to understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security‟s price or value may rise or fall. Investors should be able and willing to accept a total or partial loss of their investment. Accordingly, investors may receive back less than originally invested. Past performance is historical and is not necessarily indicative of future performance. Kuwait Financial Centre S.A.K (Markaz) does and seeks to do business, including investment banking deals, with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. For further information, please contact „Markaz‟ at P.O. Box 23444, Safat 13095, Kuwait. Tel: 00965 1804800 Fax: 00965 22450647. Email: [email protected]

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MARKAZ RESEARCH October 2012 MARKAZ RESEARCH OFFERINGS Economic Research GCC Demographic s (July – 12)

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Kuwait Investment Sec tor (Mar- 12)

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Oil & Gas Bulletin

North Afric a : Egypt, Algeria

Stress Testing Kuwait Banks (May- 11)

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MENA Unrest (Apr- 11) Kuwait Development Plan (Mar11) Kuwait Capital Market Law (Mar- 10) The “ Vic ious Square” Monetary Polic y options for Kuwait (Feb08) To Leap or To Lag: Choic es before GCC Regulators (Apr- 07) GCC for Fundamentalists (Dec - 06) GCC Leverage Risk (Nov- 06) Diworsific ation: The GCC Oil Stranglehold (Jan- 09)

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