‘Danger pay’ in shares As an investor, you have to be aware of the risk you are taking when investing in a particular stock – is the potential reward worth it? takes a closer look at the concept of risk premiums and how to calculate them.
soldiers are most familiar with the term ‘danger pay’. It refers to that something extra they receive in addition to their monthly salaries, for being willing to do service in very dangerous areas. Although this payment may seem very attractive, it is also important to remember that the soldier has to be aware of the accompanying dangers. They have to be willing to risk losing their lives for a few thousand rand extra per month.
In the investment world, we also understand the concept of danger pay, or risk premium, and although you don’t necessarily run the risk of losing your life, it remains something that an investor should be aware of and that they should always consider when it comes to compiling an investment portfolio.
What is a risk premium?
A risk premium is the percentage by which you need your investment, such as shares, to grow more by than risk-free investments such as a money-market investment, in order to make it worthwhile to invest in more dangerous areas. Many reports on how to calculate risk premiums have been released over the years and this has resulted in some overly technical methods. I find that the easiest way to calculate this percentage is to look at the difference in annual returns between shares and money-market rates respectively.
Over the past 15 years, investors have enjoyed 7.6% more growth in shares (excluding dividends and before tax) than in the risk-free money market. Investors, therefore, should like to see 8% more growth in shares than in riskfree investments in order to make shares a worthwhile investment. The graph clearly shows that investors have enjoyed a very investment-friendly environment since the great correction of 2008/09, with returns that exceeded this 8% average quite comfortably up to the end of 2014.
But what do we do now? If investors had any certainty that shares would continue to grow by more than money-market rates, this question would have an easy answer.
Unfortunately, no one is in a position to make such predictions, so the best aid to our disposal is to take a look at the general forecasts on company profits made by analysts in South Africa.
Bloomberg’s consensus forecasts give us a pretty good indication of the expected growth in terms of shares. By looking at its individual forecasts for the Top40 shares, one can see that it expects a mere 6.1% average growth over the next 12 months.
With money-market rates currently also trading at around 6%, you would need more than 14% growth in shares per year to make this higher-risk investment worthwhile. So if these analysts are correct, shares (before tax) should deliver exactly the same percentage return as money-market investments over the next 12 months.
A critical look at the Top40
Now another question: Can the price-to-earnings ratio (P/E) of nearly 21 times on the FTSE/ JSE Top40 Index be justified if it may not even cover your danger pay? This means that investors are now taking higher risks to earn possible lower returns.
Out of these 40 forecasts, analysts only expect a handful of companies to grow by more than 14% price-wise over the next year. By excluding MTN, based on the massive uncertainty surrounding the Nigerian fine, along with a number of resource companies, I found that the four companies that these analysts felt most confident about exceeding the 14% growth mark were BHP Billiton, Naspers*, Nedbank and Shoprite.
I do, however, urge investors to exercise extreme caution in current market conditions, especially when it comes to shares, by reiterating the fact that their expected danger pay may be on the lower side for now.
The four companies that these analysts felt most confident about exceeding the 14% growth mark were BHP Billiton, Naspers, Nedbank