‘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.

Fin­week

Finweek English Edition - - MARKETPLACE - Ed­i­to­rial@fin­week.co.za

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.

Worth­while in­vest­ments

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

and Sho­prite.

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