How can I benefit from credit upgrade?
Take advantage of the credit rating upgrade fever while it lasts
The stock market went up strongly last week because of the credit rating upgrade by S&P for the Philippines. While this is definitely good news, I am just curious about how this credit rating will exactly affect our economy and the stock market in general. Can you explain? – Marjeline Lao by email
For the past many years, the Philippines has always been rated low with speculative grade by international rating agencies. The uncertainties in the economy brought about by our turbulent political situation then made the Philippines highly risky in the eyes of foreign investors. Creditors fear that the country may be highly vulnerable to changes in economic conditions that would make it unable to honor their financial obligations in the process. Because of this, investors have always put a high risk premium whenever they invest in the country.
This risk premium comes in many forms. It comes in the form of high borrowing costs. Foreign banks, for example, puts extra rate on top of prevailing interest rates when government and corporates borrow money abroad. Foreign funds also demand extra returns from their investments in stock market. The high risk premium would also make the valuation of Philippine stocks unattractive that discourage many foreign investors to come into our market.
Last year, for the first time in history, the Philippines crossed over to the investment grade category from speculative group. This change signifies that the country, in the opinion of credit rating agencies such as S&P, has shown promise of improving creditworthiness because of the fiscal reforms undertaken by our government that helped fuel our economy to robust growth in the past years. Last week, the Philippines got an investment upgrade by S&P with BBB rating, which essentially says that the country now has adequate capacity to meet its financial commitments.
This rating upgrade reflects the growing confidence of foreign investors in the Philippines. This improving sentiment means lower risk premium, which translates to lower borrowing costs. Government can take advantage of this by raising fresh funds overseas to repay existing debts with high interest rates, for example. The savings in interest expense and cheaper funds abroad can be channeled to help finance various government infrastructure projects, which can help sustain the growth momentum in the economy.
Publicly listed companies can also use this higher investment grade status to raise funds abroad with lower interest costs to finance their expansion. More expansion means greater growth in future earnings, which should drive share prices higher.
The investment upgrade will also mean stronger peso. Because of the expected increase in funds flow from overseas through corporate borrowings and infusion of portfolio investments, there will be added supply of dollars in the market, which would pressure the price of US dollar to fall. Last week, the sudden surge of the foreign buying in the stock market has already caused the exchange rate to fall to Php43.65 from Php44.10. If this trend is going to continue, the peso will likely fall down to Php43 level soon.
Lower risk premium from higher credit rating will drive stock price valuation higher. As investor, you would want your investment to create value for you by earning more income than what you expect. This expectation is your minimum rate of return on your investment in stocks. Why minimum? Because this is the lowest rate that will make you switch from investing in low-yield, risk free securities, say treasury bills to high-yield, high risk equities in the stock market.
Let’s assume that you are invested in government bond that gives you annual yield of 4%. Although you don’t earn much from this, you feel that your money is fully secured because there is almost zero chance that the government will default. But you now want to invest in the stock market. You think that it can be risky but it can be highly rewarding. So for you to compensate the additional risk for higher returns, you put a premium of 6% so that your total required rate of return is 10%.
Now, let’s apply this concept to valuation. When you value a stock, you will need to estimate the cash flow that you expect to earn from it and divide this by the difference between your required rate of return and the projected earnings growth rate of the stock. Let’s say you are valuing the stock of PLDT. This stock has expected cash dividend this year of Php181 and it is projecting earnings growth rate of 3.4%.
In order to value this, simply divide the cash dividends of Php181 by the difference between your required rate of return of 10% and the projected growth rate of 3.4%, which is 6.6%. What you get is an estimated fair price of Php2,742. The announcement of credit rating upgrade brought in a lot of foreign funds last week, which pushed the share price of PLDT to Php2,974. This upgrade means higher confidence in the economy, which translates to lower risk premium. Could it be possible that foreign investors have lower required rate of return?
Let’s find out what they must be thinking. Assume that you are willing to lower your risk premium by 1% so that your total required rate of return is now at 9%. Repeat the valuation process by dividing the expected cash dividends of Php181 by the difference between your new required rate of return of 9% and expected growth rate of 3.4%, which is 5.6%. What you get is higher target price of PLDT at Php3,232.
Take advantage of the credit rating upgrade fever while it last. Increased confidence means higher stock price valuation and bigger trading opportunities. Remember to use proper diversification as different stocks have different risk profiles.
Henry Ong is a Registered Financial Planner of RFP Philippines. He is best selling book co-author of Money Matters. He also writes regularly as columnist for the Philippine Daily Inquirer.
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