Volatile companies defy logic in relative TSR hurdled vesting outcomes
30/06/2014
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Investment advisers will tell that you that, in the long term, higher risk should produce higher return. This would imply that executives in companies with higher share price volatility should be reaching their relative TSR targets more frequently than their less volatile peers.

However, Guerdon Associates’ study of the S&P/ASX 50 found that the opposite may in fact be true. That is, the value of an investment, or LTI in this case, is not necessarily related to the frequency with which it vests.

The study included the 40 S&P/ASX 50 companies that use relative TSR as an LTI hurdle. We investigated the relationship between volatility and TSR, Beta and other measures of financial performance.

The vesting analysis is based on the 33 companies that have used relative TSR for long enough to have conducted at least three performance tests. We investigated the relationship between risk and LTI vesting outcomes as well as how vesting relates to financial performance.

Analysis split the data into three categories for those with high, medium and low volatility. A company was classified as highly volatile if their current 3-year annualised volatility was at or above the 75th percentile, that is, in the top quartile of the group. Low volatile companies were those that had volatility at or below the 25th percentile. Medium volatile companies represent the 20 companies in between the low and high volatility benchmarks. A list of the companies used in the analysis is shown in the table below.

Table 1: Volatility categories

Relatively High Volatility

Medium Volatility

Relatively Low Volatility

·Iluka Resources

·Qantas Airways

·WorleyParsons

·QBE

·Incitec Pivot

·Toll Holdings

·Goodman Group

·Rio Tinto

·Santos

·Lend Lease Group

·Orica

·AMP

·Asiano

·Origin Energy

·Dexus

·Brambles

·Stockland

·Woodside Petroleum

·Oil Search

·Suncorp Group

·Mirvac Group

·BHP Billiton

·Coca-Cola Amatil

·Aurizon Holdings

·Sonic Healthcare

·APA Group

·IAG

·NAB

·CSL

·Amcor

·Westpac

·ANZ

·GPT Group

·AGL Energy

·Wesfarmers

·CommBank

·Transurban Group

·ASX

·Telstra Corp

·Woolworths

It is important to note that the average volatility of ASX 50 companies has been steadily decreasing in recent years. Therefore, even the companies in the high volatility group may not have what would be considered high share-price volatility in absolute terms. The 3-year annualised volatility, 3-year annualised TSR and 3-year Beta statistics of the group are summarised below.

Table 2: Summary statistics

Statistic

Volatility

Beta

TSR

Minimum

15.4%

0.57

-44.3%

25th Percentile

20.7%

0.73

15.6%

50th Percentile

22.6%

0.94

49.7%

75th Percentile

25.8%

1.15

75.3%

Maximum

49.9%

1.61

129.3%

The correlation between volatility and beta is 0.715. This suggests that around half of the variation in volatility is due to variation in beta, or in other words, due to sensitivity to overall market changes. The data also indicates that short (1 year) and long-term (3 year) volatility is highly correlated (0.805).

The correlation between volatility and TSR is -0.686. This suggests that volatility may be attributable to poor share price performance, which in turn may be attributable to poor current and/or expected future earnings.

This showed that the principle of higher risk, higher return does not hold true for the ASX 50 over the past three years.

Relative TSR Vesting Outcomes

Theory would suggest that an executive working for a high volatility company would experience relative TSR hurdled LTI vesting that was more variable over time than that of a low volatile company, right? Wrong. The average standard deviation of vesting outcomes was similar across the three groups of companies analysed.

Average vesting frequency and average percentage of the grants that vested over the most recent three performance periods is summarised below.

Table 3: Frequency of vesting (per 3 years) and % vesting ASX 50 LTI

Partial Vesting

Full

Vesting

Overall

Vesting

Percentage of Grant that Vested

Low Volatility

1.5/3

1.0/3

2.5/3

67%

Medium Volatility

1.4/3

0.8/3

2.1/3

58%

High Volatility

0.9/3

0.6/3

1.5/3

42%

Low volatility companies are seen to have more frequent partial and full vesting than either the medium or high volatility companies.

High volatility companies have significantly lower rates of vesting over the periods analysed. In some cases this is clearly linked to cyclical performance, particularly in the resources sector. In other cases earnings have diminishing for other reasons.

The average vesting outcomes for the last three performance periods are shown in the following table.

Table 4: Average vesting outcomes

Statistic

2013

2012

2011

Low Volatility

73%

73%

56%

Medium Volatility

57%

60%

56%

High Volatility

31%

48%

35%

The results do suggest that relative TSR is working as it is intended for companies with medium to low volatility.

Ideally the analysis would be conducted over a longer time frame and with a larger sample.

However, the results for the high volatility companies prompt the following:

1.    If companies with historically higher volatility are less likely to produce vesting based on TSR, is the alignment with shareholder experience balanced with a measure that rewards executives for managing well when (say) commodity prices drop?

2.    Is the peer group chosen appropriate based on the company’s operations and the long-term volatility? Choosing appropriate peers can be problematic given the size of the Australian market. The volatility of the company and the peers will have a significant impact on the valuation outcome.

3.    Are companies achieving an adequate return on investment, given the expensed value of the TSR grants?

Volatility in an important input to the relative TSR rights expense valuation. Higher volatility assumptions increase the expensed value of a right. In the ASX 50 group analysed, increasing volatility from the median (23%) to 30% increases the expensed value by 5%. This could be significantly higher for companies using peer groups outside the ASX 50 where returns tend to be less stable.

If the rights fail to vest, there is no opportunity to adjust the accounting expense. Therefore having a relative TSR hurdle that rarely vests incurs significantly more expense over time than a financial measure, like EPS growth or ROE, where the expense can be reversed if performance hurdles are not achieved. The converse is also true. Relative TSR hurdles that vest in full will incur a lower expense than a financial measure that vests in full.

© Guerdon Associates 2021
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