ASX is down, are TSR outcomes down too?
08/08/2022
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Relative TSR continues to remain the most common LTI measure among ASX listed companies. The popularity stems from the fact that it is perceived to compare the performance of the company against other ASX listed companies on a comparable basis. It is not, however, without its own problems (see this old but still very valid article from 2006 HERE).

As the cyclical downturn bears onto the Australian equities market, we look at the takeaways from using relative TSR as an LTI measure during the last cyclical downturn of 14 years ago and see what lessons can be applied.

In 2010, Guerdon Associates research discovered that ASX50 companies most impacted by the GFC experienced the highest growth in the years following the crisis. Conversely, stable companies did not see the same bounce in TSR. Executives in heavily impacted companies that managed to hold on to their grants throughout the GFC would have seen huge windfalls in the relative TSR LTIs and vice versa. This rewards and punishes executives for situations that are outside of their control, defeating the purpose of an incentive. (For the article covering the research see HERE.)

The lessons from the study were

  • Relative TSR measures unfairly penalise the management of less volatile companies as an economy recovers from a downturn
  • A standalone relative TSR measure for LTI may be inequitable and unfair, depending on the economic cycle and grant dates
  • A combination of absolute and relative measures may make sense to ensure equitable rewards over time (i.e. two measures are better than one)
  • If relative TSR measures are the only feasible LTI measure (e.g. in commodity based stocks where earnings are difficult to predict), then other remuneration methods should also be considered for long term shareholder alignment (e.g. encouraging share ownership over the longer term with share rights as part of fixed pay)
  • That hurdles should be reviewed carefully each year prior to grant to recognise the likely impact of economic cycles
  • Timing of grants can make a difference and should therefore be made at the same time each year to avoid accusations of opportunism

This makes the relative TSR work more like an STI during economic upheaval. Relative TSR is highly susceptible to sudden economic changes and high volatility. Despite the long performance period a sudden event could alter large perceptions and render the effect of the rest of the period moot.

How can we take these lessons into 2022 for the current situation (i.e. a cyclical equities valuation change)?

As we are in the slowdown phase the opposite of the 2010 research could occur. Executives of relatively stable companies would be expected to see higher vesting in the relative TSR plans. The volatile companies adversely affected by the slowdown would lose the progress made from the past few years. These executives will lose out on large portions of potential vesting. Executives will feel hard done by the incentives not reflecting their performance and could lead to turnover.

In the eventual recovery, higher growth companies  will be starting from a lower base. This leads to larger vesting for these executives. This creates the impression that the system is unfair, as executives are being rewarded and punished for something that is largely out of their control. This could backfire in two ways, it encourages excessive and unnecessary risk taking from executives as they chase a payout or the executive looks elsewhere for a position.

To mitigate both sides of the issue, there are multiple tools that boards can consider drawing upon:

  • Board discretion. This would be the most blunt and direct instrument. Boards could exercise discretion post results to adjust and account for the economic situation. This would draw ire from the executives and investment community alike.
  • Having a risk adjusted TSR. Adopting a risk adjusted TSR would reduce the effects of the individual companies risk profile on vesting frequency and quantum. This would provide an outcome considered more “fair” as it considers the situation for each executive more relative to the current “one size fits all” approach.
  • Tailoring the relative TSR peer group. Companies often base the relative TSR peer group against an index or large set of companies. This peer group may not be best suited for the company as it does not consider the volatility of each constituent and its correlation. By tailoring the peer group to get the best peers possible, it could reduce the large discrepancies in vesting between years and reward executives for performance relative to direct competitors.
© Guerdon Associates 2022
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