rTSR: When Do Relative Performance Metrics Capture Relative Performance?

Paul  Ma; Jee-Eun  Shin; Charles C. Y. Wang

Working Paper | HBS Working Paper Series | 2019

rTSR: When Do Relative Performance Metrics Capture Relative Performance?

by Paul Ma, Jee-Eun Shin and Charles C. Y. Wang

Abstract

Relative total shareholder returns (rTSR) has become the predominant metric to isolate managers' idiosyncratic performance. Among firms that explicitly use rTSR in relative performance contracts, 60%—those that choose specific peers as benchmarks—select rTSR metrics that do a remarkable job of filtering out the systematic component of returns in adherence to the informativeness principle. However, firms that choose index-based benchmarks retain substantial systematic noise in their rTSR metrics. We document that the selection of noisy benchmarks is associated with compensation consultants' preferences, which are uncorrelated with observable firm attributes. Firms with weak governance are more likely to choose indexes, not because of opportunism, but because they do not adequately scrutinize outside experts' advice. Collectively, our findings provide a new explanation for why some executives are evaluated based on systematic noise and novel evidence on how compensation consultants can impact firms.

Keywords: Relative TSR; Relative performance evaluation; systematic risk; board of directors; Compensation Consultants; style effects; Executive Compensation; Performance Evaluation; Corporate Governance;

Language: English

Format: Print

57 pages

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Citation:

Ma, Paul, Jee-Eun Shin, and Charles C. Y. Wang. "rTSR: When Do Relative Performance Metrics Capture Relative Performance?" Harvard Business School Working Paper, No. 19-112, April 2019. (Revised May 2019.)

The case describes the investment of hedge fund, Totem Point Management in Analog Semiconductors (ADI) as a way to discuss forecasting and valuation in growth companies. In June 2016, hedge fund Totem Point invested in ADI at around $55 a share. In general, Totem Point aimed for their investments to yield 50% returns over a two-year time horizon. It was now 2018, and Totem Point was evaluating whether to maintain its position in ADI, expand it, or close it and walk away with its (substantial) winnings from the investment. Though the stock had done well in the prior two years, it had recently seen numerous downgrades by sell-side analysts, as its price slid 15% from a historic high. The question facing Totem Point, was whether it would grow by a further 50% over the next two years. To answer this question, Totem Point considered growth trends in each of ADI’s main end-markets: industrial applications, consumer applications, automotive applications, and telecommunications applications. If these end-markets expanded over the coming two years, ADI would do very well, but if they failed to expand, the stock would stagnate. Totem Point’s task was to figure out which scenario was most likely and what that scenario would mean for the stock’s price.

During 2007–2016, S&P 500 firms distributed to shareholders $7 trillion via buybacks and dividends, over 96% of their aggregate net income, prompting claims that "short-termism" is impairing firms' ability to invest and innovate. We show that, when taking into account both direct and indirect equity issuances, net shareholder payouts by all public firms during this period were only 41% of net income. And, in fact, during this decade investment increased substantially while cash balances ballooned. In short, S&P 500 shareholder-payout figures cannot provide much basis for the notion that short-termism has been depriving public firms of needed capital.

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rTSR: When Do Relative Performance Metrics Capture Relative Performance?

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