FROM A TOTAL RETURNS to shareholders perspective, companies performed relatively well over the past fifteen to twenty years. With the proliferation of compensation schemes incorporating stock prices in one way or the other, CEOs also reaped considerable rewards. More often than not, CEO performance evaluations in such schemes are based on absolute rather than relative returns. Would we expect CEO performance evaluations to be drastically different when placed on the scale of relative returns? This article attempts to answer this question by evaluating both relative and absolute performance of CEOs across four industries: automobiles, household products, metals and mining, and telecommunications.

Background and importance
As companies and jurisdictions in North America and elsewhere come to grips with how to remain competitive and grow in the changing world economic order, it has become critical for leaders to once again examine the broader good of shareholders, employees, management and other stakeholders, in order to successfully recalibrate the society’s underlying business structures. In the spirit of this endeavour, this study offers an intriguing look into a larger dimension of corporate performance during times economic expansion (macro and micro), and how particular companies and their leadership have faired over the same period. The overarching goal is to offer a Board of Directors the data, tools, and rigorous analysis required to correct sub-optimal decisions and structures of the past and incorporate new models for compensation, performance evaluation, equity and capital structure, and selection of management.

Data and methodology
A group of 32 companies across the four industries were selected for the purposes of this analysis. The selection was restricted to 7 to 10 large public companies – as measured by trailing twelve-month revenues – within each industry (Exhibit 1). In order to control for regional variations, selection was restricted to North American companies for all industries except automobiles. In the latter case, we felt that regional variations were not as much of an issue, owing to the high degree of globalization within the auto sector.

After the selection process, total returns to share holders (TRS) were calculated for each company for a twenty one (21) year period from 1988 to 2008. In those instances when companies went public after 1988 or when information was not available, TRS was not calculated for earlier years. The TRS for an industry was calculated as an arithmetic average of the TRSs of its constituent companies. Thereafter, to the extent possible, CEOs for each company were determined for the same 1988–2008 period. Finally, company and industry performance – measured as compound annual growth rates (CAGRs) – was matched up with CEO tenure to determine absolute and relative performance of 89 CEOs across 32 companies and four industries. A description of all the metrics used in the analysis is provided in Exhibit 2.

The importance of longer-term CAGRs
Given that company TRS was used as a proxy for CEO performance, it was not surprising to find that industry volatility was reflected in variability across CEO performance. However, it was surprising to discover that higher variability in industry did not lead to higher variability in CEO performance, at least when performance was measured on an absolute basis (compare Exhibit 3 and Exhibit 4). However, when measured on a relative basis, the trend is closer to expectation. For instance, relatively larger standard deviations in metals and mining and telecommunication services (Exhibit 3) find parallels in high CEO performance variability (i.e. a wide box plot in Exhibit 7). In contrast, the low standard deviation of household products finds a parallel in low CEO performance variability (i.e. a narrow box plot in Exhibit 7).

Board members would do well to explicitly account for industry volatility when choosing the structure and time frame of a CEO’s compensation. In volatile industries, it is difficult to ascertain CEO performance over narrow time horizons, since any moves a CEO would be making to chart a successful course will be drowned out by near-term fluctuations. Accordingly, compensation based on longer-term CAGRs would be more appropriate in such cases (the average tenure of the 89 CEOs in the sample was 5.9 years).

Relative performance together with longer-term CAGRs
Adding the element of performance relative to peers would make longer-term CAGRs even better measures. In order to arrive at this measure, CAGRs for the industry were subtracted from CEO CAGRs for the appropriate time period. For example, if a CEO’s CAGR was 10% over the period 1990–1995 and the industry CAGR was 15% over the same period, the relative CAGR would be –5% (= 10%–15%). With the exception of household products, the majority of CEOs (approximately 60%) exhibit negative relative performance (Exhibit 5 and Exhibit 6). The reason for this trend is the existence of a few longer-tenured CEOs that have performed relatively well being outweighed by many shorter-tenured CEOs that have performed relatively poorly. This can be explained conceptually as follows: suppose there are two companies in an industry, one with a CAGR of 15% and the other with a CAGR of 5%. Thus, the industry CAGR is 10% (= [15%+5%]/2). Further suppose that the first company has had one CEO over the period 1988–2008 while the other has had four CEOs, the former having a CAGR of 15% and the latter four a CAGR of 5% each. While a more rigorous analysis across a larger set of companies and industries would be needed to confirm this trend, the implication of the majority of CEOs being poor performers on a longer-term CAGR measure is intriguing. It suggests that compensation committees ought to be penalizing the majority of CEOs in some shape or form, for instance, through tighter controls on bonus payouts.

Investigating specific cases
In general, the data we analyzed showed that relative performance made most CEOs look worse than before. In fact, the entire performance distribution shifted left when CEOs were measured relative to their industry (Exhibit 7). In some cases, previously spectacular looking CEOs appeared more modest when compared to the industry (e.g. Davies from Church & Dwight in Exhibit 9). In one case, a CEO with negative absolute returns actually earned positive relative returns (e.g. Sabia from BCE in Exhibit 11).

Highlights and discussion of recommendations
An assessment of CEO and industry performance across automobile, household product, metals and mining, and telecommunications companies revealed a number of interesting insights. First, considerable variability exists in the performance of industries. Accordingly, board members should be wary of rewarding CEOs on the basis of near-term (recent past) results. Instead, longer-term CAGRs should be used to judge CEO performance. One need not go far into history to witness a similar case of how dangerous incentives based on near-term goals can be, as one of the leading causes of the capital markets meltdown in 2008 was the flawed and misaligned compensation structures in place for traders and derivatives markets.

Second, when measured relative to the industry, CEO performance reveals a disturbing trend. With the exception of household products, approximately 60% of the CEOs performed below the industry average. If the trend is confirmed with a broader set of data, then compensation committees ought to be penalizing the majority of CEOs for below average performance – for instance, through tighter bonus controls. One mechanism already being employed by some jurisdictions is varying forms of regulatory intervention whereby certain activities are penalized, usually ex-ante but potentially ex-post in exceptional circumstances.

Finally, looking at specific cases reveals that while relative performance in general makes most CEOs look less spectacular than absolute performance would, it also has the potential of achieving the counterintuitive result of making some CEOs appear better than they would have under absolute returns. In general, the goal should be to reward CEOs for strong performance on variables under their control and less so on those that are impacted by the economy as a whole. One way of achieving this is through tight coupling of performance-based compensation and achieving MD&A objectives. We propose a compensation model whereby the fixed portion is the cost of having a CEO-level person running a corporation. The variable portion should be split into two (2) parts, one for achieving MD&A objectives (for which he/she was hired) and the other for performance relative to peers and competitors.

In the sequel to this article, we hope to match performance metrics to actual compensation figures to get a clearer picture on the potential opportunities that may exist in fine-tuning how boards should be thinking about CEO compensation.
 

Sunny Bhasin is a managing partner and Yousuf Haque is an associate in Surje’s Toronto office.
 

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