Employee Share Options, model theory and the Greek/Irish Default Conundrum

Looks like the Irish have gone and joined the Greeks in causing trouble in the Eurozone paradise. It’s coming up to the end of the tax year, and The Firm informs me I haven’t used my employee share options yet. Stands to reason as I didn’t expect to be working there in five years’ time. However, it’s come to my notice that if I retire I get to spring these ESIP shares free of tax and NI without holding for five years. Now I don’t know about you but I loathe paying tax, so I prick up my ears and wonder if I’m about to miss an opportunity to stop that B’stard George Osborne stealing some of the Ermine’s heard-earned cash.

So what’s the Employee Share Incentive Plan about then?

Somewhere in the distant past it was deemed A Good Thing if employees had skin in the game relative to the share price, that’s even lowly grunts like me that are about five layers of management down from The Board. And Hector the Taxman lets you buy these shares before tax and NI have been taken off. If you are a higher rate taxpayer then you save losing 42% of your salary. Now I would be a HRT payer but I hate people stealing my money so much I pay all the excess over the HRT threshold into my pension AVCs so I am a basic rate tax payer. So I get to save 32% on this. The catch is that you do actually get to buy the shares at the time of taking the decision, and the shares are then embargoed for 5 years, take ‘em out before then and you get tapped for the tax and NI you saved. You are also exposed to share price volatility, and you do get the dividends. Which is nice, as The Firm isn’t a bad divi payer at all.

What are the Risks and Rewards and How can I Mitigate them?

Let’s assume that The Firm is reasonably okay priced relative to its historical PE. The yield is about 3.5%, but I’m only aiming to hold the shares for sub a year, though I may change my mind once I am no longer working for them as they are a reasonable component for a HYP, and if The Firm is good enough for Neil Woodford’s High Income trust and I have no other exposure to its sector then perhaps I should just hold.

Rewards

Depending on how you look at it, I pay £1020 of post-tax income to buy £1500 worth of shares, a gain of 47%. Or as I look at it, I started out with £1500 and stopped the taxman stealing 1/3 of it. Either way, a gain of £480. I can’t buy any more than £1500 of shares, that’s the rules. If The Firm or the market takes this sort of viewpoint then I get to take a slice of the upside, and also some reasonably good dividend yield. The implicit yield of The Firm is upped from about 3.5% to about 4.5 by the tax discount on purchase price alone.

Risks

If The Firm screws up and the share price goes down the toilet. It’s been known, worst case is it has been about a third of what it is now, but that was an exceptional cock-up that was perpetrated by some directors who wanted to pump the SP to get their options, then left before the SHTF. Can’t guarantee that’s not about to happen again, but cooler heads seem to be prevailing.

Estimated Probability – 40:60 up 10% or down by 10%

The Greeks and/or the Irish cause a huge ruckus that destroys the Eurozone. Another form of the SP going down the toilet, let’s say this slaughters the UK stock market by 50% of its value, and The Firm gets caught in the crossfire.

These are the main risks we suffer from. I could also add general Black Swan risks, such as getting hit by a meteorite at 625 to 1 but that would be facetious :) There is, of course, a chance the stock market may go for a second near death experience as in 2007 but that might as well be lumped in with my estimate of the chance of the Greeks/Irish defaulting.

Estimated Probability of Eurozone crash (over the < 1 year holding period) 30%

Mitigation strategies

I could use IGIndex to short my shareholding, converting the volatile shareholding into a fixed cash holding (minus the cost of shorting, and the cost of dividends, but of course I would get the dividends to offset that)

I will represent this choice as a fixed cost of 5% of the holding, ie £75. I get rid of the risks of the Greeks, or The Firm screwing up, but I introduce some risk of IGIndex, the counterparty, going titsup.

Estimated Probability of IGIndex failing – 0.1%

Modelling My viewpoints

I joned the Model Thinking course called out by Monevator (vaguely at the behest of Charlie Munger ISTR). One of the lectures deal with Decision Trees, so I figured i would take this for a spin and see what it says I should do. My choices are to buy the ESIP shares or not, and to hedge them at IGIndex or not. There are three uncontrolled risks IMO – a Greek default halving the value of the shares (from analogy to what happened with the market in general with Lehmans), the possibly of The Firm being slightly overvalued IMO, modelled as a 40% change of the shares going up 10% as opposed to a 60% chance of them going down 10%, and the risk of IGIndex failing, which I put at 0.1%.

Go with my Gut or Model It?

My gut feeling was go for it, and probably don’t bother to short.

I ran all this lot into something called TreePlan, from www.treeplan.com. This is an add-on for Excel, and works okay, though it handles like a greased pig on an ice-rink; it is all too easy to blow away a branch of the tree at a stroke, there is no Undo with that. But it does the job.

The result was surprising

The results of the decision tree calculation. Computer says take branch 1 and 2. Buy the shares and short them.

So going with my gut would have sent me along the wrong track, slightly. Or I am not correctly quantifying my risk perception, either over-weighting the likelihood of failure or over-weighting the cost of failure. The costs of failure are pretty clear on this one, so I am probably either irrational or quantifying risk perception wrong.

Let me for a moment slough off my white pelt and pretend I am Ermevator, picking up some of Monevator‘s world-view. He tends to be more chipper about the stock market and the prospects for its investors even when being downbeat. He’d be more neutral to the Firm’s SP, if anything favouring a slight uptick, that I have represented by shortening the odds on a 10% uptick to 55% to 45%. And he probably wouldn’t let me get away with a 30% risk of Greek default, on the principle that the politicians will probably muddle through. So I’ve dropped that as low as I can go, to a 10% risk.

An Ermevator would probably buy the shares and find the 45% uplift provided by HMRC enough hedge against future downside risks.

Computer says buy the shares and wing it.

Interestingly, the difference in outcome isn’t all about the Greeks. Bear in mind that the time horizon for this exercise is less than a year, even I might concede that 10% is probably a better reflection of the Eurozone implosion risk over the next year than 30%. However, simply changing that in the top model doesn’t change the solution. It is only by being more optimistic all round, about both the Greeks and the Firm that the Ermevator’s path becomes favoured, ie hold the shares without shorting. So I need to reflect more on where I think The Firm’s SP is going to go, as well as collect more data on how much IG will charge to hedge this over about 9 months. I also need to refine my thinking inasmuch as it probably only makes sense to short the £1020 that I forego by taking ESIP, rather than the £1500 total stake. Which reduces my shorting costs by 30% and uncovers the value of 30% of the dividends.

All in all a surprising result from Model Thinking, which has taught me quite a lot about my worldview and its ramifications, and that this decision which looked fairly simple has more wrinkles than meets the eye. Whether it is worth so much mentation over £1500 worth of shares is a different matter, but it’s nice to actually apply something you’ve leanred at ‘vitual university’ to a real-world problem within a week of learning it. Charlie Munger was right, the old dog, and a hat tip to Charlie, Scott Page/UoM and Monevator for helping me think smarter :)

 

 

Thanks for the hat tip! I have to make a few follow-ups though.

Ermanvator can have a much higher percentage chance of Greek defaulting, if he likes. I wrote as long ago as May 2010 that I think “it’s extremely likely Greece will default”. (http://monevator.com/2010/05/08/greeks-gift-us-a-buying-opportunity/)

Where I differ from most over the past 18 months is I don’t think it matters. The only time I really got spooked was before Christmas, when credit was truly freezing up. Banking crisis was the credible risk IMHO, but it was clear by Christmas (thanks to reading a few smart hedge funds, not all my own thoughts I admit) that the ECB was taking this off the table with the now well-discussed three-year lending facility. So my mini-wobble didn’t last long.

Nobody cared about Greece three years ago and nobody will care in three years time, that’s my central prediction. Italy or Spain would be different, but I don’t expect disaster there – especially not from Italy which is, IMHO, basically, loaded, despite all you read. :)

As for the modelling, very interesting. Don’t you also have to model what you’d otherwise do with the £1000 though?

Given you’re hardcore saving, I bet it would go into high yield shares. And given your downside scenarios would surely impact *any* high yield share, not just The Firm’s, this would I suspect make it even better to take the offer and grab the immediate tax uplift?

Great reading you getting into all the wheezes, anyway. Imagine if you Ermine had excused himself from chasing Natasha in the BBC bar and turned financially nerdy earlier! ;)

But where would be the fun in that… ;)

I guess with the Greeks it’s the weighting of the effect Ermevator would have to drop ;)

With the modelling you’re right, I should have made the bottom track return about 4.5% of £1020, so about £46. So the share purchase is a win of about 9 times.

The whole thing has served me well, because I was selling off stakes of The Firm bought through ESIP on the old mantra of ‘don’t hold your employer’ because of the job risk + shares risk. This is breaking down in my case because what the hell do I care about the risk of redundancy ;)The Firm would be a decent addition to my HYP, which has zero exposure to its sector because of my ESIP shares. So I’m going to change policy and simply leave these be, tax unwrapped because as a BR taxpayer now and in retirement I can take the divi without paying tax. So I’ve got a significant financial win from the Model Thinking course already.

So I’ll buy, and not bother shorting them because all I’d do with the money is buy HYP shares, so why not stick with what I’ve just bought. D’oh!

As for the Natashas, well, they were fun :) I’ve got no need to be the richest guy in the graveyard so je ne regrette rien…

 

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>