How Investing in Intangibles — Like Employee Satisfaction — Translates into Financial Returns

How Investing in Intangibles — Like Employee Satisfaction — Translates into Financial Returns

Published: January 09, 2008 in Knowledge@Wharton

to management theories developed in the Industrial Age, employee
satisfaction is an important ingredient for financial success,
according to a new research paper by Wharton finance professor Alex Edmans.
His findings also challenge the importance of short-term financial
results and may have implications for investors interested in targeting
socially responsible companies.

In a paper titled, "Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,"
Edmans examines the stock returns of companies with high employee
satisfaction and compares them to various benchmarks — the broader
market, peer firms in the same industry, and companies with similar
characteristics. His research indicates that firms cited as good places
to work earn returns that are more than double those of the overall

Companies on Fortune magazine’s annual list of the "100
Best Companies to Work for in America" between 1998 and 2005 returned
14% per year, compared to 6% a year for the overall market, according
to Edmans. The results also hold up using an earlier version of the
survey that dates back to 1984. "One might think this is an obvious
relationship — that you don’t need to do a study showing that if
workers are happy, the company performs better. But actually, it’s not
that obvious," says Edmans. "Traditional management theory treats
workers like any other input — get as much out of them as possible and
pay them as little as you can get away with."

Those ideas came to dominate management thinking during the
industrial age when economic expansion was based largely on industrial
machinery. In that environment, workers were required to perform
relatively simple tasks and they were easily replaceable. Companies
motivated workers mainly with money, paying by the piece in order to
reward employees who churned out the most products.

In today’s business world shaped by new technology, knowledge and
creative thinking, the value of each employee is increasingly
important, although hard to measure directly, Edmans says. "Nowadays
companies are producing more high-quality products. They are focusing
on innovation and looking for the value-added to come from workers
rather than machines." Since key outputs, such as teamwork, building
client relationships and idea generation, are difficult to measure,
motivating workers by paying by the piece is less effective. This leads
to the increasing importance of employee satisfaction as a motivational
tool. Pleasant working conditions can lead to employees identifying
with the firm, and thus exerting more effort than the minimum required
by the employment contract. Moreover, it can be a powerful method of
retaining key employees.

To test his theory that happy workers generate better returns, Edmans used the annual survey published by Fortune
and conducted by the independent Great Place to Work Institute in San
Francisco as a measure of employee satisfaction. Edmans says the survey
is a valuable gauge of employee satisfaction because it is based on
in-depth surveys of a firm’s employees, rather than just an external
observation of stated policies. Fortune began publishing the list in 1998, but Edmans also used earlier versions of the list published in book form in 1984 and 1993.

"This paper documents statistically and economically significant
long-horizon returns to portfolios containing companies with high
employee satisfaction," Edmans writes in his paper. "These findings
imply that the market fails to incorporate intangible assets fully into
stock valuations — even if the existence of such assets is verified by
a widely respected survey."

Edmans’ paper controls for numerous variables, including industry
returns, firm risk, and firm characteristics such as size and value. He
notes, however, that the work rests on a relatively small sample since
the survey is limited to 100 companies a year, of which only 65 to 70
are publicly traded at one time.

Not an ‘Either-or’ Choice

Beyond exploring the link between employee satisfaction and
financial performance, the paper may have other implications, Edmans
suggests. First, the research could help inform socially responsible
investing, which Edmans notes has become increasingly popular in the
past 10 years. In this form of investing, ethical and social
considerations are factored in along with expected financial returns
when investors make decisions about taking stakes in companies.

"The traditional view of socially responsible investing is that it
is an ‘either-or’ situation. For example, companies that endeavor to
reduce their impact on climate change may offer lower shareholder
returns, since such efforts often involve significant expenditures,"
says Edmans. However, if the firm’s treatment of its own employees is
one of the criteria investors use to determine whether a company is
socially responsible, the study indicates that socially responsible
investors may not need to sacrifice strong returns. This consideration
could be especially important for fund managers investing on behalf of
union pension plans or other employee benefit programs.

While the study has generated significant interest among socially
responsible investing (SRI) practitioners, Edmans cautions that the
research so far applies only to socially responsible investment that is
focused on employees. The study does not address other screens
investors may use to target socially responsible companies, such as
environmental standards or religious philosophy.

Another, more subtle implication of the research, says Edmans, goes
to the nature of short-term thinking among corporate managers. Even if
managers believe employee satisfaction enhances long-term corporate
performance, they may not act on their beliefs because investing in
employees often reduces earnings in the short term. "This is a large
concern people have had for a couple of decades now — that the
American corporate system is short-term or myopic," Edmans notes.

That concern, he adds, is driven by managers who argue it is not
possible to credibly communicate to investors that profits might be
lower in one period in order to invest in employee satisfaction that
may pay off in the future. "This is why I take the most visible measure
of employee satisfaction — the Fortune list — as
independent verification of a company’s employee satisfaction. What the
paper shows is that even this highly visible measure is not
incorporated into the stock market."

Edmans says the list is typically published in mid-January. He
constructs his portfolios from the start of February, giving the market
ample opportunity to react to the information in the list. If the
market fully incorporated the contents of the list, he should not have
found superior returns to his portfolio. "If this highly visible means
of employee satisfaction is not responded to, then it suggests that
intangibles in general — the vast majority of which has nothing close
to the Fortune list to verify them independently — might be quite difficult to factor into the stock price," says Edmans.

Edmans cautions, however, that a correlation between employee
satisfaction and stock returns need not imply causation. Although he
controls for many observable variables, it is impossible to rule out
the story that an unobservable variable, such as superior management
practices, may cause both higher returns and satisfied employees.
However, even under this interpretation, "it still remains that the
market does not incorporate intangibles (whether they are satisfaction
levels or good management) even when made publicly available, and that
an investor could have earned significant risk-adjusted returns by
trading on the Fortune list."

More Skin in the Game

While the study shows there may be a reward in the market for
investing in intangibles over time, Edmans points out that the research
is not sufficient to encourage investors to shift away from the current
short-term focus. "What’s needed is not just for the manager to know
employee satisfaction matters, but also to have the incentive to act on
this," he says. If managers are compensated largely on short-term share
price, their decisions about investing in employee satisfaction or
other intangibles will not change. He suggested one way to correct this
problem would be to compensate managers with stock or options that
cannot be sold for a number of years.

Another response to the problem of management myopia might be for
shareholders to take larger stakes in firms. Edmans explored this idea
in an earlier paper titled, "Blockholders, Market Efficiency, and
Managerial Myopia." "If you only own a very small percentage, there is
no incentive to do your own research. You don’t have enough skin in the
game," he says. "If you have a larger stake, you have the incentive to
research the company’s fundamentals rather than just trade on
short-term earnings."

According to Edmans, Warren Buffett is a good example of an investor
who takes a large enough position in a firm to adopt a long-term
perspective that pays off beyond a strategy focused on short-term
returns. Similarly, Bill Miller, chairman and chief investment officer
of Legg Mason — who famously beat the S&P 500 for 15 years in a
row — deliberately holds a concentrated portfolio containing a small
number of stocks, to allow him to understand each company deeply.
"There is the Wall Street adage that, upon seeing a company announce
low earnings, ‘the market sells first and asks questions later,’ which
threatens to induce managers to over-emphasize short-term earnings,"
says Edmans. "However, shareholders with sizable stakes have the
incentive to ask the questions first — i.e., find out whether low
earnings may in fact result from long-term investment."

One company that exemplifies many elements of Edmans’s research is Google, which was number one on the most recent Fortune
list. In addition to its reputation for caring about employees’
welfare, it is known for emphasizing corporate social responsibility
more generally. When Google went public, it wrote a letter to
shareholders acknowledging Wall Street’s "rules of the game," which are
that public firms should make quarterly earnings forecasts and meet
these short-term targets. Google explicitly stated that it would not
play by these rules and instead would focus on long-run growth. So far,
Google’s performance has vindicated this approach.

Overall, Edmans’s research is part of a broader shift among
academics to develop new theories focused on the modern firm. "When I
was at Morgan Stanley, we would value firms according to their tangible
assets, cash flows and earnings — which is common across most of Wall
Street and much existing academic research," he says. "But nowadays,
significant components of a firm’s value cannot be captured by
accounting numbers."


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