Does the Stock Market Value Intangibles? Employee Satisfaction and Equity Prices: 9/10

Investment Potential Rating:
9/10 (1 worst, 10 best)

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OVERVIEW:
Does the Stock Market Value Intangibles? Employee Satisfaction and Equity Prices
ALEX EDMANS
MIT
Draft Version: March, 2008
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=985735

Abstract:
This paper analyzes the relationship between employee satisfaction and long-run stock price performance. A portfolio of stocks selected by Fortune magazine as the Best companies to Work For in America”in January 1998 would have earned average annual returns of 13% by the end of 2005, over double the market return, and a monthly four-factor alpha of 0.7%. The results are robust to a number of controls. These findings have two main implications. First, they suggest that employee satisfaction improves corporate performance rather than representing inefficiently excessive non-pecuniary compensation. Second, they imply that the stock market does not fully value intangibles, even when they are made visible by a publicly available survey. This suggests that intangible investment generally may not be incorporated into interim prices, providing support for managerial myopia theories.

Data Source:
List of tradeable companies from the Forbes 500 "Best Places to Work for in America" issue that hits the magazine stands in late January each year.

Data Specification and Hypotheses:

The idea here is that human capital is what creates economic value for American firms in today's ideas-based service economy (human capital, simply refers to these widgets non-economists call "people"--weird)

Theoretically, the stock market should recognize the value firms provide when they create a human capital competitive advantage higher than that of firms who do a poor job of managing their human capital.

The key way firms can create returns in excess of their hurdle rates is if they can somehow maintain their access to the best human capital without having to pay them insane wages that would completely wipe out their profit. For example, if XYZ company hires amazing employees who produce millions of dollars, but these employees also cost millions of dollars to employee, the benefit to company shareholders in a simple sense is ZERO. Nevertheless, one way a firm could attract amazing employees without having to pay wages that are TOO insane, is by having an amazing work culture. According to the story told in this paper, the firms that have amazing work cultures can be found in Fortune's ranking of the "Best Places to Work for in America"(not a perfect measure, but effective).

Investment Strategy:

To date, this is the simplest trading strategy discussed on the Empirical Finance Research blog.

Step 1: In the last week of January when the new Forbes issue hits newsstands--buy it.

Step 2: Either invest your portfolio in all the publically traded companies in the top companies and hold for the long-term (Portfolio I), or hold these companies for a year and rebalance the portfolio when the next issue of Forbes comes out the following year (Portfolio II).

Step 3: Outperform the market. Portfolio I earns a 12.7% avg annual return vs the market's 5.6%. Portfolio II enjoys a 13.3% return by rebalancing the portfolio each year as the new issue updates the best firms to work for in America. On a risk adjusted basis using the Fama-French/Carhart 4-factor-throw-everything-in-to-include-the-kitchen-sink model, the monthly alpha estimates for portfolio I and II range from .6% to .7% per month. Controlling for industries, the alphas ranges from .4% to .5% per month--not too shabby.


Implementation Issues and Remarks:

There really isn't anything to not like with this trading strategy, save the fact it is "too easy." It reminds me of the Joel Greenblatt trading strategy outlined in his book The Little Blue Book that Beats the Market. The thought of investing being so easy makes many investing pros and investment pro wannabees (I'm in this category) cringe, because it effectively says their years of experience and aptitude were a huge waste of time.
So on to the basics: Diversification? Check, each year the portfolio holds 50-70 companies in an assortment of industries. Easy to implement? Check, all you need to do is a yearly rebalance; if you are super low maintenance, simply buy the companies on the list and hold them for five to ten years. Cost to implement? Very low. The average market cap of the companies involved is around $22bil (median is $6bil) and many of the stocks have very deep and liquid markets. Great returns? Yes, double the CRSP value-weighted index. Limited risk? Well, depends on who you ask, I guess. On one hand, using the standard risk adjustment models the strategy looks good; on the other hand, these stocks have market betas around one so you can expect to feel the general pain of the markets mood swings as they occur.

WRG