Does the stock market fully value intangibles? Employee satisfaction and equity prices

Abstract

This paper analyzes the relationship between employee satisfaction and long-run stock returns. A value-weighted portfolio of the “100 Best Companies to Work For in America” earned an annual four-factor alpha of 3.5% from 1984 to 2009, and 2.1% above industry benchmarks. The results are robust to controls for firm characteristics, different weighting methodologies, and the removal of outliers. The Best Companies also exhibited significantly more positive earnings surprises and announcement returns. These findings have three main implications. First, consistent with human capital-centered theories of the firm, employee satisfaction is positively correlated with shareholder returns and need not represent managerial slack. Second, the stock market does not fully value intangibles, even when independently verified by a highly public survey on large firms. Third, certain socially responsible investing (SRI) screens may improve investment returns.

Introduction

This paper analyzes the relationship between employee satisfaction and long-run stock returns. A value-weighted portfolio of the “100 Best Companies to Work For in America” (Levering, Moskowitz, and Katz, 1984; Levering and Moskowitz, 1993) earned a four-factor alpha of 0.29% per month from 1984 to 2009, or 3.5% per year. These figures exclude any event-study reaction to list inclusion and capture only long-run drift. When compared to industry-matched benchmarks, the alpha remains a statistically significant 2.1%. The results are also robust to controlling for firm characteristics, different weighting methodologies, and adjusting for outliers. The outperformance is at least as strong from 1998, even though the list was published in Fortune magazine and thus highly visible to investors. The Best Companies (BCs) exhibit significantly more positive earnings surprises and stock price reactions to earnings announcements: over the four announcement dates in each year, they earn 1.2–1.7% more than peer firms. These findings contribute to three strands of research: the increasing importance of human capital in the modern corporation; the equity market's failure to fully incorporate the value of intangible assets; and the effect of socially responsible investing (SRI) screens on investment performance.

Existing theories yield conflicting predictions as to whether employee satisfaction is beneficial for firm value. Traditional theories (e.g., Taylor, 1911) are based on the capital-intensive firm of the early 20th century, which focused on cost efficiency. Employees perform unskilled tasks and have no special status; just like other inputs such as raw materials, management's goal is to extract maximum output while minimizing their cost. Satisfaction arises if employees are overpaid or underworked, both of which reduce firm value.¹ Principal-agent theory also supports this zero-sum view: the firm's objective function is maximized by holding the worker to her reservation wage. In contrast, more recent theories argue that the role of employees has dramatically changed over the past century. The current environment emphasizes quality and innovation, for which human, rather than physical, capital is particularly important (Zingales, 2000). Human relations theories (e.g., Maslow, 1943, Hertzberg, 1959, McGregor, 1960) view employees as key organizational assets, rather than expendable commodities, who can create substantial value by inventing new products or building client relationships. These theories argue that satisfaction can improve retention and motivation, to the benefit of shareholders.

Which theory is borne out in reality is an important question for both managers and investors, and provides the first motivation for this paper. If the traditional view still holds today, managers should minimize expenditure on worker benefits, and investors should avoid firms that fail to do so. In contrast to this view, and the existing evidence reviewed in Section 2.1, I find a strong, robust, positive correlation between satisfaction and shareholder returns. This result provides empirical support for recent theories of the firm focused on employees as the key assets, e.g., Rajan and Zingales (1998), Carlin and Gervais (2009), and Berk, Stanton, and Zechner (2010).

I study long-run stock returns for three main reasons. First, they suffer fewer reverse causality issues than valuation ratios or profits. A positive correlation between valuation/profits and satisfaction could occur if performance causes satisfaction, but a well-performing firm should not exhibit superior future returns as profits should already be in the current stock price, since they are tangible.² Second, they are more directly linked to shareholder value than profits, capturing all the channels through which satisfaction may benefit shareholders and representing the returns they actually receive. In addition to profits, satisfaction may lead to many other tangible outcomes valued by the market, such as new products or contracts. Studying returns also allows for controls for risk.³ Third, valuation ratios or event-study returns may substantially underestimate any relationship, given ample previous evidence that the market fails to fully incorporate intangibles. Firms with high R&D (Lev and Sougiannis, 1996; Chan, Lakonishok, and Sougiannis, 2001), advertising (Chan, Lakonishok, and Sougiannis, 2001), patent citations (Deng, Lev, and Narin, 1999), and software development costs (Aboody and Lev, 1998) all earn superior long-run returns. The market may be even more likely to undervalue employee satisfaction since theory has ambiguous predictions for whether it is desirable for firm value.

Indeed, investigating the market's incorporation of satisfaction is my second goal. I aim not only to extend earlier results to another category of intangibles, but also to shed light on the causes of the non-incorporation documented previously. The main explanation for prior results is that intangibles are not incorporated because the market lacks information on their value (the “lack-of-information” hypothesis). While R&D spending can be observed in an income statement, this is an input measure uninformative of its quality or success (Lev, 2004). Even if information is available on an output measure such as patent citations, the market may ignore it if it is not salient (Deng et al.'s citation measure had to be hand-constructed) or about small firms which are not widely followed (Hong, Lim, and Stein, 2000).

This paper evaluates the above hypothesis by using a quite different measure of intangibles to prior research, which addresses investors' lack of information. The BC list measures satisfaction (an output) rather than expenditure on employee-friendly programs (an input). It is also particularly visible: from 1998 it has been widely disseminated by Fortune, and it covers large companies (median market value of $5bn in 1998). Moreover, it is released on a specific event date which attracts widespread attention, because it discloses information on several companies simultaneously.⁴ If lack of information is the primary reason for previous non-incorporation findings, there should be no excess returns to the BC list.

My analysis is a joint test of satisfaction both benefiting firm value and not being fully valued by the market. By delaying portfolio formation until the month after list publication, I give the market ample opportunity to react to its content. Yet, I still find significant outperformance. This result suggests that the non-incorporation of intangibles found by prior research does not stem purely from lack of information, but other factors. Even if investors were aware of firms' levels of satisfaction, they may have been unaware of its benefits, since theory provides ambiguous predictions. An alternative explanation is that investors use traditional valuation methodologies, devised for the 20th century firm and based on physical assets, which cannot incorporate intangibles easily. The results also support managerial myopia theories (e.g., Stein, 1988, Edmans, 2009), in which managers underinvest in intangible assets because they are invisible to outsiders and thus do not improve the stock price. Even if managers are able to provide information on the value of their intangibles (e.g., by hiring independent firms to audit their value), the market may not capitalize them.

In addition to the valuation of intangibles, the paper contributes to the broader literature on market underreaction since the Fortune study has a clearly defined release date, in contrast to previous intangible measures. Prior research finds that underreaction is strongest for small firms (e.g., Hong, Lim, and Stein, 2000); more generally, Fama and French (2008) find that most anomalies are confined to small stocks and thus hard to exploit given their high transactions costs. Here, underreaction occurs even though most firms in the BC list are large, and so the mispricing is exploitable.

The third implication relates to the profitability of SRI strategies, whereby investors only select companies that have a positive impact on stakeholders other than shareholders. Employee welfare is an SRI screen used by a number of funds. Traditional portfolio theory (e.g., Markowitz, 1959) suggests that any SRI screen reduces returns, since it restricts an investor's choice set; mathematically, a constrained optimization is never better than an unconstrained optimization. Indeed, many existing studies find a zero (Hamilton, Jo, and Statman, 1993; Kurtz and DiBartolomeo, 1996, Guerard, 1997; Bauer, Koedijk, and Otten, 2005; Schröder, 2007, Statman and Glushkov, 2008) or negative (Geczy, Stambaugh, and Levin, 2005; Brammer, Brooks, and Pavelin, 2006; Renneboog, Ter Horst, and Zhang, 2008; Hong and Kacperczyk, 2009) effect of SRI screens. While Moskowitz (1972), Luck and Pilotte (1993), and Derwall, Guenster, Bauer, and Koedijk (2005) find certain SRI screens improve returns, these results are based on short time periods.

The Markowitz (1959) argument suggests that any SRI screen worsens performance, and so it is sufficient to uncover one screen that improves performance to contradict it. I study a screen based on employee satisfaction as there is a strong theoretical motivation for why it may exhibit a positive correlation with stock returns (see Section 2). Indeed, I find an SRI screen that can improve returns. If an investor is aware of every asset in the economy, an SRI screen can never help, as non-SRI investors are free to choose the screened stocks anyway. However, if she can only learn about a subset of the available universe due to time constraints (as in Merton, 1987), the SRI screen – rather than excluding good investments – may focus the choice set on good investments. A firm's concern for other stakeholders, such as employees, may ultimately benefit shareholders (the first implication of the paper), yet not be priced by the market as “stakeholder capital” is intangible (the second implication).

There are several potential explanations for the positive returns found in this paper. One is mispricing: high satisfaction causes higher firm value, as predicted by human capital theories, but the market fails to capitalize it immediately. Indeed, both the magnitude and duration of the excess returns are similar to or lower than found by analyses of long-run returns to other intangibles, firm characteristics, or corporate events. Thus, the mispricing implied by this explanation is within the bounds of what prior literature has found to be feasible. Under a mispricing channel, an intangible only affects the stock price when it subsequently manifests in tangible outcomes that are valued by the market. I indeed find that the BCs have significantly more positive earnings surprises than peer firms and greater abnormal returns to earnings announcements. A mispricing story also implies that the BCs' outperformance might not be permanent, for two reasons. First, some firms are only on the list for a finite period: employee satisfaction may vary with changes in management or a firm's human resource policy (perhaps as a result of financial constraints). Thus, the level of intangibles and hence mispricing fall over time. Second, even for firms for which satisfaction is reasonably permanent, the market may learn about its true value over time as it releases positive tangible news. Consistent with both channels, I find the drift to list inclusion declines over time and becomes insignificant in the fifth year. In contrast, prior studies of mergers and acquisitions (M&A) (Agrawal, Jaffe, and Mandelker, 1992; Loughran and Vijh, 1997), value strategies (Lakonishok, Shleifer, and Vishny, 1994), and equity issuance (Spiess and Affleck-Graves, 1995, Loughran and Ritter, 1995) find no evidence of returns declining in the fifth year, and so the above explanation requires less mispricing than these earlier findings. Consistent with the second channel in particular, the returns sharply decline in the fifth year even for firms that remain on the list for all five years. Consistent with the first channel in particular, buying stocks dropped from the BC list or not updating the portfolio for future lists leads to lower returns than holding the most current list.

An alternative causal interpretation is that superior returns are caused not by employee satisfaction, but list inclusion per se—it encourages SRI funds to buy the BCs, and this demand caused their prices to rise. I find that SRI funds that use labor or employment screens increased their weighting on the BCs over time, but this effect can explain at most 0.02% of the annual outperformance. Moreover, as with other long-run event studies (e.g., Gompers, Ishii, and Metrick, 2003; Yermack, 2006, Liu and Yermack, 2007), we do not have a natural experiment with random assignment of the variable of interest to firms, and so the data admit non-causal explanations. First, the use of long-run stock returns only reduces, rather than eliminates, reverse causality concerns. While publicly observed profits should already be in the current stock price, reverse causality can occur in the presence of private information; employees with favorable information report higher satisfaction today, and the market is unaware that the list conveys such information. This explanation is unlikely given the seven-month time lag between responding to the BC survey and the start of the return compounding window; in addition, existing studies suggest that workers have no superior information on their firm's future returns (e.g., Benartzi, 2001, Bergman and Jenter, 2007). Second, satisfaction may proxy for other variables that are positively linked to stock returns and also misvalued by the market. While I control for an extensive set of observable characteristics and covariances, by their very nature unobservables (such as good management) cannot be directly controlled for. If either reverse causality or omitted variables account for the bulk of the results, improving employee welfare may not cause increases in shareholder value. However, the second and third conclusions of the paper still remain: the existence of a profitable SRI trading strategy on large firms, and the market's failure to incorporate the contents of a highly visible measure of intangibles—regardless of whether the list captures satisfaction, management, or employee confidence.

This paper is organized as follows. Section 2 discusses the theoretical motivation for hypothesizing a link between employee satisfaction and stock returns. Section 3 discusses the data and methodology and Section 4 presents the results. Section 5 discusses the possible explanations for the findings and Section 6 concludes.