The Best Companies to Work For are Also Good Investments

The research, including the 2013 study, “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,” by Alex Edmans, the June 2020 study, “Corporate Sustainability and Stock Returns: Evidence from Employee Satisfaction,” by Kyle Welch and Aaron Yoon, and the August 2021 study, “Measuring Culture,” by Kai Wu, has found:

• There is a strong, robust, positive correlation between employee satisfaction and shareholder returns – firms with high levels of employee satisfaction have generated superior long-term returns even when controlling for industries or factor risk.

• Net labor flows of highly skilled workers such as engineers, scientists and middle managers – workers who are central to the firm’s operations and able to directly observe the firm’s production process – are highly predictive of abnormal stock returns, while other types of labor flows are less informative about future performance.

• The link between gross labor outflows and abnormal stock returns is more pronounced than the link between gross labor inflows and abnormal stock returns.

• Increases in net labor outflows are predictive of reductions in corporate earnings, primarily through increases in operating expenses and SG&A (selling, general and administrative expenses).

• Equity analysts and investors do not appear to fully incorporate information from labor flows into their corporate earnings expectations – they consistently overestimate (underestimate) the earnings of firms that experience high (low) net labor outflows.

• Firms in a long portfolio based on employee satisfaction are characterized by earnings surprises that are positive on average, while firms in a short portfolio exhibit earnings surprises that are negative on average.

• Treating employees well builds up a reserve of goodwill, which is paid back in the form of greater motivation and loyalty, and satisfied employees are more likely to spread the word, enhancing brand and recruiting efforts.

In summary, the findings show that the stock market has not fully valued intangibles, and certain socially responsible investing (SRI) screens may improve investment returns.

New evidence

Hamid Boustanifar and Young Dae Kang contribute to the employee satisfaction literature with their study, “Employee Satisfaction and Long-run Stock Returns, 1984-2020,” published in the June 2022 issue of the Financial Analysts Journal, in which they extended Edmans’ research based on the list of the 100 best companies (BC) to work for in America (produced by the Great Place to Work Institute) over the period 1984-2009, adding an additional 11 years (through 2020). This is an important update because if markets are efficient, anomalies should disappear post-publication. Their data sample included 283 unique public companies in the BC portfolio throughout the sample period, with an average of 50 companies per year.

Since the first update to the list was published in February 1993, Boustanifar and Kang rebalanced the original portfolio in March 1993. Starting from 1998, Fortune has been announcing the list in mid-January. Therefore, they rebalanced their portfolio on the first day of February – by forming the portfolio about two weeks after the announcement, their analysis tested a joint hypothesis that employee satisfaction improves firm value, and that the stock market does not fully consider this public information in the short term. (In recent years the list has been announced later. For example, the 2021 list was announced on April 14, 2021, and the 2022 list was announced on April 11, 2022.)

While Edmans used the Carhart four-factor model as his benchmark (beta, size, value and momentum), Boustanifar and Kang also estimated BC portfolio alpha using the newer factor models not available at the time of publication of Edmans’ work: the six-factor model of Fama and French (beta, size, value, momentum, profitability and investment), q4-factor model (beta, size, profitability [ROE] and investment), q5-factor model (adding expected investment growth), and a six-factor model (beta, size, value, momentum, beta against beta and quality). Following is a summary of their findings:

• BCs tended to be more common in industries that are more dependent on human capital such as computer software, banking, trading, pharmaceutical products and electronic equipment, and much less common in real estate, coal, utilities, aircraft, tobacco products, and beer and liquor. Industries with no publicly traded BCs included agriculture, rubber and plastic products, fabricated products, shipbuilding and railroad equipment, defense, precious metals, nonmetallic and industrial metal mining.

• BCs were large companies, with an average (median) market capitalization of $55 billion ($20 billion). There were very few stocks whose size was below the 20th percentile NYSE breakpoints, and it was rare to observe BCs that were smaller than the NYSE 5th percentile breakpoints (in many years there was no BC in this category).

• While workplace culture (and hence employee satisfaction) was typically persistent within firms, on average 26% of BCs in a given year were not on the next year’s list. Similarly, on average more than 20% of firms in a given year’s list were newly added firms that were not part of a previous list.

• BCs had relatively high market-to-book ratios and gross-profit-to-total-assets ratios, were quality companies that spent relatively little on capital expenditures and had relatively large amounts of intangibles on their balance sheets.

• Up to 22% of the BC portfolio’s Carhart (beta, size, value and momentum factors) alpha could be attributed to exposures to more recently incorporated factors such as investment, profitability and quality – demonstrating the importance of accounting for exposures to the newer factors, as BCs tend to be companies with higher profitability and of higher quality.

• The BC equal-weighted portfolio’s monthly alpha, accounting for trading costs, ranged between 17 basis points (bps) and 23 bps during the period 1984-2020. The alphas were positive and statistically significant across all factor models.

• The excess returns were not due to firm characteristics or industry composition, and the abnormal returns remained virtually unchanged when excluding small stocks.

• A value-weighted BC portfolio did not generate excess returns that were robust across time and factor models because a few mega-cap stocks dominated the value-weighted portfolio.

• The abnormal returns were positive, significant and robust when using a capped value-weighted portfolio where small BCs had weights according to their size, but no mega-cap stock dominated the portfolio.

• The estimated excess returns were positive in most periods – BCs did not outperform only in good times. However, the largest excess returns came from bad times (crisis periods).

*** Indicates significance at 1% level.

• There was no upward or downward trend in the size of the BC portfolio’s alpha during the four-decade sample.

Investor takeaways

Boustanifar and Kang’s findings provide evidence on the important role played by employee satisfaction, corporate culture and corporate social responsibility on expected stock returns, especially in bad times when stronger returns are most valued. They also demonstrated that the employee satisfaction anomaly has persisted long after the publication of Edmans’ original research. An interesting question is: Given the increased attention to employee satisfaction in the academic community, will the anomaly persist 10 years from now? One possibility is that even with increased research into the anomaly, the dramatic increase in fund flows to ESG strategies could drive the valuations of companies with high S (socially responsible) scores higher, leading to short-term outperformance but lower future expected returns when a new equilibrium is finally reached.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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