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December 26, 2007
Screening for Satisfaction
    by Anne Moore Odell

The 2007 Moskowitz Prize for Socially Responsible Investing was awarded to a study that shows higher employee satisfaction has historically correlated to higher stock prices.


Making your shareholders richer might start with making your employees happier. The 2007 Moskowitz Prize for Socially Responsible Investing was awarded last month to a study that draws a parallel between higher employee satisfaction and higher stock prices.

"Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices" by Alex Edmans of the University of Pennsylvania's The Wharton School was awarded the $5,000 prize named after socially responsible investment innovator Milt Moskowitz. The prize supports SRI research and is presented by Center for Responsible Business at the Haas School of Business, in cooperation with the Social Investment Forum.

Lloyd Kurtz, Portfolio Manager at Nelson Capital Management and a Lecturer at the Haas School of Business, University of California at Berkeley is the Moskowitz Prize Program Administrator. Kurtz told SocialFunds.com: "In my career I have seen perhaps two academic studies that persuasively make the case that a social investment variable was associated with positive long-term risk-adjusted returns. The first was Nadja Gunster's study of the Innovest environmental ratings that won the Prize in 2005. "

The Prize-winning study is chosen each year from a field of 30 or more academic studies, both published and unpublished. An all-volunteer judging group selects the award winning study.

The sponsors of the Moskowitz Prize are Calvert Group, First Affirmative Financial Network, Nelson Capital Management, Rockefeller and Co., and Trillium Asset Management.

"Employee satisfaction can improve shareholder returns," Edmans said. "While it may seem obvious that firms do better if their employees are happier, this actually runs counter to traditional management theories. Conventional wisdom is that shareholder value is maximized by minimizing the returns to other stakeholders, e.g. paying their employees as little as possible, both in terms of cash salary and working conditions. This paper suggests the opposite: it's not a zero-sum game."

Edmans' study starts with a portfolio of stocks created from Fortune magazine's "Best Companies to Work For in America" in 1998. By the end of 2005, this portfolio earned over twice the market return while also outperforming industry benchmarks. Interestingly, the award's namesake Moskowitz is the co-author of Fortune's list.

For socially responsible investors, Edmans' research helps show that investing responsibly, at least screening for employee satisfaction, can improve returns. The study didn't examine other SRI screens.

"Studies often find that SRI screens worsen returns, or at best have no effect on returns," explained Edmans. "The conventional view is that you need to accept lower returns to invest responsibly: it's an either-or decision. This paper suggests that investors may not face a trade-off."

The role of employees has greatly changed over the past century. One hundred years ago, consumers demanded low-cost, standardized products. These goods were produced by instructing employees to perform unskilled, repetitive tasks such as on assembly lines. There was no need to provide pleasant working conditions to retain workers since they undertook simple tasks, departures were nonchalantly met by new recruitment. Employee satisfaction had no role in motivation either. The threat of firing, and pay-for-effort were sufficient to induce effort.

However, employees' roles have changed. "Nowadays, product quality and innovation are increasingly important - perhaps because greater incomes mean that consumers are willing to pay for quality. This in turn requires employees to exhibit creativity and initiative, rather than simply following instructions. Indeed, they are now the main source of value creation in many companies," Edmans added.

This explains the increasing importance of employee satisfaction. It is a way of retaining key workers, allowing the firm to build competitive advantage through a superior workforce. In addition, it is a powerful motivator. Satisfaction leads to workers identifying with the firm, and thus exerting more effort than required by the employment contract. Pay-for-output is a less effective tool, since many important outputs (e.g. building customer relations) are hard to measure.

The second part of Edmans' study looks at how the market has, in the past, undervalued intangibles, such as investments in human capital. Edmans defines intangibles as "any asset that is valuable to a firm but cannot be easily valued by outsiders, e.g. a strong corporate culture, good relationships with suppliers and customers."

The study uses Fortune magazine's list of "100 Best Companies to Work For" because it is highly visible to investors in the market and is an independent verification of intangibles. Edmans formed his portfolio of companies from Fortune's list several weeks after its publication, after the response to the list would have been visible in stock prices.

Since these portfolios earned superior returns, the Fortune list was not priced by the stock market. This suggests that intangibles in general (the vast majority of which are not independently verified) are not incorporated into prices.

The study goes onto state that managers concerned with the stock price, may thus invest too little in intangibles. This can have serious consequences on the long-term growth of the firm.

Parnassus Investments' Workplace Fund has created a portfolio of companies that offer excellent workplaces with the help of Moskowitz. Kurtz also reported that Nelson incorporates the "100 Best Companies to Work For" data into their investment decisions, for both SRI and non-SRI portfolios. Edmans, likewise, has said that he will invest his prize money in a mutual fund that invests in companies with good workplace practices.

 

 
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