Sustainable Investing

Why investors are looking carefully at “human capital management”

May 17, 2022

As the pandemic wanes, investors and companies are focusing on this key ESG factor. Here’s what you need to know.

We live in a new investing reality. More extensive data, corporate disclosure and regulatory reporting on environmental, social and governance (ESG) issues give investors new insights into how well companies are managed. Investors are paying increasing attention to how ESG factors affect something specific: corporate performance. Done right, a focus on ESG issues can potentially lower investment risk and generate higher returns.

But not all ESG information is material. Financially material ESG factors are factors that could have a significant impact – both positive and negative – on a company’s business model and value drivers, such as revenue growth, margins, required capital and risk. The material factors differ from one sector to another. Examples include supply chain management, environmental policy, worker health and safety, and corporate governance.. In other words, not all information has a fundamental impact on a company’s financial well-being. Investors need to distinguish between what is and isn’t material. How a company performs on material ESG factors can often signal whether it is likely to produce an attractive risk-adjusted return to investors.

In this article, we zero in on one critical ESG factor, human capital management. Human capital encompasses the skills, knowledge and experience that employees bring to an organization and the value that they create. Especially in the waning days of a global pandemic, investors and companies are increasingly focused on improving their human capital management practices, which can have a material impact on corporate performance depending on how well it is managed. 

Human capital: People, skills and value delivered

How can investors think about human capital management, a broadly material ESG factor? First, acknowledge reality: The world of work has changed. Even before the outbreak of COVID-19, companies were more carefully considering human capital issues—how to recruit and retain the right people with the right skills to serve customers and stakeholders and deliver shareholder value.

Increasingly, a greater share of a company’s value is derived from its people—who generate intellectual property—than its physical property (such as machines, equipment and real estate)1.

Today, as companies navigate a tight labor market and the broader repercussions of the “Great Resignation,” many are reorganizing to attract, retain and motivate their workforce. More and more, investors are looking to understand how companies assess and monitor human capital management and corporate culture, particularly in response to COVID-19.

A recent report from the ADP Research Institute examined “the most powerful predictors of retention, performance, engagement, resilience and inclusion.”1 No factor was as significant as how employees answered three questions: “Was I excited to work every day last week? Did I have a chance to use my strengths every day? At work do I get a chance to do what I’m good at and something I love?”

ADP’s findings align broadly with research from Dan Ariely, Duke University professor of psychology and behavioral economics, on the links between human capital management and an organization’s overall performance. He finds that authentic feelings of appreciation and fairness (broadly defined) are key elements of an organization’s culture that are connected to higher productivity2.

Turnover data can be revealing: some research shows higher turnover correlating with weaker performance3. Still, not much of human capital management data is standardized or uniform. That means it requires some work to make it useful for investment decision-making. For those ready to do the research, identifying material information among this data could be a real opportunity.

Intangible assets on corporate balance sheets

As always, investor research includes a close look at corporate balance sheets. The balance sheet treats human capital, the value of a company’s employees and intellectual property, as among the company’s intangible assets. That’s always been true, but it matters much more now: In 1985, only 32% of the market value of the S&P 500 were intangible. By 2020, that share had grown to 90%. In other words, intangible assets including human capital are increasingly valued and need careful management to ensure profitability. 

Think of a human capital-intensive tech company whose value is almost entirely derived from one powerful algorithm (a creation of human brains). Imagine that the team (the human capital) responsible for the creation and development of the algorithm suddenly left the company. Who can doubt that this would be material information? 

Intangible assets as a percentage of S&P 500 market value

Source: Ocean Tomo, Annual Study of Intangible Asset Market Value, 2020.
Intangible Assets as Percent of Market Value, Source: Ocean Tomo, Annual Study of Intangible Asset Market Value, 2020.

Human capital issues in shareholder proxies

We also see evidence of an increased investor focus on human capital issues in the growing number of shareholder proposals that address them. During the first half of 2021, shareholders filed 101 human capital management proposals with Russell 3000 companies, 18 more than a year earlier. These proposals helped fuel a record level of support for environmental and social shareholder proposals in the 2021 proxy season—and will likely do so again this year.

Proposals increasingly centered on diversity, a key element of human capital management: Shareholders filed 77 diversity-related proposals, almost double the number in 2020.

Shareholder proposals are a proxy for shareholder interest. Investors are increasingly interested in human capital because they know it is material to returns. Shareholders are asking for additional disclosure on human capital because it’s a bigger source of future value4. We expect the number of shareholder proposals will grow substantially in the coming years, as companies and investors deepen their concern about human capital.

Demographic pressures (including, in the U.S., the continued retirement of Baby Boomers), the demands of rapidly evolving technology, the focus on mental health and wellness to drive quality work and productivity—all these forces, and others, will keep the spotlight on human capital.

How can I invest?

Finding and analyzing information about human capital management (and other material ESG factors) requires considerable research and due diligence. But you don’t have to do the digging yourself. Consider a well-managed fund or investment strategy whose research teams and managers are scouring all available data and— again, this is key—determining what of the information is and isn’t material.

If you’re considering a strategy that is identified as an ESG strategy, you’ll want to be sure that the label is earned—and that it’s not a case of so-called “greenwashing” (the illusion, but not the reality, of corporate attention to ESG issues).

Different paths can take you to the same destination: a smart focus on material ESG factors, including human capital, potentially leading to stronger risk-adjusted returns.

We can help

For a thorough analysis of how ESG considerations might fit into your portfolio and best align with your family’s goals, reach out to your J.P. Morgan team.

 

1 Buckingham, Marcus. “Harvard Business Review: Designing Work That People Love.” ADP Research Institute, 19 Apr. 2022, https://www.adpri.org/media/harvard-business-review-designing-work-that-people-love/.

2 Zhang, Hannah. “Looking For a Good Investment? Find a Company That Understands Its Employees.” Institutional Investor, 25 Jan. 2022, https://www.institutionalinvestor.com/article/b1wh5htywlzjbz/Looking-For-a-Good-Investment-Find-a-Company-That-Understands-Its-Employees.

3 REVELIO LABS. “Want to Know Where Revenue is Headed? Look at this Metric.” Revelio Labs, 15 Mar. 2022, https://www.reveliolabs.com/news/business/want-to-know-where-revenue-is-headed-look-at-this-metric/

4 Jackie Cook and John Hale, “2019 ESG Proxy Voting Trends by 50 U.S. Fund Families,” Morningstar, https://corpgov.law.harvard.edu/2020/03/23/2019-esg-proxy-voting-trends-by-50-u-s-fund-families.

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