Commentary: Human capital management has quantifiable implications for investors

When we talk about capital as a way to create value for shareholders, we typically refer to financial or physical capital. However, human capital — a company's workforce and its combined skills and attributes — should not be overlooked. Despite being historically undervalued by investors, it can have a powerful influence on profitability, both positive and negative. The failure to address it strategically has been starkly evident since the COVID-19 pandemic, as labor disputes about worker rights and protections frequently appear in the headlines. But when deftly managed, human capital is a critical source of sustainable and scalable competitive advantage to organizations.

One reason why human capital has been undervalued is that it has been previously difficult to quantify. But there has been progress on this front as recent research has helped investors more concretely understand the tangible impact of strong and effective human capital management. The $457.9 billion California Public Employees' Retirement System, Sacramento; University of Oxford; and Schroders recently worked together on a research framework that confirmed what many sophisticated investors understood to be true: Human capital can act as a clear driver of company productivity and profitability.

Human capital management consists of an organization's systems and processes that seek to optimize a return on investments in human capital. Investors should evaluate the following factors:

1. Operating model and workforce strategy: how companies set up and organize their workforce to deliver on business strategy and mission.
   
2. Culture and inclusion: shared beliefs, attitudes and goals of a company, embodied and communicated in a way that allows all employees to thrive.
   
3. Incentive and performance management: motivating employees and teaching them how to improve.
   
4. Talent and learning: recruitment, development and retention of the workforce.
   
5. Innovation: the flow of ideas and information that allows for company evolution.

In the face of economic volatility, this research shows that companies with strong human capital management are likely to be more resilient and capable of navigating future economic cycles effectively.

Human capital is often viewed as something intangible. But while there are intangible elements, it can unlock quantifiable returns. Effective human capital management is the catalyst that permits this crucial transformation, driving productivity and turning investments into real earnings.

Integrating human capital analysis into investment practice is beneficial for structural and cyclical reasons. Structurally, while the bargaining power of labor groups has diminished over the past few decades, labor writ largely still has some advantages. The number of those quitting jobs remains at an all-time high, while the number of unemployed per job listing is still historically low. Furthermore, with knowledge-based firms (e.g., technology, financials, healthcare) now dominating the global market cap, human capital management has taken on enhanced importance as the market puts emphasis on the value of people vs. products.

Simply put, even as the news heralds a new age of artificial intelligence across industries, the relevance of people as stewards of value creation will remain high.

Although there are several metrics to quantitatively measure human capital management, the most important is human capital return on investment or HCROI. Its purpose is to evaluate and determine the return on investment in people; it takes into account a host of factors such as net operating profit after tax and the cost of human capital (salaries, benefits and compensation, churn, training and other expenses). Companies with a high HCROI are those that have a high cost of human capital that is coupled with strong profits.

What we found is that there is a positive correlation between HCROI and stronger returns. In one case study, we evaluated two beverage companies ("Company A" and "Company B") which generated 7.6% and 6.5% returns, respectively.

Being in the same industry, both had similar labor intensity and similar capital turnover. However, despite Company A having a larger workforce and lower wages, it had a stronger human capital management framework, and thus higher leverage on its investment in people, which correlated with stronger returns, even after controlling for various factors.

This suggests that incorporating human capital management analysis into the investment process can potentially drive returns for investors and help them avoid risk.

But despite the progress toward quantifying the impact of human capital, the best analysis must always combine quantitative and qualitative assessments. This much was clear following numerous interviews with HR experts during the research process. Human capital is far too nuanced to reduce to a single objective measure.

By combining the quantitative and qualitative, investors can ask companies the right questions — enlightening questions that can yield insights about what teams are doing to manage, strengthen and invest in their human capital. Doing so will help uncover where there are actionable opportunities to improve human capital management. This is particularly important given corporate disclosure of human capital-related data remains minimal. In the future, we hope to see richer and more regular disclosures, which will benefit investors and allow for more robust analysis.

It is impossible to put a concrete monetary value on a company's culture; there's no one number that can fully capture the importance of trust or individual human systems to a company's value creation model. But by quantifying those elements of employee investment that can be measured, and by considering financial and employee outcomes in tandem, investors can better identify opportunities and risks that human capital presents in any given organization.

Marina Severinovsky is head of sustainability, North America, for Schroders. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.