Commentary: Linking human capital management to equity performance

A company's employees are widely accepted to be one of its most valuable assets, yet public accounting standards don't currently consider human capital to be an asset at all. Instead, it's categorized as an expense or future liability on balance sheets. As a result, most investors aren't aware of the potential alpha in the workforce. This oversight presents a compelling opportunity for those with the ability to take advantage of this pricing inefficiency.

Broadly speaking, human capital is an intangible asset that encompasses the habits, knowledge, talent, motivation, and experiences of an organization. While widely held to be a critical component to a company's long-term success or failure, it has emerged only recently as an effective investment screen thanks in part to the improved ability to measure the impact of human capital on stock price performance.

Over the past three years, the global quantitative and derivatives strategy team at J.P. Morgan Securities has analyzed the data behind the human capital factor (or HCF), an approach developed by investment research firm Irrational Capital that seeks to quantify the link between human capital management and equity performance using a combination of public and private data sources.

The proprietary pillar of the data is constructed from the analysis of 2.6 million individual responses to human resources surveys, comprising more than 71 million unique survey data points covering over 1,300 publicly traded U.S. companies and spanning the last 15 years. This dataset includes ratings on the usual and easy-to-measure topics such as compensation, benefits, and training, but adds a wide range of far more important and difficult to measure characteristics of the employee-employer relationship. The HCF is able to deeply evaluate the human side of the organization, and tangibly measure levels of appreciation, pride and trust and the relationship with one's manager, the sense of psychological safety and more within the organization.

The other datasets used in constructing the HCF are derived from public sources that feature company-specific insights. While this dataset is smaller in overall scope (30 million unique data points), it includes coverage of more than 4,200 U.S. companies.

These datasets are combined and then each company's human capital factor score is calculated through an assortment of analytical techniques. The result is a measure of how effectively these organizations treat their team members. This rating is then used as the metric for stock selection. Based on our analysis, the HCF has delivered consistent outperformance. In fact, the HCF portfolio has outperformed the benchmark (MSCI USA index) by 4.0% per annum over the full period of our back tests, which span the last 14 years (2009-2023).

Further, a trio of ETFs built on the human capital factor all bested their respective benchmarks last year. The index underlying the Harbor Human Capital Factor Unconstrained ETF (HAPY) posted a 35.6% gain in 2023, topping the Russell 1000's return of 24.5%; the index tracked by Harbor Human Capital Factor US Large Cap ETF (HAPI) returned 30.7%, which outperformed the S&P 500's 26.3% total return for the year; and the index tracked by Harbor Human Capital Factor US Small Cap ETF (HAPS), which launched in April 2023, climbed 17.7% through year-end versus 16.9% for the Russell 2000 for the year.

In addition to this strong performance, the HCF data also reveals several key insights. Irrational Capital segments the questions and responses to the HR surveys into seven different dimensions. Six dimensions are related to capturing different aspects of intrinsic motivation, including how successful companies are at engaging their staff beyond material and monetary incentives. These dimensions include direct management, innovation, organizational alignment (or employees' feelings on how much they are informed and aligned on the direction, goal and value of the organization) and more.

The common misconception that financial compensation alone determines employee motivation or has an outsized effect on future equity performance is not supported by our analysis. In fact, the only dimension that failed to beat the benchmark over the sample period (since 2012) when run in isolation was extrinsic motivation, which refers to benefits that are external to an individual such as compensation.

While financial rewards are intended to motivate individuals, employees respond to more than compensation and benefits to be highly motivated and productive in the workplace. For example, one dimension that has demonstrated consistent outperformance over time is organizational effectiveness, which describes the ability of a group to achieve its goals and objectives with little waste (effort, time, energy, attention). Organizational effectiveness is a reflection of how well a company is able to utilize their human resources effectively and treat their employees with respect by valuing their time.

The HCF signals positive long-term performance across all sectors, proving that employees who feel well connected and supported move their company forward, regardless of industry. However, closer analysis reveals the financial services and technology sectors have both demonstrated significant multiyear improvements across all seven dimensions. With companies in both sectors relying heavily on their human capital for growth, it's not surprising to see that firms in these sectors are focused on improving all aspects of how they treat their employees.

Conversely, three sectors experiencing notable declines across the dimensions are consumer, cyclical, energy and real estate. In each of these sectors, human capital may play a more subordinated role relative to tangible assets, commodity prices and other input costs.

Among the many variables considered when evaluating securities with an eye toward managing risk and enhancing returns, human capital management has never been "top of mind" — or perhaps credibly accessible — for investors. However, the tide may be turning as the role of human capital in gaining competitive advantage in the knowledge economy is examined in greater detail within the workplace and society at large.

Not coincidently, the tools and data to measure this key asset have simultaneously evolved to more accurately determine which companies treat their people better and how it impacts value creation in the form of future stock price appreciation, which we view as the ultimate measure of performance. As a result of this convergence, investors have an opportunity to tap into an investment factor that is not correctly priced by the market. It turns out that the answer to achieving investment outperformance has been in front of us all along.

Khuram Chaudhry is a managing director and head of European quantitative strategy on J.P. Morgan Securities' global quantitative and derivatives strategy team. He is based in London. 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.