Play to Your Strengths(c) Managing Your Internal Labor Markets for Lasting Compe[. .. ]ntage

None of these approaches has gained broad acceptance in the investment community. Nevertheless, the importance of human capital, as difficult to measure as it may be, is apparent to the professionals who are most familiar with asset valuation, according to a 2003 survey by CFO Research Services. That survey asked financial professionals in 180 large organizations to assess the impact of their companies’ human capital on business objectives such as profitability, customer satisfaction, and innovation. Those financial professionals overwhelmingly identified human capital as a main driver of almost every key metric of business performance, including profits.

In light of the acknowledged impact of human capital on the measures that matter to investors—customer satisfaction, profitability, and so forth—one has to wonder what investors are doing to obtain information about this critical but intangible asset. To what extent is the professional investment community inquiring about human capital issues? What issues are being considered? Which human capital measures, if any, are these people obtaining from companies?

The CFO Research Services survey provides some of the answers. According to its findings, financial executives in 49 percent of the publicly traded companies surveyed reported that the investment community was probing human capital issues to at least a moderate extent. Only 15 percent indicated that no one was asking.^[9]

The level of interest in human capital issues appears to vary by industry. For example, financial services and computer-related firms reported greater attention to human capital issues by the investment community than did manufacturers. Even then, the focus of attention on human capital was limited. According to the survey, financial analysts who asked about human capital issues focused primarily on the leadership team and the existence of succession plans. A survey conducted in 2002 by the Conference Board involving 102 mostly large North American (63 percent) and European (37 percent) companies reported that investors were interested in information about human capital.^[10] Just over a third of the respondents saw investors requesting measures such as employee retention, compensation, and workforce profiles.

Some of those requests have come from institutional investors with an intense interest in human capital. Consider Calvert Asset Management Company, which manages more than $8 billion of investment capital by using “socially responsible investment” criteria. To be an investment target for Calvert, a company must measure up to various social and environmental criteria, including workforce diversity, labor-management relations, workplace safety, and working conditions. CalPERS (the California Public Employees Retirement System) is an even larger investor and has been a pioneer in the movement to obtain and evaluate information about human capital from the companies in which it invests. CalPERS focuses on things such as employee turnover and opportunities for education in judging its investment candidates. Several European-based money managers also seek human capital data, SAM (Sustainable Asset Management) and Friends, Ivory & Sime among them. Those institutional investors seek out companies that meet two tests:

1. Demonstrated social responsibility

2. Acceptable risk-adjusted returns to shareholders

The companies that pass the first test are subjected to more conventional financial analysis that determines whether they pass the second test.

The use of human capital information to screen out socially unacceptable investments has been practiced for a long time. Calvert, for example, has been in existence for over a quarter of a century. In contrast, discerning which companies are best at creating value from human capital assets is a more recent, almost nascent pursuit. However, the importance of this information in investment decision making is apparent. Over 60 percent of the respondents to a 1999 survey conducted by Ernst & Young said that nonfinancial data drove 20 to 50 percent of their investment decisions.^[11]

Interest in alternative investment metrics, some of which capture human capital information, is not limited to large institutional investors. Popular magazines have joined the action. Allison Kopicki and Tom Contiliano explained in Bloomberg Personal Finance how investors can use “key performance indicators” (KPIs) to supplement traditional measures of company performance.^[12] Some KPIs can be calculated from figures reported in different parts of corporate financial statements; others require the disclosure of new information. KPIs linked to human capital include revenue per employee, changes in the attributes of corporate officers (e.g., cumulative experience in and out of the industry, diversity of background, global representation), and the ratio of R&D expenditures to sales.

To make matters more difficult for investors, some key performance indicators can be misleading, such as employee turnover. Many people regard employee turnover as a key indicator of how well a company is doing with its human capital asset. “People turnover is important in every industry” Kopicki and Contiliano report. The Conference Board agrees: “High turnover produces more mistakes, lower customer satisfaction, increased workload, and lower morale.”^[13]

Blanket proclamations such as these are intuitively appealing but often misleading because the link between turnover and organizational performance can vary widely across industries and firms. Further, who is turning over in an organization generally matters much more than the percentage of turnover. For example, 20 percent voluntary turnover among personnel who are either easy to recruit, never interact with customers, or need little training may have little impact on business performance. The same percentage of voluntary turnover in the R&D department of a high-tech company, however, could be crippling over time; those highly trained defectors would be difficult and costly to replace and would take significant intellectual capital with them, and their departures surely would set back important projects.

In some cases, such as turnover of poor performers, low turnover may do considerable harm to a business, such as the company Digitt that was described in Chapter 7. Those changes surely would have passed muster according to this narrowly defined turnover standard, yet low turnover was the single most powerful indicator that Digitt was depreciating its human capital assets. Investors clearly need more discriminating measures than these.

The test of whether turnover is a useful KPI is that it have an impact on business performance. This test must be performed separately for each business. Using a Business Impact Modeling approach, we have assessed the impact of employee turnover in many companies in several industries. In one company, a business-to-business services firm, turnover was running in excess of 20 percent annually and dramatically affected profitability. Thus turnover was a key performance indicator for that company. In a company in the food service industry substantially higher turnover was the norm, exceeding 100 percent in some years. However, turnover in that company had only a minor impact on a key business performance measure, earnings. Tracking turnover in that company and attacking it with expensive programs would be a fool’s errand. In a third company, a financial services firm, employee turnover substantially reduced business performance, but only in certain employee segments. Here the overall employee turnover rate mattered little; it was the turnover rate in one segment of the workforce that affected the company’s financial performance. Thus a segment-specific turnover number would be a useful KPI; a blanket number would reveal little of value.

^[9]Human Capital Management: The CFO’s Perspective. Boston: CFO Publishing Corp., 2003, 12.

^[10]Stephen Gates, Value at Work—The Risks and Opportunities of Human Capital Measurement and Reporting. New York: The Conference Board, 2002, 13.

^[11]“Measures That Matter,” Ernst & Young LLP, Paper, New York, 1999, 6–9.

^[12]Allison Kopicki and Tom Contiliano, “Reveal Your Stock’s Secrets,” Bloomberg Personal Finance, February 2003, 62–70.

^[13]Stephen Gates, The Conference Board, “Value at Work—The Risks and Opportunities of Human Capital Measurement and Reporting,” 2002, 13.