A common sales-pitch of ESG strategies is the idea that those strategies not only do good for the planet and other stakeholders, but also generate higher returns. I am generally skeptic about this, but there are studies showing that certain ESG variables historically indeed predicted higher returns. A prominent example for this is the paper on employee satisfaction by Alex Edmans (2011). This week’s AGNOSTIC Paper is an out-of-sample test of this study with somewhat more thorough testing.
Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.
Setup and Idea
The idea of the original Edmans (2011) paper and this week’s out-of-sample test is very straight forward. All else equal, happier employees should be more productive and generate better results for their firms. Companies with happier employees should therefore be fundamentally better. I think we can all agree on this. For those who want it more scientifically, Edmans (2011) also provides some theories of human capital that arrive at the same conclusion.
It is tempting to assume that companies with happier employees will therefore also generate better stock returns. Although this was true historically, it is actually not so obvious. In an efficient market investors would identify superior companies and reward them with a higher price today until all abnormal returns disappear. So to make money from this effect, you not only need happier employees but also a stock market that doesn’t already discounts that information into the current price. As the two studies show, this (more important) second condition was apparently also satisfied over the last years…
Data and Methodology
The authors use the 100 Best Companies To Work for in America List as a sample of companies with happier employees (best companies or “BC”). The Great Place to Work Institute maintains this list and publishes it every January or February in Fortune magazine. The list results from a comprehensive survey among employees and, according to the authors, covered a workforce of more than 4.1M people in the latest year. While the details on the methodology are proprietary, the authors argue (and I agree) that this is a reasonable and transparent proxy for employee satisfaction.
The authors obtain the “best companies” in each year from 1984 to 2020. On average, these are about 50 stocks per year because not all companies are public. Overall, the sample covers 283 unique companies. Interestingly, the list is quite persistent over time. Only about 26% of companies drop out of the list in each year. The list covers companies from 41 out of 49 Fama-French industries, but human-capital-intense industries like Software, Banking, or Pharma are unsurprisingly over-represented. Also quite unsurprisingly, BCs tend to be larger with an average and median market capitalization of $55B and $20B, respectively.
The remaining methodology of the authors’ is quite straight forward. They simply use the BC lists in each year to backtest the performance of companies with happier employees. Specifically, they examine equal-weighted portfolios of the BCs and rebalance them annually in the month after the release of the latest list. They also report results for value-weighted portfolios but argue that those are under-diversified because of a few very large companies. Finally, they use the major factors to analyze the risk-adjusted performance of BCs.
Important Results and Takeaways
“Best Companies” outperformed several benchmarks
The first two charts show that BCs outperformed their industry- and characteristics-matched benchmarks during two different sample periods (1984 to 2000 and 2001 to 2020). The industry-matched benchmark has the same exposures to the 49 Fama-French industries as the BC portfolio. The characteristics-matched portfolio has the same exposures to Size, Value, and Momentum. As a consequence, those benchmarks estimate the idiosyncratic returns of BCs beyond industries and some well-known factors. Note however, that these benchmarks are hypothetical calculations and not investable.
The authors explain that “For a better visualization, we use two different y-scale for pre- and post-2000, hence two separate graphs.”. To be honest, I do not fully understand why but the two charts are a good and practical summary of the results.
“Best Companies” outperformed during crises and out-of-sample
In the next step, the authors use Fama-MacBeth regressions to further analyze BCs’ performance. In particular, they test the hypothesis that most of the outperformance comes from good times. This is the common “luxury” argument that investors only care about ESG during good times. The authors’ results don’t support this. If anything, most of the outperformance actually comes from the worst crises.
To further illustrate this point, they plot the cumulative alpha of BCs in the chart above. While there are some bumps along the road, the pattern shows that excess returns not only come from single periods. The red line indicates the end of the original Edmans (2011) sample. Given that excess returns continue to accumulate thereafter, this is important out-of-sample evidence for the superior performance of BCs.
Quality and Low-Risk factors explain some of the premium on “Best Companies”
Full disclosure: this is my favorite section of the paper. In the original study, Edmans (2011) uses just four factors (Market, Size, Value, Momentum) to test the alphas of BCs. This is no critique as other factors weren’t as popular back then. However, if BCs are indeed fundamentally better this should of course show up in the quality factor. This week’s authors use those insights and estimate the alphas of BCs against a six factor model that includes the Betting Against Beta and Quality Minus Junk factor, two specific type of defensive investing. The table below summarizes the result and AFP refers to the six factor model including Market (Mkt), Size (SMB), Value (HML), Momentum (UMD), Quality (QMJ), and Low Beta (BAB).
The authors explain that profitability and quality factors explain a considerable part of BCs’ alphas. In my opinion, this is very reasonable and beautifully illustrates how we can use the major factors to de-mystify novel variables. Don’t get me wrong, employee satisfaction remains a powerful signal because the alphas are still statistically significant. But it is mostly an extension to quality investing instead of a whole new factor. Those results also partly explain the outperformance of BCs during crises as there tends to be a “flight to quality” during bad times.
Conclusions and Further Ideas
Why have I picked this paper? There are two reasons. First, I find it interesting that there are ESG signals which (at least historically) predicted higher stock returns. Second, the paper is a wonderful example how to use the major factors to de-mystify new signals and creative data sources. Don’t get me wrong, it is a great research idea to test the impact of happier employees via the Best Companies List. But after controlling for the well-known quality and low-risk factors, the alpha of the strategy shrinks considerably (although it remains positive). So even though employee satisfaction seems to be a creative new variable, it is essentially just a more sophisticated extension to the well-known quality/defensive factor.
A further issue with the analyses, and you probably expected that coming, is robustness. Using the BC List is a great research idea but it doesn’t really tell us if employee satisfaction systematically explains returns in the entire universe of stocks. In addition to that, some of the robustness checks we want to have for new factors are currently missing. Do other signals for employee satisfaction produce similar results? Is there a similar effect for the Best Companies of other regions? And the ultimate question, who is on the other side of the trade? Why do BCs still outperform even though the original Edmans study is more than 10 years old?
To their credit, Edmans and the authors are well-aware of these issues and provide some first suggestive ideas. Until those questions are not answered in more detail, however, I wouldn’t bet too much money on employee satisfaction as a standalone factor. Instead, I believe we should rather view it as what it most likely is – a creative extension of quality investing that also incorporates one dimension of ESG into the investment process…
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