Wharton and London Business School research shows employee welfare and financial returns are linked

Alex Edmans is professor of finance at London Business School and Wharton. 

He's been researching the links between investing in employee welfare, and financial returns. 

Alex's prior research shows that companies listed in some "Best Companies To Work For" lists beat the market by 2 to 3 per cent per year over a 26 year period. 

His new study, released last month, extended the results to 14 countries.

Alex Edmans
It shows that the results hold in nations with flexible labour markets, where the retention and motivation benefits of employee welfare are particularly strong. 

Here's an op ed he wrote recently about his work. 

I sent him some questions, which he has answered below. His responses make for interesting reading.

TW: Your earlier research suggested that US firms with high employee welfare outperform their peers by 2-3%/year over a 26-year period, controlling for other determinants of stock returns. What was the reaction to this, and how did you work it out?

AE: It’s hard to assess objectively but I believe that it was  positively received. 

The conventional wisdom is that companies should try to extract as much out of their employees as possible, so people liked the message that “doing the right thing” is actually good for you. 

More generally, while there has been an active CSR movement, and an active human relations movement, there was little evidence that these initiatives improve the bottom line – the business case is unclear and so it was hard to push through CSR/HR initiatives. 

This paper helped support this. In fact, as mentioned in point 4 below, if anything the reaction was “too” positive – people got overexcited about it and said that the paper proved that CSR improves firm value (when it only looked at one dimension, employee welfare, and only in the US).

I came up with these findings as follows. I take the list of the 100 Best Companies to Work For in America (and in the second paper, similar lists worldwide). 

Then I calculate the return to these Best Companies starting from one month after the list was published (to ensure my results aren’t driven by reverse causality). 

I compare the returns of the Best Companies not only to the overall market, but also to companies in the same industry. For example, Google is frequently in the Best Companies list, but its high returns could be due to the tech industry doing well, rather than its employee satisfaction. 

I also compare each company to peer firms with similar characteristics (e.g. size, dividend yield, recent performance, valuation ratios). 

In short, I try to control for as much as possible, to isolate the effect of employee satisfaction. 

I also remove the effect of outliers, to ensure that any superior performance of the Best Companies isn’t due to a few star performers such as Google.

TW: Your new paper looks at 14 countries. It shows that the original results do hold in a global context, but only in countries with high labour market flexibility, since employee welfare is particularly beneficial for retention, recruitment, and motivation where labour markets are flexible. Tell us which countries that meet this criteria and a little more about why you believe your findings are accurate.

AE: Countries with high labour market flexibility include UK, US, and Canada. 

We use two measures of labour market flexibility, both of which have been used in prior research (and thus accepted to be good measures of LMF). 

One is the OECD Employment Protection Index, the second is the labour market flexibility categories of the Fraser Institute’s Economic Freedom of the World index. Under both measures of LMF, we find that the return to being a Best Company is increasing in the level of LMF. 

We believe the findings are accurate for two reasons: 

1) They hold under both level of labour market flexibility. 

2) We control for other country-level differences, such as GDP growth, the size of the capital market, the rule of law etc. 

This ensures that it’s LMF, rather than other country-level factors, that are driving the results.

TW: So what about countries without high labour market flexibility, does this mean that it’s harder to make the case for higher employee welfare activities by companies? 

AE: The results suggest that, on average, the returns to having above-average employee satisfaction are lower. 

This makes sense – in countries with rigid labour markets, regulation already guarantees companies a minimum level of employee satisfaction, so perhaps there’s not as much need to go above and beyond. However, note that this is only an average result. 

It doesn’t mean that companies in countries with low LMF should never invest more than the minimum amount. 

There will still be initiatives to increase ES that are also beneficial to firm value – it’s just that the company should be more circumspect at evaluating these opportunities. 

By analogy, taller soccer goalkeepers tend to be better than shorter goalkeepers. 

But, that doesn’t mean that a team should never sign a short goalkeeper, just that a team might need to evaluate a short goalkeeper more carefully when deciding whether to sign him.

TW: You argue that this paper shows the importance of the institutional environment for the value of CSR. Why?

AE: The first paper was fortunate to be met with a positive reaction. 

The prevailing view was that CSR is at the expense of shareholder value – a dollar invested in other stakeholders is a dollar taken away from shareholders. 

The first paper overturned this conventional wisdom, and so made a splash. 

However, some readers may have got over-excited about it, and interpreted it as “proving” that investing in employees necessarily improves firm value – thus all companies should simply invest more in employees and their value will automatically rise. 

In science, you can prove things. Hydrochloric acid in the UK is the same as hydrochloric acid in Brazil, so if you combine it with sodium hydroxide, you’ll get salt in both countries. 

But, social science is about people, and people are different across countries, so you can’t necessarily extrapolate the findings in one country to another. While the original paper did find an interesting result, it was only based on US data. This new paper shows that the results in the first paper do hold in other countries – but only those countries with high labour market flexibility.

The institutional environment is important because business decisions that work in one country may not work in another country. 

That’s true for non-CSR decisions – for example, a restaurant in China will often have private dining rooms because business is often conducted over dinner in China, whereas this is rarer in a restaurant in the UK. 

So, it’s logical that it’s true for CSR decisions as well. Investing in high employee welfare is valuable if labour markets are flexible and thus having good working conditions can allow you to hire new workers. 

If labour markets are flexible, you face constraints on hiring, so there are fewer benefits of having high employee welfare.

TW: You also suggest that this is the first academic study to investigate the profitability of an SRI strategy in a global context. Why do you think this area is under-studied? In my experience a lot of research has been done in the ‘business case for responsible capitalism’ space in the last 20 years. 

AE: The “business case for responsible capitalism” has indeed been well-studied over the last 20 years, but primarily by researchers in Management or Strategy. 

These papers typically study the relationship with profits or other measures of firm value. However, it’s difficult to ascribe causality. 

If CSR is positively correlated with profits, it could be that CSR leads to higher profits, or only profitable firms can spend on CSR.

I’m from Finance. In Finance, we look at stock returns, rather than profits. The advantage of looking at stock returns is that this can address reverse causality issues. 

For example, for the UK list published in April 2012, I study the returns of the listed companies between May 2012 and April 2013. 

If high satisfaction in April 2012 were the result, rather than cause, of good performance, the stock price would already be high in April 2012, and so you should not expect superior stock returns going forward. 

However, because CSR has not historically been a Finance topic, few people from finance had studied CSR. In particular, the prevailing wisdom in finance was so clear that CSR could not lead to high stock returns. 

Milton Friedman famously said in 1970 that “the social responsibility of business is to increase profit”. In addition, many finance academics believe markets are efficient and you can’t beat the market with any trading strategy – especially not a “fluffy” one like social responsibility. 



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