Thursday, January 27, 2011

How Talent Pays Off For Investors

Companies that attract and motivate talent deliver better returns to their shareholders. That's the conclusion from an analysis of Fortune's "Best 100 Companies to Work For." Why should this be true? While I can't explain why stocks go up and down in general, it's possible that Best 100 companies attract and motivate top talent that delivers better products; customers gobble them up and, as a result, the companies achieve surprisingly superior growth and profitability.

This suggests an opportunity for a mutual fund to sell shares in a bundle of these top 100 companies -- but a better strategy might be to invest just in the ones that have stayed on the list for the last 12 years since it was started.

The stock market performance of these Best 100 companies is clearly superior. According to Fortune, the annualized return of an investment in the Best 100 companies on the 1998 list -- the year Fortune introduced it -- was 11.06% (far higher than the S&P 500's 3.83% return). And this superior performance also held up recently -- investing in all the publicly traded Best 100 companies on the 2011 list at the beginning of 2010 would have yielded a be 23.11% return by the end of 2010 (far better than the S&P's 15.06% return at year end).

Why is this happening? My 2003 book, Value Leadership: The 7 Principles That Drive Corporate Value in Any Economy, presents a theory. I suggested that better performing companies implement practices that create consistent, measurable value for employees, customers, investors, and communities. And they do this differently for each stakeholder. Here's how:
  • Employees. Create a work environment that attracts and motivates the most talented people in the industry.
  • Customers. Develop new products that give customers more of what they want than competitors' do.
  • Investors. Exceed investor growth expectations consistently.
  • Communities. Invest in community projects that motivate employees, attract customers, and produce valuable spin-off effects. 
To illustrate how this idea of value plays out in the real world, I identified seven principles that companies use to put value leadership into practice. I then found eight publicly traded companies that came closest to applying these principles -- Value Leaders -- and compared them to peer companies in their industries. (One of my sources for such companies was the Best 100 list.)

The Value Leaders won on many key shareholder value dimensions. For example, I found that between 1997 and 2002, Value Leaders grew 35% faster and had 109% higher profit margins than the industry in which they competed. Moreover, between 1992 and 2002, the Value Leaders saw their stock prices spike 491% -- more than four times the S&P 500's 106% during that period.

Three of these Value Leaders were on the Best 100 list in 1998 and 2010. Below are the names and the change in their stock prices since the start of 1998:
  • Goldman Sachs (GS): +139% (since its May 1999 IPO)
  • J. M. Smucker (SJM): +149%
  • Microsoft (MSFT): +78%
While I think the logic of investing in talent remains compelling, there are other important measures that investors ought to use to screen companies. For example, investors should assess whether a company uses that talent to invent market-beating new products in a productive way.

And to help with that, I developed a Value Quotient -- a measure between 0% and 100% that explains how well a company follows the seven principles. As I posted, Google earned a respectable 88% and its new CEO, Larry Page, faces the challenge of how to make more productive use of its huge pool of talent. 

If you lack the patience for such analysis, though, investing in a bundle of public companies that consistently make the Best 100 list is a reasonable bet on the value of superior talent management.


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