From 1991 to 2018, capital expenditures as a percentage of total sales remained relatively flat, at about 10 percent. On the other hand, personnel expenses almost doubled during that time. In fact, by 2018 personnel expenses (the costs for hiring, wages, salaries, and bonuses; social security and insurance costs; costs for employee training and development; perquisites like catering and workwear; and post-termination benefits) consumed approximately half of all of the average firm’s revenues of publicly traded European firms reporting under International Financial Reporting Standards (IFRS). Reflecting this trend, many CEOs have stated that “employees are our greatest asset.” However, due to accounting rules requiring that most expenditures related to employees be treated as costs and expensed as incurred, the value of employees is an intangible asset that does not appear on any balance sheet. That raises the question: If employees are a firm’s greatest asset and yet, as an intangible asset (as are research and development and advertising expenses), their value doesn’t appear on any balance sheet, does the market properly value the asset?
Recent research, including the 2020 studies “Explaining the Recent Failure of Value Investing,” “Intangible Capital and the Value Factor: Has Your Value Definition Just Expired?” and “Equity Investing in the Age of Intangibles,” has investigated the impact on equity valuations and returns resulting from the dramatic increase in the relative importance of intangible assets compared to physical assets. The findings have been consistent that the increasing importance of intangibles, at least for highly intangible industries, is playing an important role in the cross-section of returns and thus should be addressed in portfolio construction. This lack of having a hard accounting measure for intangibles could be one thing impacting the underperformance of the value factor. But the lack of a strong measurement for intangibles affects not just value metrics but other measures, such as profitability, which often scale by the book value of total assets, both of which are affected by intangibles—and investors recognize at least some of their value.
Human Capital as Intangible Asset
Matthias Regier and Ethan Rouen contribute to the literature on intangible capital with their October 2020 paper, “The Stock Market Valuation of Human Capital Creation.”
They began by noting:
“Accounting rules require that most expenditures related to employees be treated as costs and expensed as incurred. The reason for this treatment is that unlike with assets, firms do not have control over their employees (i.e., employees are not forced to remain employed by the firm). Still, costs related to employees likely consist of two components, the immediate expense that ensures that employees contribute to maintaining current business operations, and the investment that encourages employees to improve in their roles and grow the firm.”
Unfortunately, they noted:
“While IFRS requires firms to disclose PE [personnel expenses], under U.S. Generally Accepted Accounting Principles (GAAP), firms are required to disclose only the total number of employees and, since 2018, the salary of the median employee, a measure that lacks relation to future performance. Given these limited disclosures, investors face informational challenges when attempting to recognize the variation in firms’ abilities to effectively invest in intangible assets broadly and generate human capital specifically.”
To address this problem, they developed measures of firm-level human capital creation from publicly disclosed personnel expenditures (PE)—a line item that firms are required to disclose under International Financial Reporting Standards—and examined the stock market valuation of these characteristics, allowing them to capture cross-industry and cross-firm variation in the ability to create future value from PE. They then analyzed whether and when the stock market realizes the future value created by PE.
Personnel Expenses and Value Creation
Regier and Rouen explained:
“While a portion of PE is consumed contemporaneously to ensure the continuation of current operations of a firm, PE also contains personnel investments to attract and retain talent, and train workers to improve operations in the future. Given the growing importance of human capital to firms’ operations, markets should realize at least some of the human capital quality when it is created.”
“While PE is expensed as incurred, a component of the expenditure can be thought of as similar to buying a machine that will continue to produce value during its useful life. Therefore, firms that invest heavily in building human capital understate their earnings. If the market fixates on reported earnings, these firms will be undervalued in the current period and generate abnormal returns in subsequent periods. … At the same time, firms with high PE may be riskier on average. Opportunities to grow the firm’s human capital do not necessarily reflect the efficacy of those investments, creating greater uncertainty about the firm’s expected future income. PE may also be difficult or costly to adjust in the short run, leading to high labor leverage, which results in firms’ operating profits being more sensitive to shocks and which is positively associated with firms’ equity risk. This could lead markets to demand a risk premium.”
Their data sample covered firms listed on an EU-regulated market because they must disclose, according to IFRS, their PE. Their sample included the current 27 members of the EU as well as the United Kingdom, which left the EU in early 2020. They added Norway and Switzerland, for a total of 30 countries and almost 12,000 firms for the period 1990-2018.
They began their analysis by calculating from PE the variation in firms’ efficacy in creating human capital by identifying the relation between prior period PE and current firm performance.
The authors explained:
“Specifically, for a large sample of firms across 30 European countries, we begin by regressing at the industry level current operating income on several years of lagged PE to identify the optimal lag structure for each industry. In some industries, as many as three or four years of lagged PE are significantly positively associated with current operating income (e.g., manufacturing) while in other industries, prior PE has no relation to current performance (e.g., chemicals). Next, we rerun these regressions at the firm-year level using the industry-determined lag structure. Summing the coefficients on prior PE from these regressions provides a firm-year estimate of the PE future value, or PEFV. We view total PE scaled by total assets as a proxy for a firm’s opportunity to create human capital, while PEFV represents a proxy for the efficacy of that investment.”
Their analysis sorted firms into portfolios three ways:
- On the efficacy of the firm to generate future values from PE (PEFV).
- Based on current PE, scaled by total assets (PE/TA) as a proxy for firms’ opportunities to develop human capital.
- Based on the interaction of efficacy and opportunity (PEFV*PE/TA).
Following is a summary of their findings:
- The magnitude of the future values generated by PE varied considerably across industries.
- The relation between total PE and stock price was negative and significant. However, the relation between PEFV and contemporaneous price was positive and significant.
- Firms with higher PEFV had fewer employees, higher market-to-book ratios (the stock market differentiates between the current operating expense component of PE and the future value of PE, which is treated as an intangible asset), fewer tangible assets, higher sales growth, and more training for employees.
- Faster growing and less capital-intensive firms had higher PEFV, providing confidence in this measure as an effective proxy for investments in human capital. Adding to this confidence, PEFV was positively associated with various measures of future employee productivity, providing evidence that investments in human capital leads to future productivity gains.
- Consistent with PEFV being associated with human capital creation, the relationship between the number of days a company trains employees and PEFV was positive and significant.
- Long-short portfolios based on the human capital creation efficacy (opportunity) produced annualized abnormal returns of 4.0 to 5.4 percent (6.0 to 7.5 percent).
- Portfolios formed on the combination of efficacy and opportunities produced the strongest abnormal returns of 6.3 to 9.3 percent in annualized terms.
- The economically and statistically significant returns were robust to equal- or value-weighting the portfolios, as well as the Fama-French five-factor model and adding momentum as a sixth factor.
- The excess returns have characteristics supporting both a risk-based (markets require a risk premium for firms with high PE to TA) explanation as well as a behavioral (mispricing) explanation.
Their findings led Regier and Rouen to conclude:
“Our results provide evidence of the importance to valuation of accurate human capital measurement.”
They noted that the evidence of significant excess returns they found suggests that:
“the market fails to fully impound both the opportunity and efficacy of human capital development embedded in PE.”
“Taken together, our results suggest that firms’ personnel expenditures reflect not just the cost of labor in the current period but also the investment in human capital contained within that cost, and that market participants fail to fully understand the opportunity and efficacy of human capital development embedded in the disclosure of the expense.”
Addressing the Intangibles Problem
One way that academics and fund managers have tried to address the issues related to intangibles not being on the balance sheet is to use alternative value metrics such as price-to-earnings (P/E), price-to-cash flow (P/CF), and enterprise value-to-earnings before interest, taxes, depreciation, and amortization (EV/EBITDA). Many fund families (such as Alpha Architect, AQR, BlackRock, Bridgeway, and Research Affiliates) use multiple metrics. Another alternative is to add other factors into the definition of the eligible universe. For example, since 2013 Dimensional has included profitability as a screen in their value funds. A third alternative is to add back to book value an estimate of the value of intangibles, such as R&D expenses. A fourth way to address the issue is to apply what some call “contextual” stock selection, using different metrics or different weightings of those metrics depending on the intangible intensity. For example, if book value is not well specified for industries with high intangibles, it may be less effective in those industries than in industries with low intangibles. However, none of these directly address PE and PEFV.
Regier and Rouen’s findings, “suggest that firms’ personnel expenditures reflect not just the cost of labor in the current period but also the investment in human capital contained within that cost, and that market participants fail to fully understand the opportunity and efficacy of human capital development embedded in the disclosure of the expense.” The bottom line is that the increasing importance of intangibles, at least for highly intangible industries, is playing an important role in the cross-section of returns and should be addressed in portfolio construction. Unfortunately, at least in the U.S., disclosures around human capital are limited and opaque. Given the findings, the SEC should make PE disclosures mandatory, making PE transparent. It will be interesting to see how investment management firms begin to incorporate these findings.
One last important point: Given the dramatic shift away from hard assets to intangibles that has occurred over the last 30 years, Regier and Rouen’s finding that high PEFV firms tend to be high market-to-book value firms (growth firms) perhaps helps explain the relatively poor performance of value stocks over the most recent decade.
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