Human capital – an investment factor

Dominique Barker: Welcome to The Sustainability Agenda, a podcast series focusing on the evolving complexities of the sustainability landscape with a view on addressing current issues in a concise format to help you navigate and take action. I’m your host, Dominique Barker. Please join me as we explore today’s most pressing matters with special guests that will give you some new perspective and help you make sense of what really matters.

Dan Ariely: People tell me it’s surprising, but it’s not surprising at all. When they started this, I would go to investors and they would say things like, oh, we invest only based on fundamentals. And I was like, what do you mean ‘fundamentals’? Like, what, the balance sheet is a fundamental? What’s more fundamental than human capital?

Dominique Barker: Dominique Barker: Today, we welcome Professor Dan Ariely. Dan is a founding partner of Irrational Capital, which focuses on behavioural economic research and strategy development. Dan is a leading behavioural economist, author, entrepreneur, and he was also a professor of psychology and behavioural economics at Duke. He’s a founding member of the Centre for Advanced Hindsight. His work in behavioural economics has led to the publication of several New York Times bestselling publications, and I just point you to Irrationally Yours, amongst others. He’s delivered several TED talks, and he’s a co-creator of the film documentary Dishonestly: The Truth About Lies. On today’s episode, we’re going to be focusing on human capital, how we can measure an intangible asset, and what it means in the context of S in ESG. I’m going to quote Dan Ariely. He says of all the investments companies make, creating a strong culture is one of the best ways to create value. This is why employee behaviour and motivation is such an important predictor of stock market performance. So welcome to today’s episode, Professor Ariely.

Dan Ariely: My pleasure. Lovely. Lovely to be here.

Dominique Barker: So let’s start with a bit of an overview for our audience. Professor Ariely, can you please talk a bit about the work you’ve done at Duke and Irrational Capital on that topic and some of your key findings?

Dan Ariely: Yeah. So generally speaking, my research career had three chapters. Chapter number one, I was a lab researcher, which means I would set up lab environment that would bring people in. I would measure how hard they work. I would give people small bonuses or large bonuses that would tax them at different rates. I would try to simulate something from the world in the lab and see how people behave, including, by the way, going to cheap places like India and giving people a six months bonuses on performance, which I could afford in India. The second chapter I used to go into companies and try to improve motivation, and I have to say that it was a little bit sad to realize how easy it is to see to improve motivation. And the reason I’m saying it was it was sad because it meant that nobody was really paying enough attention to it, right? The fact that I could come and propose a few things and have measurable improvement meant that people did not really pay enough attention to employee motivation. And then the third chapter. The most interesting one started about five years ago, and this is when we started Irrational Capital and the question of my partner, David, my business partner, was the question of Can we quantify how companies treat their employees, how employees feel about the company? And would that have a predictable element in terms of the stock market performance? And this was a really good question. Of course, it’s a question of can we get the data? I was sure that if we could measure the right thing, it would show it because we know lots of things about motivation.

Dan Ariely: But the question was, could we get the right data? So we went on the journey to look for data, and we found data from private sources like company surveys and engagement surveys that asked lots of people, lots of questions, and we got some publicly available data, think Glassdoor, LinkedIn and stuff like that. And we started by asking the question of forget the portfolio for a second, what is the quality of our signals? So imagine, for example, we would take a signal and imagine that we got an estimate of how good was the coffee quality in a company. And we took the Russell one thousand and we had data about each company and how good their coffee quality is, and we sorted them from the best coffee quality to the worst coffee quality. And we bought in the process of two thousand six, which is the first year we had data for. We bought the companies who are market leaders in terms of coffee quality. And then two thousand seven came we got new data in. Some companies might have gone up and some might have gone down. And again, we bought the top 20 percent companies to treat their employees best on quality of coffee. And then we had this portfolio up to, let’s say, 20 20. How good will that portfolio forms, how well will perform compared to the S&P 500? Now, of course, coffee is not that interesting, but we measure lots of things.

Dan Ariely: We measured salary and we measured employee benefits, health benefits, financial benefits. We measure sense of appreciation, psychological safety and so on. And generally, what we found is that the extrinsic motivation factors things like salary, retirement benefits, health benefits, quality of coffee chairs, tables doesn’t matter that much. But we found that intrinsic motivation mattered a lot and the intrinsic motivation we further divided into two components. And we call them goodwill and utility embracing. And what are those two to think about goodwill? Think about the difference between the minimum. You have to work not to get fired and the maximum you can work if you’re truly excited about what you’re doing. And I hope you all agree that it’s a big gap. And not only is it a big gap, it’s under our control as employees, how much we work as a university professor. I have a very big gap. I have tenure. They can’t fire me. But how? How do we work? And the more you move into the knowledge economy, the more is under your control. Like you can sit in front of a computer and not think or you can be buzzing and it’s under the individual’s decision. And the second component utility embracing this is about doing things that are good for the company, even if they’re not good for you at the moment. So take, as an example, a janitor in hospital and imagine a dead janitor has a job description. In one day there’s a patient crying or there’s a person lost in the hospital should the janitor said.

Dan Ariely: It’s not in my job description. In fact, if I help the patient crying or I help the person get lost, it will take me longer to complete my work. But of course, we want the janitor to adopt the utility of the whole company and not follow their narrow job description. We want people to help each other. We want people to improve each other’s work. We want people to basically do things that are not in their job description. And when we quantify things this way, we see that both of those components, both the goodwill component and the utility embracing component have a big effect on predicting and correlating to market performance. And I’ll give you just one example. It turns out that salary is not a big deal. Relative salary of fairness and salary is a big deal.

Dominique Barker: So Professor Ariely, so think about this concept of purpose, which I know a lot of companies have come out with their purpose statement and being purpose driven, which I think speaks to some of these intangibles of what employees are looking for. Does corporate culture drive company performance and what are other factors? So are there tangible measures like compensation, promotions, et cetera? What are those that count to drive company performance?

Dan Ariely: So again, the things that don’t matter are salary, financial retirement. And so the things the things that do matter, feeling appreciated is one of the best things truly feeling. Appreciate being aligned with the goals of the company. You know, if a company has a statement of purpose, it doesn’t really mean that people feel aligned to that statement. Right? Yes, we can measure if a company has an its logo on the website somewhere purpose. But the question is, do people feel aligned to their purpose? And that’s much more complex. That’s real culture. The culture is not about, yes, we have a checkbox. We have a statement on our in every room in the company. The culture is about, do people feel that the company really is living up to that and they feel that they are connected to? Another thing that is really interesting is that we found, actually, I’ll ask you, can you guess what is the best thing that companies can do to crush human motivation? Nobody really wants to do it, of course.

Dominique Barker: Give them boring tasks. No, I can’t guess.

Dan Ariely: You’re close, you close. It’s called bureaucracy. 

Dominique Barker: Right, Ok, that makes sense. Yeah.

Dan Ariely: And why? Because in essence, bureaucracy is telling people, We don’t trust you. Yes, you can take somebody for lunch, but we want to see 14 receipts and a video documentation of the whole thing and so on. And bureaucracy could be the correct approach for the average case for the average worker. But when it’s not the right thing and people all of a sudden have to do something just because without the logic, they feel that their time is being wasted. And this is a real killer for alignment. If you want me to care about the utility of the company, I work for Company X and I want Company X to be successful. And all of a sudden Company X is giving me a bureaucratic hurdle that is not helping me promote the goals of Company X. My conclusion is I did not want to buy Company X or Company X is not really serious about wanting that. But all of a sudden things go awry. Another interesting one is that companies that do well are companies that don’t punish mistakes that were being done with good intentions. And here’s the logic every company wants people to take risks. If you if you want to do anything new, you have to take a risk. Sometimes you say you’re right, sometimes you’re wrong. But if you tell people never be wrong, nobody will ever take a risk. Therefore, the company would not move forward, and some companies say we want innovation. But they give people the feeling that they’ll get punished if they gamble wrongly. So people just don’t gamble. And that kills motivation. Psychological safety is a big deal, of course, connected to this ability to make mistakes. Honest mistakes.

Dominique Barker: So Professor Ariely, you’ve developed this human capital factor. Can you describe it and talk about it, how it measures some of these things that you’re talking about in a quantifiable way? 

Dan Ariely: Yeah, So we have lots of data. And as I said, some of it comes from private sources. Some of it comes from public sources. We have this decision tree extrinsic motivation, intrinsic motivation within intrinsic motivation. It’s about goodwill, how much energy we’re putting into some direction or utility, embracing how much we look at the goodness of the company as a whole and not at our job description. And we have way to measure those. Specifically, we measure some other things, like perception of fairness and salary, perception of fairness in promotions on this mistakes matter and so on. And we take all of those measures and we have a score for each company. So each company in the in the Russell one thousand, it has a score of how people feel within that company. And it’s not easily gauged by outside forces like if you look at actual salaries, it doesn’t predict it. If you look at health benefits, it doesn’t predict it. It’s really about how people feel inside and as a metaphor, think about the pain. You could have two people who experience the same electrical shock in very, very different ways. The outside stimulus is not what matters. If you feel that you’re being treated unfairly, there’s no outside measure. There’s no. If you feeling that you’re being treated unfairly, it’s over. That’s your feeling. And that’s what’s important. That’s what you get out every day. Go to the office feeling that you’re treated unfairly. By the way, some of the things that don’t matter are things that fade into the background.

Dan Ariely: When was the last time you thought about your health benefits? We think about it maybe twice a year, but we don’t think about it every day. On the other hand, if you feel that you’re being treated unfairly, then you can’t not think about it. If you’re a woman and you feel that the guy in the cubicle next to you is being treated better just because of a chromosome different, that’s just you don’t get over it. It’s upsetting all the time, and therefore it keeps on hurting motivation. So we have a score for each company. And what’s interesting is that that that scores as a really good correlation with what’s happening in the in the stock market. The following year. Right. So we basically if you think about the logic of human motivation, it says if I have a motivated workforce, at some point this would show up in better products, better services. It doesn’t happen on the same day. It’s not as if, like one day I come with an injection of motivation. Tomorrow, everything is improving. It takes some time, but it predicts the future. We also pushed extra hard to try and figure out what happened during COVID. And what we found is that everything we knew from before became even more true. And why is that? If you think about the separation between intrinsic and intrinsic motivation, when we were in the office, they were extrinsic motivation elements that kept us going like, maybe you have a glass door or a window and people can see, and when you’re in a meeting, you can’t be on your phone the whole time.

Dan Ariely: People watch you. It’s like if you think about the classroom, when the kid is in the classroom, the teacher can say, Sit up, don’t talk to your friend, put your phone down when the kid is home with Zoom. The balance of power has changed. The kids can just turn off the teacher. The same thing is also true for adults. All of a sudden, when we work from home, the role of intrinsic motivation has increased. So we see that that COVID has been an incredible period where companies that invested in human capital did much, much better than companies that did not. And because I think that we’re not likely to go back to the office five days a week anytime in the near future. I think that the extra importance of human capital is going to persist for a while. So every day that somebody spends at home running the office, the temptations are more supervision is tougher. Things that help people stay in focus. So the internal engine needs to be needs to be higher. Just think about how more difficult it is to reach out to people and say, Hey, would you like help or could you help me write? Everything needs more, more effort in that regard, so people do need to care more. So the companies that are better at that, better at creating human capital, I think, are going to be even more successful in the future.

Dominique Barker: Well, it’s a very interesting topic to think about human capital as a predictor. For outperformance of a stock versus an index. 

Dan Ariely: Can I stop you for a second? Yeah, people tell me it’s surprising, but it’s not surprising at all. When they started this, I would go to investors and they would say things like, Oh, we invest only based on fundamentals. And I was like, What do you mean fundamental? Like, What’s the balance sheet is a fundamental what’s more fundamental than human capital? I mean, I think it’s a shocking thing that we think about human capital, that we don’t quantify human capital on our annual reports. If you think about what like you buy a warehouse, it’s an investment, you improve your human capital, it’s a cost. It’s kind of shocking that we don’t think about human capital as a fundamental investment.

Dominique Barker: Well, Professor Ariely, I was going to say that we came out with our purpose statement just under three years ago, and I’ve seen a shift internally at our organization in terms of human capital and that is actually starting to play out. Our stock is doing much better versus the other Canadian banks, and I fully attribute that to human capital. And I think that as we continue to face some challenges related to labour shortages and churn of employees, it’s becoming an even more important issue to manage for companies. So what I was going to say it’s intrinsically makes a lot of sense to me, and it’s been interesting that you’ve been able to quantify it, which I know in the stock market. We always love to quantify things as much as possible. So thank you very much for today’s interview. I really appreciate your time and all the work that you’ve done for the human capital factor. We’re going to discuss some products that we have at CIBC in in a moment here.

Dan Ariely: My pleasure.

Dominique Barker: Dominique Barker: So the CIBC Human Capital Index was jointly developed by CIBC and Irrational Capital. There are a few ways that clients can view the strategy. They can look at this as a dedicated investment for an ESG allocation. They can look at this as an equity replacement and the tool to use there is the Human Capital Index, or HCI, which is currently constructed as an enhanced beta index. And finally, as an alpha strategy. The data demonstrate that there is alpha in allocating to equities with higher human capital factor scores. And this really was the subject of our call today, so some clients are looking at customized strategies as an alpha overlay. If you have any questions, please feel free to reach out to your CIBC representative to ask for additional information.

Dominique Barker: Please join us next time as we tackle some of sustainability’s biggest questions providing different perspectives to help you move forward. I’m your host, Dominique Barker, and this is The Sustainability Agenda.

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