Companies with stronger Human Capital Return on Investment (HCROI) create more value through the cycle according to the Human Capital Management study.
The report into the value of sustainable human capital was conducted by Schroders, the California Public Employees’ Retirement System (CalPERS) and Saïd Business School, University of Oxford.
Angus Bauer, head of Sustainable Investment Research at Schroders, said in the report that HCROI is an accounting-based quantitative measure that can be used alongside Employee Economic Value Added (EEVA) and other metrics to assess the effectiveness of human capital management.
“HCROI is positively correlated with forward excess returns over multiple time horizons and across sectors, even after controlling for a variety of factors,” he added. “Companies with stronger HCROI create more value through the cycle.”
As a result, HCROI analysis can be used as part of a broader investment and engagement process, helping investors to interrogate why companies with similar levels of labor investment can achieve different fundamental outcomes.
However, data is an issue for investors as corporate disclosure of human capital-related data remains poor. Bauer said that richer and more pervasive disclosure would benefit market participants and asset owners.
The study explained that Return on Capital Employed (ROCE) profiles, or even long product cycles, afford investors and managers high margins of safety and time, supporting investment decisions.
Therefore, a similar margin of safety and time could be achieved through effective controls for measuring, monitoring and managing core human systems.
“Companies with strong human capital management are likely to be more capable of navigating the future effectively, regardless of what is thrown at them, because they can rely on their management toolkit and their people doing right by the company and its stakeholders,” said the study.
The report continued that introducing human capital in firms’ ROCE decomposition signals an important shift in the treatment of human capital-related costs from treating what is still largely considered an operating expense to more like an investment.
This reflects the view that human capital is a long-term asset, with earnings power, and potential for appreciation or depreciation, linked to the organisation management abilities.
The study concluded that the predictive power of HCROI, after deliberately acknowledging a variety of other potential drivers within a multifactor framework, is statistically significant across the universe for all horizons and that companies with higher HCROI create more value through the cycle (see graph).
Firms which combine top ROCE and top HCROI (blue pluses) show consistently higher excess ROCE than top ROCE firms only (blue solid line).
Conversely, those with top ROCE but bottom HCROI show consistently lower excess ROCE over time (blue minuses). There is a similar relationship for bottom ROCE firms.
“While high HCROI companies have higher ROCE and net margins on average and maintain these higher levels even after 5 years, low HCROI does contribute to faster mean reversion of companies with higher starting net margins,” added the report.
It added, “Given one of our priors in this work was that human capital management can help create and sustain competitive advantage, or margins of safety, it is encouraging that this is not negated by our analysis of persistence through the cycle.”
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