Shyamal Majumdar: Human capital in equity research

THE HUMAN FACTOR

If a growing number of equity analysts worldwide are taking human capital management seriously and have started capturing the value of such intangibles in their research reports, part of the credit must go to Enhanced Analytics Initiative (EAI), launched by a group of European institutional investors in October 2004.

The initiative is unique. Here's why. The institutional investors, which promoted EAI, realised that they made their investment decisions based on the sort of extra-financial information that rarely features in analysts' reports, and that brokers needed to be encouraged to provide this information.

The solution: the EAI promoters offered 5 per cent of their own broker commissions to entice analysts to cover intangibles for such research.

In short, the EAI is designed to give brokers a commercial incentive to produce innovative and differentiated research to show that a substantive part of a company's value is related to its extra-financial performance or intangibles.

Such issues typically include corporate governance, human capital management, value creation or destruction during mergers and acquisitions, or corporate performance on material environmental issues such as climate change.

An HR consultant says that while it would be difficult to quantify the impact of the initiative, the potential is enormous. For instance, very few equity analysts comment on the alignment between remuneration and business strategy. Chances are that a good analyst will start to look at that now.

According to a note prepared by the EAI, the total amount set aside for this project is¤ 4 to 5 million for 2005. Participants can join as members (who must manage assets, and have commissions to allocate), or as associate members (where they are supportive of the initiative, and encourage their external managers to participate).

Associate membership is free, full members pay a fee to cover essential costs, including an independent monthly evaluation of broker research.

HR consultants Mercer says while the exact mix of beliefs will vary among EAI members, what they do collectively believe is that enhanced analysis and heightened transparency around extra-financial issues would provide a desirable outcome for their members and clients.

According to the EAI (the full details are available in enhanced-analytics.com), a growing body of research has shown conclusively that weak management of extra-financial issues like corporate governance failures are clearly linked with poor financial performance across a range of companies. Example: Enron, Worldcom, Vivendi Universal and so on.

Weak human capital management has also undermined corporate profitability in many companies. Similarly, weak environmental management can threaten corporate success. Weak management of a company's staff and customers can also put shareholder value at risk.

Companies can indeed develop positive stakeholder relationships and stronger brands from good risk management. But the nature of such competitive advantage tends to be time-limited as peers seek to undercut advantage.

But as can be seen with the various phases of fortune of several companies, reputation with key stakeholders "" staff and clients "" has often been a good lead indicator of financial performance.

Moreover, companies that are well attuned into changing customer needs and expectations and regulatory developments can sometimes deliver superior financial results.

In many cases, these changes call for healthier, safer or more environmentally-friendly products and services. Oil and gas majors, which are increasing their exposure to natural gas and renewable energy, and car manufacturers, which develop hybrid and fuel cells technologies, are building a competitive advantage in a changing business environment.

EAI says research output from this project will provide all fund managers with a more complete view of investment risks and opportunities by eliciting better research on underlying drivers of company performance, that is, factors that have the potential to impact companies' profitability and/ or reputation yet are not well covered in traditional financial analysis.

The project also seeks better research on key social and environmental challenges (such as human capital management, global warming and climate change) that have profound and long-lasting effects on company strategies and business models. Research will also be encouraged in the field of mergers and acquisitions where a significant proportion of transactions turn out to be value destructive.

The criteria by which the EAI will determine outstanding extra-financial and intangibles research include comprehensiveness, comparability between companies, integration of extra-financial into financial analysis, coverage of a broad universe, and responsiveness of service.

EAI members have also commissioned an outside consultant to conduct an independent review of the extra-financial and intangibles research brokers have produced in the past 18 months, and will assess how the project is proceeding every six months. Fiduciary duty requires the trustees to justify the appropriate use of commissions, which are after all client assets.

Are Indian institutional investors listening?