Human Capital

What Is Human Capital?

An organization is often said to only be as good as its people from top to bottom, which is why human capital is so important to a company. 

The term human capital simply refers to the economic value of a company’s workers’ experience and skills. The Organisation for Economic Co-operation and Development (OECD) defines it this way: “the knowledge, skills, competencies and other attributes embodied in individuals or groups of individuals acquired during their life and used to produce goods, services or ideas in market circumstances.”

The whole concept of human capital can be traced back to the 18th century. Adam Smith referred to the concept in his book, “An Inquiry into the Nature and Causes of the Wealth of Nations”. In the book, Adams suggested that improving human capital through training and education leads to a more profitable enterprise, which adds to the collective wealth of society. According to Smith, that makes it a win-win for everyone.

Then, in the 1950s and early 1960s, Nobel Prize winners and University of Chicago economists Gary Becker and Theodore Schultz were among those primarily responsible for the development of the theory of human capital. Becker realized the investment in workers was little different for a company than investing in capital equipment. 

Fast forward to today and human capital is extremely important to businesses because it is believed to be a big boost to productivity, which leads to gains in profitability. That is why many companies invest in their employees, such as paying for education and training. 

In effect, the chances of a company’s success becomes higher as it nurtures its human capital.

Why Invest Using the Human Capital Factor Strategy?

Today, we live in a new investing reality. Many large institutional investors pay close attention to ESG (environmental, social and governance) factors. And one crucial ESG factor is human capital management.

This focus makes sense since, increasingly, a greater share of a company’s value is derived from its people—who generate intellectual property—rather than its physical property and equipment.

Research from Dan Ariely, Duke University professor of psychology and behavioral economics, focused on the links between human capital management and an organization’s overall performance. He found that authentic feelings of appreciation and fairness (broadly defined) are key elements of an organization’s culture that are connected to higher productivity.

There is other research showing that turnover data (think the Great Resignation) can be revealing. Companies with higher turnover correlate with weaker performance versus its peers.

All of this academic research is important to investors. Corporate balance sheets treat human capital as part of a company’s intangible assets. That’s always been true, but it matters much more now. In 1985, only 32% of the market value of the S&P 500 were intangible. By 2020, that share had grown to 90%. 

In other words, intangible assets – including human capital – are increasingly valuable and need careful management to ensure profitability. That’s why many CEOs truthfully say that a company’s employees are our greatest asset.

Human Capital Investing

This new-found focus on human capital has led to a new entrant in the landscape of factor investing.

According to J.P. Morgan, the Human Capital Factor (HCF) – a strategy that analyzes certain employee perceptions such as pride, purpose, and psychological safety – has demonstrated that it may be more relevant to a company’s stock performance than other investment factors.

This strategy was developed by an investment research firm called Irrational Capital, co-founded by the aforementioned Dan Ariely. HCF quantifies corporate culture by studying employee behaviors and motivations, rather than by just looking at things like compensation packages or the number of diverse members on the board.

In other words, it is a data-driven strategy that tries to capture the link between strong corporate culture and the value of a company’s stock. Companies with a high HCF score seem to have an edge on their competitors.

J.P. Morgan analyzed HCF’s performance across a wide range of indices, including the Nasdaq, Russell 1000, and MSCI USA. By back-testing stock performance data from 2015, J.P. Morgan found that the Nasdaq HCF Long portfolio delivered an excess return of 3.1%, while the Nasdaq HCF Long-Short portfolio generated a significantly higher annual return of 13.3%. For the Russell 1000 and MSCI USA indices, the HCF Long portfolios delivered excess returns of 3.7% and 6.2%, respectively.

The J.P. Morgan report concluded that “within the tech-heavy Nasdaq, the HCF is highly proficient at identifying underperformers.” 

How to Invest in Human Capital

A smart focus on material ESG factors, such as human capital, can potentially lead you to better risk-adjusted returns.

Finding and analyzing information about human capital management requires considerable research. However, there are funds that have done the legwork for you. These can be found with an AI-aided search at www.magnifi.com.  

Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.

The information and data are as May 31, 2022 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.