There are several different types of intangible assets that companies have. Brand recognition, good will and intellectual property are commonly cited examples. But there’s one hugely important intangible that arguably receives less attention than it should: corporate culture. Although it’s hard to measure, new research shows it shouldn’t be ignored, as LARRY SWEDROE explains.
The poor performance of the value factor over the past decade has led to researchers investigating ways to improve performance. Given the dramatic increase in the relative importance of intangibles on corporate balance sheets, it’s not surprising that much of that research, including the 2020 studies Equity Investing in the Age of Intangibles, Explaining the Recent Failure of Value Investing and Intangible Capital and the Value Factor: Has Your Value Definition Just Expired?, has focused on intangibles. An interesting take on the rise of intangibles is Kai Wu’s June 2021 paper, Intangible Value, utilising text analysis instead of financials to create an intangible value factor.
The hypothesis is that because global accounting standards require companies to expense rather than capitalise the amount spent on activities that create intangible capital, there is a systematic and persistent understatement of the book value of equity. To address this issue, some researchers have adjusted book-to-price ratios to account for the biases caused by unrecorded intangible capital. Their empirical findings suggest an improvement for value strategies, using such adjustments as including unrecorded intangibles in the book value, which increases the value premium and aligns with risk-based explanations.
While research on intangibles has tended to focus on intellectual property and brand, very little attention has been paid to perhaps the most important intangible of all: corporate culture. The explanation for the lack of attention is likely due to the fact that while many, if not most, CEOs have stated that “employees are our greatest asset,” due to accounting rules the value of employees is an intangible asset that does not appear on any balance sheet. Another explanation is that the value of corporate culture is hard to measure. However, just because something is hard to do doesn’t mean we should not try.
Employee satisfaction and equity prices
In his 2013 study, Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices, Alex Edmans analyzed the relationship between employee satisfaction and long-run stock returns. Scoring companies in four areas — credibility (communication to employees), respect (opportunities and benefits), fairness (compensation, diversity) and pride/camaraderie (teamwork, philanthropy, celebrations) — he found a strong, robust, positive correlation between satisfaction and shareholder returns. Firms with high levels of employee satisfaction generate superior long-term returns even when controlling for industries or factor risk. His findings led Edmans to conclude that employee satisfaction is positively correlated with future shareholder returns, implying that the stock market does not fully value intangibles.
New research on corporate culture
Kai Wu contributes to the literature on the role of intangibles with his August 2021 paper, Measuring Culture. He began by noting: “Company culture is widely recognised to be a key intangible asset, yet few investors have attempted to formally measure it.” The problem, he explained, is that “culture is a fuzzy concept, whose many facets cannot be reduced to a single number. Moreover, there is no consensus around what exactly is a ‘good’ culture. Amazon’s culture is held up as a paragon of both innovation and brutality.” To solve the problem, Wu used natural language processing to build multidimensional culture profiles for each company and demonstrated that culture can be measured, as can its impact, which may be under-appreciated by the market.
To examine the values held by rank-and-file employees (which can be very different from the values espoused by the CEO and the company — 80 percent of large companies post their values on their website), Wu used Glassdoor, which provides a forum for current and former employees to post reviews of their employers. Over the past decade, millions of reviews have been posted on the website. Glassdoor allowed Wu to examine if companies “walk the talk.”
In a related July 2020 study of nearly 700 large companies, When It Comes to Culture, Does Your Company Walk the Talk?, Donald Sull, Stefano Turconi and Charles Sull identified 62 distinct values mentioned by at least 1 percent of the companies with official values statements. Integrity was the most common, listed by 65 percent of all companies, followed by collaboration (53 percent), customer focus (48 percent) and respect (35 percent).
To determine if companies did walk the talk, they analyzed Glassdoor reviews and found that “there is no correlation between the cultural values a company emphasises in its published statements and how well the company lives up to those values in the eyes of employees.” All the correlations between official and actual values were very weak, and four of the nine—collaboration, customer orientation, execution and diversity — were negatively correlated.
Wu noted that research has found that seven broad categories of the above values explain a large part of a company’s culture and also provide information on employee satisfaction. The seven categories—innovation, teamwork, results orientation, integrity, customer orientation, detail orientation and transparency make up a company’s organisational culture profile (OCP). Wu used the OCP framework to define the seven dimensions of company “personality” and then analyzed how it correlated with future equity performance. He built culture profiles from both employee reviews and earnings calls for the same company, allowing him to contrast what management said is their culture with the beliefs of rank-and-file employees. Following is a summary of his findings:
- Each industry has its own culture. For example, technology and health care companies tend to have innovative cultures, while consumer companies prioritize the customer. However, there can be significant intra-industry variance.
- Culture decays extremely slowly, maintaining a strong 45 percent correlation to its original setting even a decade later. However, while culture is stable on average, it is not predestined. For example, smaller companies tend to have more malleable cultures. Thus, culture is a very long-duration intangible asset — companies with good cultures enjoy a long-lived advantage, while those with bad cultures can be dogged by this liability for many years.
- Firms with strong cultures (based on the seven OCP dimensions) have outperformed the stock market, while those with toxic cultures have lagged.
- All seven OCP factors had abnormally positive performance at the onset of the COVID-19 crisis.
- Outside of the seven universal factors, many other cultural values are more contextual. For example, a culture of stability does confer some benefits to firms in “procedural” (versus creative) industries, but is a liability for creative firms. Similarly, stability helps firms in industries with low growth expectations, though it hurts high-growth firms.
- Firms with cultures that are highly focused on one or two cultural factors at the expense of others (Amazon is obsessed with customer service and innovation, but less concerned with fostering a nurturing work environment) have outperformed. Similarly, companies with unique cultures that are very different from their peers have outperformed. The market has rewarded leaders with a strong vision for their company culture and the ability to stick to this vision even if it means not being able to please everyone.
- With the exception of the innovation value, the correlation between stated corporate values and employee perceptions was weak, corroborating prior research findings that the values on company websites are mainly for public relations purposes — investors need to look beyond the official company line to the values held by employees.
Wu’s findings demonstrate that corporate culture does matter.
Why culture matters
Wu elaborated on some of the important reasons why culture is important.
- It constitutes the first principles that underpin decision-making, allowing for faster decisions.
- It helps promote consistency across a company.
- It is especially valuable in complex, dynamic and ambiguous environments where fully monitoring and directing employee behavior is impossible.
- It is particularly valuable in crises, such as the current pandemic, when there is no time to create a new playbook.
- It is a force multiplier on an underlying pool of talent, helping to get the most out of employees, even those who would not otherwise be natural innovators. Conversely, a rigid culture can stifle innovation, driving a company’s most creative employees to quit in frustration.
- Great company culture can improve employee satisfaction. Happy employees are more loyal and motivated and are more likely to recommend their company to potential hires and customers.
Wu’s findings led him to conclude that employee goodwill is an intangible asset that enables firms to achieve their goals: “Treating your employees well builds up a reserve of goodwill, which is paid back in the form of greater motivation and loyalty. Furthermore, happy employees are more likely to spread the word, enhancing brand and recruiting efforts.” He added: “Culture is an important type of intangible capital. Culture provides a moat around a firm’s human capital. The rising importance of human capital in the knowledge economy implies that this moat is becoming increasingly key.”
The evidence suggests that corporate culture is a long-duration intangible asset that is not properly valued by the market. In fact, Wu noted that it “is often not only ignored by the market but can even be penalised by investors focused on tangible quarterly results.” It will be interesting to see if evidenced-based investment firms begin to incorporate Wu’s and other researchers’ findings on the value of corporate culture. As Wu stated: “Buying companies with great cultures may offer investors the potential to do both well and good.”
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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