Stock prices and intangibles

Here is a great study from Alex Edmans at Wharton – Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices:

This paper analyzes the relationship between employee satisfaction and long-run stock performance. An annually rebalanced portfolio of Fortune magazine’s “Best Companies to Work For in America” earned 14% per year from 1998-2005, over double the market return, and a four-factor alpha of 0.64%. The portfolio also outperformed industry- and characteristics-matched benchmarks. Returns continue to be significant when extending the sample back to 1984, before the list was published in Fortune. These findings have three main implications. First, employee satisfaction is positively correlated with shareholder returns and need not represent excessive non-pecuniary compensation. Second, the stock market does not fully value intangibles, even when independently verified by a publicly available survey. This suggests that intangible investment generally may not be incorporated into short-term prices, underpinning managerial myopia theories. Third, certain socially responsible investing (“SRI”) screens may improve investment returns.

In other words, intangibles matter. In this case, employee satisfaction matters.
By the way, Edmans’ paper won the 2007 Moskowitz Prize for Socially Responsible Investing, given by the Center for Responsible Business, Haas School of Business at UC Berkeley. For more, see Edmans’ research website, including summary of the paper and the slides of a recent talk.
Thanks to Mary Adams’ blog posting at The Hybrid Vigor Institute and to Empirical Finance Research Blog for alerting me to this study.

Market failure and investing in intangibles

I think everyone would agree that one of our major investments in intangible assets is education. Part of our investments in education is the student loan program. These loans to cover part of the cost of higher education — made by the private sector — can be justified on economic grounds as a sound investment since college graduates earn higher incomes. Because of concern over the risk of such loans and to further the public policy of making such loans available to everyone, the government guarantees the loans. The private sector serves as the processing mechanism.
But now we are seeing a new form of market failure in the student loan process. Companies are cutting back on student loans not because they are risky — but because they are not as profitable as they could be. The issue is especially pronounced with community colleges. According to the New York Times (Student Loans Start to Bypass 2-Year Colleges):

The banks that are pulling out say their decisions are based on an analysis of which colleges have higher default rates, low numbers of borrowers and small loan amounts that make the business less profitable. (The average amount borrowed by community college students is about $3,200 a year, according to the College Board.) Still, the cherry-picking strikes some as peculiar; after all, the government is guaranteeing 95 percent of the value of these loans.
Mark C. Rodgers, a spokesman for Citibank, which lends through its Student Loan Corporation unit, said the bank had “temporarily suspended lending at schools which tend to have loans with lower balances and shorter periods over which we earn interest. And, in general, we are suspending lending at certain schools where we anticipate processing minimal loan volume.”

This is a very worrisome trend — especially almost every study of US competitiveness calls for strengthening our community college system. Policymakers have been pushing for more direct involvement by the Federal government in the student loan process (see Statement from U.S. Secretary of Education Margaret Spellings and U.S.Secretary of The Treasury Henry Paulson). This market failure of cherry-picking is likely to accelerate the process.
Investing in intangibles that promote economic growth but where the market has failed has been a long standing role of government. Here is another case where the government needs to step in and help the market along.
But rather than set up a new government bureaucracy, let me suggest a “market-based” solution. Large financial institutions have for a long time stayed away from the small loan business for the same reasons cited above: low balances and shorter time periods. To fill that gap, micro loan institutions have emerged – most notably in the third-world and based on the work of Noble Laureate Muhammad Yunus and Grameen Bank
As the big institutions pull out of the community college business, micro loan institutions should move in. They need not be microfinance in the traditional sense (as being loans of a few hundred dollars and based on solidarity lending). They can be larger – but informed by the micro loan experience.
What they will need is regulatory and certification help from the government. Education Secretary Spellings, call Mr. Yunus.