Employee satisfaction, labour market flexibility, and stock returns around the world

In a new NBER working paper Alex Edmans, Lucius Li, and Chendi Zhang study the relationship between employee satisfaction and abnormal stock returns around the world, using lists of the “Best Companies to Work For” in 14 countries. They show that employee satisfaction is associated with positive abnormal returns in countries with high labour market flexibility, such as the U.S. and U.K., but not in countries with low labour market flexibility, such as Germany. I wonder New Zealand would come in this ranking.

These results are consistent with high employee satisfaction being a valuable tool for recruitment, retention, and motivation in flexible labour markets, where firms face fewer constraints on hiring and firing. In contrast, in regulated labour markets, legislation already provides minimum standards for worker welfare and so additional expenditure may exhibit diminishing returns. The results have implications for the differential profitability of socially responsible investing (“SRI”) strategies around the world. In particular, they emphasise the importance of taking institutional features into account when forming such strategies.

The conclusions of the paper:

This paper studies how the relationship between employee satisfaction and stock returns depends critically on the level of a country’s labor market flexibility. The alphas documented by Edmans (2011, 2012) for the U.S. are not anomalous in a global context, in terms of economic significance, and do extend to several other countries. However, they do not automatically generalize to every country – being listed as a Best Company to Work For is associated with superior returns only in countries with high labor market flexibility. These results are consistent with the idea that the recruitment, retention, and motivational benefits of employee satisfaction are most valuable in countries in which firms face fewer constraints on hiring and firing. These benefits are lower in countries with inflexible labor markets, leading to a downward shift in the marginal benefit of expenditure on employee welfare. Moreover, in such countries, regulations already provide a floor for worker welfare, leading to a movement down the marginal benefit curve. Both forces reduce the marginal benefit of investing in worker satisfaction, and thus being listed as a Best Company may reflect an agency problem.

The results emphasize the importance of the institutional context for both managers and investors. Edmans (2011, 2012) uses long-run stock returns as the dependent variable to mitigate concerns about reverse causality from firm performance to employee satisfaction – any publicly- available performance measure should be incorporated into the stock price at the start of the return compounding window. However, these papers do not make strong claims about causality, as it may be that a third, unobservable variable (e.g. management quality) drives both employee satisfaction and stock returns. Even if their results are interpreted as causal, it is not the case that managers can hope to increase stock returns by investing in employee satisfaction, as a positive link only exists in countries with high labor market flexibility. Turning to investors, a strategy of investing in firms with high employee satisfaction will only generate superior returns in countries with high labor market flexibility. Given that the vast majority of empirical asset pricing studies that uncover alpha are based on U.S. data, the results emphasize caution in applying these strategies overseas. This caution is especially warranted for strategies that are likely to be dependent on the institutional or cultural environment, such as socially responsible investing strategies. Just as the value of employee satisfaction depends on the flexibility of labor markets and existing regulations on worker welfare, the value of other SRI screens such as gender diversity, animal rights, environmental protection, and operating in an ethical industry also likely depend on the context.

The role of labour market flexibility for the results of the paper is interesting. New Zealand is not in their data set and I wonder how flexible our labour markets would look internationally.