Dialogue Q1 2024

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FOCUS THE FUNDAMENTALS OF GROWTH

efficient and agile. But, because analysts have struggled to measure it, it is challenging to consider as an input for investment decisions. Irrational Capital is trying to change that with a new metric: the Human Capital Factor™ (HCF).

The Human Capital Factor Irrational Capital mines a plethora of disperse data to create the HCF. Sources include company survey data and publicly available assessments, including reviews on recruitment sites, such as Glassdoor. Some sources are relatively nascent. For example, Glassdoor is a household name now, but only came into existence in 2007. Yet it has been possible to back-test the performance of companies with a high-HCF versus the market benchmark. The results are illuminating. To analyze the HCF, JP Morgan used the MSCI USA Index, which comprises more than 600 stocks. It formed and tested two share portfolios for the years between 2009 and 2020. As of 31 December in each year, it placed a concentrated portfolio of 30 stocks with the highest HCF scores in the long-HCF portfolio. The 30 stocks with the lowest HCF scores were assigned to the short-HCF portfolio. The portfolios were weighted and regularly rebalanced, to ensure a fair comparison. The results tell a clear story. The high-HCF portfolio achieved an annualized return of +20.9%, compared to just +13.3% for the MSCI overall. When the high-HCF portfolio was rebalanced to make it ‘sector-neutral’ – reflecting the sectoral composition of the MSCI benchmark – the difference remained profound. The sector-neutral high-HCF portfolio showed an annualized return of +19.2%, substantially higher than the Index benchmark (see graphic 1, left).

The human catalyst A strong Human Capital Factor ignites growth Writing Dan Ariely

Heavy hitters

“I

only want to invest in fundamentals.” Such is a common statement from financiers. Yet these self-proclaimed ‘fundamental investors’ are people who regularly ignore a key aspect of a successful business. The term ‘fundamental’ is used to describe financiers who back companies only when the hard financial data available to them looks positive. While the approach might sound sensible, it is limited – because the available data is insufficient and inadequate. One of the fundamental predictors of growth that goes largely unquantified is human capital – the people power within a firm that drives it forward. Human capital is a sort of free energy for businesses. When harnessed, it acts like a perpetual motion machine, igniting growth by making companies more innovative, creative, productive,

1 Human highs Annualized return (%) on portfolios Long HCF

20.9 Long HCF Sector-Neutral

19.2 MSCI USA Benchmark

13.3 Short HCF

13.2

One fascinating element of HCF is the way it cuts across all branches of the economy. When we set about quantifying HCF, we’d expected it to be a major factor in the so-called knowledge economy – capital-light firms such as Google and Meta. We had anticipated it to be a less important factor in sectors like manufacturing. The surprise was that HCF is as vital for capital-heavy industries as for capital-light sectors. Why is this? One example might shed some light. I met Joe, an engineer who worked at a pipe company. The company is unable to use oil as a lubricant when manufacturing its pipes, so it uses molten glass. The raw glass was sourced from recycled car windshields from a major car maker. The pipe-maker had a problem: a greater proportion than expected of its pipes were cracking and failing, and nobody knew why. Out of an interest in and devotion to his job – not because he

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