The Human Factor: Taking a Less Subjective Approach to Investment Decisions: Equity Analysts and Bankers Alike Can Benefit from Looking Further Afield from the Figures When Making a Share Recommendation or Assessing a Debt Proposal. (Investments)
Royal, Carol, O'Donnell, Loretta, Journal of Banking and Financial Services
The recent global corporate governance problems have put the issue of securities analysts and their independence--or lack of--squarely in the spotlight.
But while politicians and regulators debate the desirability of reforms to instill such independence another issue has also emerged: whether the information used to assess corporate performance can be relied on.
In the US, more than half of the shares issued by public companies are controlled by institutional investors, who are becoming increasingly concerned about internal performance. Their staples of trade are measurement methods such as economic value added, cash flow return on investing or activity based costing.
For commercial bankers, the story is similar. Lending proposals are either accepted or rejected on the basis of set financial ratios such as debt to equity and loan to valuation.
But should they be looking further afield? We argue that such quantitative techniques are only `lag' indicators of performance. We argue that lead indicators, such as human capital analysis, should be used side by side with financial quantitative data to glean a more transparent picture of an organisation.
The analysts' role
Generally, securities analysts are employed by a brokerage firm, bank or investment bank and their role is to conduct thorough research into all aspects of the current and prospective financial condition of a listed company. This usually results in a research report, forming the basis for an investment recommendation.
Analysts' main source of data is the financial variety, drawn from publicly available accounts and their own modelling. This suits the skill set of most analysts, who overwhelmingly have undergraduate qualifications in finance and business, or in specialised fields such as engineering or actuarial studies.
But the game is changing. Looking to the future, qualitative research skills will become increasingly important in making those all-important earnings forecasts.
These skills include an understanding of sustainable human resource management practices, organisational change and organisational behaviour. Appropriate analysis methods include case studies, observing participants, surveys, oral histories and document analysis. These are foreign to (not systematically used by) most analysts.
What's driving the trend is increasing evidence that the way in which a company manages its human resources does have a tangible impact on share price.
In a survey last year carried out by US researchers, it was found that non-financial insights made up a large proportion of investment decisions. The survey, of 275 active US institutional investors, found that about one-third of investment decisions were based on non-financial data, of which more than half was human resources based.
Other commonly used non-financial data related to marketing, strategy and quality aspects. Of the respondents, more than 60 per cent said between 20 per cent and 50 per cent of decisions were non-financial.
Another study, by Watson Wyatt Worldwide Research, links specific human resource management practices to above average returns to shareholders. The data indicates that human capital significantly affects current and prospective financial future performance.
Furthermore, superior human capital management is a leading--rather than lagging--indicator of improved financial success.
So, analysts and indeed corporate bankers need to have access to both qualitative and quantitative tools to do their job properly.
In fact some academic researchers have gone further, suggesting that financial research on its own can distort the analyst's true understanding of an organisation's performance.
Quantitative financial data often shows that properties shared by all organisations in an industry sector such as banking may be superficial, obvious or unimportant. …