Lead versus lag indicators: educating analysts

In the final instalment of a two-part series, Craig Donaldson examines lead and lag indicators of company performance and looks at how HR and executives can educate analysts about making more accurate, long-term assessments

On the face of it, probably not a lot seems to have changed with the way analysts assess company stocks and the value of intangible assets in recent years. However, a closer inspection reveals significant differences in the way analysts weigh up such factors.

A recent study by Accenture revealed that, in 1980, the book value of a company comprised 80 per cent of its market value. In 1990, this figure decreased to 55 per cent, while intangible assets formed 45 per cent of market value. In 2002, only 25 per cent of a company’s book value was reflected in its market value, while the intangibles ballooned to 75 per cent. Despite this, only 22 per cent of investors believe a company’s value is tied up in intangible assets.

“There is a large gap between investors’ perceptions and reality,” according to Dan London, managing partner of Accenture’s finance and performance management service line. “Over the past 25 years, intangible assets have supplanted tangible assets as the key determinate of a company’s value, yet traditional accounting methods remain focused on the tangibles, so a significant portion of corporate assets are going undervalued and unreported to investors.”

Analysts are reasonably clear on the effect human capital metrics have on organisations, according to Lyle Potgieter, CEO of IXP3 Human Capital. Rather, the issue is more about access to relevant information. In examining the average annual report for Australian listed companies, human capital is lucky to appear as a one-line statement in the profit and loss statement, under employee or maybe operational expenses. Given that such expenses are generally 60 per cent of operational expenses, according to Potgieter, he believes important details are missing including net profit per person employed; staff turnover; bonuses paid as a percentage of total staff eligible for a bonus; number of staff who achieved their business objectives; quantum of bonuses paid relative to EBIT; and staff engagement ratio.

“In our view, the issue of lead versus lag indicators is not as much of an issue of educating analysts, but rather providing the analysts with adequate information from which they can make sound and educated assessments of organisations,” he says.

Educating analysts

Executives and HR professionals will play an important role in educating investors about the value of intangible assets, according to a number of experts. William Ammentorp, Macquarie Research Equities analyst, says companies need to communicate the financial impact of intangibles to the investment and analyst community. “It’s important to show a linkage – not a causal linkage, but a real linkage with financial outputs, which is really what investors are looking for. If you can show that an engaged workforce has a good correlation with financial performance, and show that in a rigorous way, most investors will give you a hearing,” he says.

Michael Hawker, CEO of Insurance Australia Group, spends a lot of time talking with analysts about the value of intangibles, according to Sam Mostyn, head of culture and reputation for the company. “We’re probably in that transition stage with analysts, where we’ve got to find those links and draw them more clearly, and find those financial measurements that align with high engagement,” she says.

It’s important to line the intangibles up with financial measurements, she says, and communicate this in a way so analysts can see that one thing can lead to another in a financial performance sense.

“One of the greatest pitfalls is to look at very short-term performance criteria of any company whether that company’s performing to its best,” she cautions. “Analysts quite often miss the potential questions around the current state of any workforce in companies they’re analysing, particularly around things to do with engagement, cultural mix, safety performance and turnover.”

These and other issues such as management capability, stakeholder relations, supplier relationships, succession planning, engagement and leadership, are increasingly of concern to analysts, according to Mostyn. “I’d say our CFO has seen these topics raised a lot more often by analysts, particularly outside Australia.”

Executive champions

According to Mostyn, the CEO and CFO play critical roles in educating analysts about the value of human capital. In talking with the financial community, CEOs and CFOs can make it their business to discuss sustainable business practices, good workforce planning and the fundamental importance of intangibles such as recruitment, engagement, diversity and safety.

“The whole question of workforce analytics and the role of the CEO and CFO is crucial. If the CFO doesn’t see the link between the procurement and demographic changes and productivity, then you’ve probably got other false economies running through the place,” she says.

Craig Bingham, managing director of fund manager Portfolio Partners, underlines the significance of having champions of communicating the importance of intangible assets, in order for analysts to embrace the idea. “Your traditional financial analyst isn’t bent this way. There’s an education process here – this champion has to grind away at this and explain why these things matter and present tangible evidence to attest to this. If they can do this in a measured way, this will integrate into the communication program. But if you don’t have that champion, it will be uphill,” he says.

This is not an issue HR can run workshops on, Bingham explains. There’s no better classroom than a hands-on work environment, and if your champion is talking to and working alongside analysts, they get insights into the management team and can better see the tangible value of intangibles, rather than just the academic value, he says.

Improving executive accountability

HR directors can partner with CEOs and CFOs and help in building rigor into systems that capture relevant data, according to Mostyn. In the process, HR can better weather the internal politics that can come with changes of CEO. “Irrespective of the change of personality at the top of an organisation, those systems are still in place, linking recruitment, engagement, turnover, productivity – and in a way that can be understood by line management. As such, it’s going to be harder for a new chief executive, just by sheer force of personality, to unravel those performance metrics,” Mostyn says.

If, however, there are no hard metrics around human capital, it’s easy for changing CEOs to escape more rigorous internal disciplines of measurement, she adds. “You’ll get a waxing and waning as chief executives come and go. It’s really incumbent on organisations to embed this stuff into the core metrics of the organisation, so it’s owned by management at all levels of the organisation.”

By having systems in place to apply hard measures on human capital, it’s also easier to avoid warm and fuzzy language, she adds. “You have to get in the hard language of analysts. You can’t be separate to the business and you can’t be an advocate for the business if you don’t understand the drivers of that business. Increasingly, I think HR directors and executives have to partner with CEOs, CFOs and senior line management to deliver financially relevant measures.”

The role of HR

There has been a multitude of studies demonstrating the strong link between intangible assets and long-term company performance. But this research is yet to gain any significant traction in both the analyst community and companies themselves.

This presents an opportunity for HR professionals, who need to step up and point out that intangibles matter, why they matter and present their value in a numerical fashion, according to Ammentorp. “It’s a new chance for the HR professionals to step up. It’s about pushing the agenda and showing HR does deserve a seat at the leadership table because it offers critical input into the strategic and financial success of the organisation.”

Given that information around good people management, employee engagement, leadership and culture are not readily available, analysts have extreme difficulty rating stocks on non financial metrics, according to IXP3 Human Capital’s Potgieter. “Analysts are, however, increasingly rating stocks on non financial metrics,” he says.

Recently, an analyst published a rating on one of the large Australian banks based on human capital metrics, in particular staff turnover, according to Potgieter. Given that analysts are now rating on human capital metrics, this in turn means that HR directors will increasingly need to be prepared to provide metrics to analysts (or internal investor relations staff) in a short timeframe.

“HR directors will increasingly be called upon to produce human capital metrics as the demand for this information increases from both analysts and shareholders alike,” he says. “HR directors will need to start tracking these metrics and put in place systems that will enable the metrics to be produced as and when they are required.”

Automated systems and dashboards are critical systems that deliver reporting in the format that it is available on demand, Potgieter adds. HR directors will also increasingly be asked to attend Annual General Meetings to field questions from analysts and shareholders, he predicts.

“In many organisations, there will also be a requirement to add additional skills to the traditional HR team. HR directors will need individuals with IT, financial and HR skills to implement, monitor and control systems required to collate this information,”Potgieter says.

A look at the future

The Accenture study found that 67 per cent of investors believe it is still a major challenge to assess a company’s true value and its prospects for future growth. In addition, only 24 per cent rated corporations’ ability to help them assess the companies’ future growth as either excellent or good.

Nonetheless, nearly two thirds of investors still look to both tangible and intangible assets of a company as they make their decision to invest in a stock. Echoing this same concern, almost half of investors said that determining the value of intangible assets is a major challenge.

“My prediction is that, within the next five years, nearly everybody will be spending a vast majority of their time analysing these intangible areas,” says Bingham. “The two intangible areas that they will focus on will be human capital and sustainable energy usage. They will be the two key drivers that will impact this market and draw the analysts into focusing on these areas.”

There will also be developments in human capital metrics and ratios, which will be used by analysts and shareholders to evaluate organisations, according to Potgieter. Several academics and analysts are currently working on defining which lead indicators provide the best insight into an organisation’s future success.

There will also be a number of significant developments for HR professionals, he adds. “HR will increasingly become more involved in the business as their role becomes more critical in managing and reporting on human capital metrics. HR will move out of an operational and policing role to that of strategic advisor with boardroom presence,” he says.

“CEOs, CFOs, analysts and shareholders will rely on this information as it becomes the benchmark lead indicator of success. This is due to the increased reliance on people as organisations migrate their mode of operation from industrial thinking to information age thinking.”

If organisations fail to do this voluntarily, Mostyn predicts an increase in regulation around some intangible factors. “There will be an increase in better companies that understand these indicators and their link to success. Those that don’t get it will fall by the wayside, because they won’t be there over the medium to long term,” she says.

“They’ll be so swamped dealing with the regulatory environment that they’ll forget that this is about opportunities and the best possible workforce, to deliver the best possible outcome to shareholders, suppliers and stakeholders.”

The shortcomings of short-termism

Now, more than ever, there are indications that companies and investors can work together to actively address the issue of stock market short-termism. A recent Conference Board report, Revisiting Stock Market Short-Termism, found that short-termism has many negative effects, including focusing investor and corporate attention on near-term quarterly earnings to the possible detriment of longer-term corporate growth. The pressure to meet short-term quarterly earnings numbers can cause undue market volatility.

This may, in turn, cause management to lose sight of its strategic business model which would compromise its global competitiveness as well as its ability to make investments in such critical long-term focused areas as research and development and environmental controls. "Recently, economic distortions generated by short-termism have been accentuated by speculative factors and, in certain cases, less than desirable business ethics practices," according to Matteo Tonello, senior research associate at The Conference Board Global Corporate Governance Research Centre, and the author of the report.

Steve Vamos, managing director of Microsoft Australia, says many companies and their managers unwittingly fall into the trap of short-termism. For example, if a manager is worried that an initiative to improve customer satisfaction will cause short-term revenue impact, Vamos says this is "a complete fallacy and delusional … How can you possibly think that doing anything good for your customer today, is going to hurt you in the short-term? It can only hurt you in the short-term if your short-term measures are wrong and your short-term goals are distorted."

"If your revenue goal for a customer in the current year requires you to do something that hurts them from a longer term relationship viewpoint, you've got the wrong short-term revenue goals."

Vamos says the ROI will be there, but businesses have to overcome short-term thinking and focus on long-term initiatives that will improve stakeholder relationships and foster and develop good work environments. "They're the things that produce great outcomes," he says.