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CSR and Sustainability

Wharton and London Business School research shows employee welfare and financial returns are linked

Alex Edmans is professor of
finance at London Business School and Wharton. 
He’s been researching the
links between investing in employee welfare, and financial returns. 
Alex’s prior research shows
that companies listed in some “Best Companies To Work For” lists beat
the market by 2 to 3 per cent per year over a 26 year period. 
His new study, released
last month, extended the results to 14 countries.
Alex Edmans
It shows that the results
hold in nations with flexible labour markets, where the retention and motivation
benefits of employee welfare are particularly strong. 
Here’s an op ed he wrote recently about his work. 
I sent him some questions,
which he has answered below. His responses make for interesting reading.
TW: Your earlier
research suggested that US firms with high employee welfare outperform their peers
by 2-3%/year over a 26-year period, controlling for other determinants of stock
returns. What was the reaction to this, and how did you work it out?
AE: It’s hard to assess
objectively but I believe that it was  positively received. 
The conventional wisdom is
that companies should try to extract as much out of their employees as possible,
so people liked the message that “doing the right thing” is actually good for
More generally, while there
has been an active CSR movement, and an active human relations movement, there
was little evidence that these initiatives improve the bottom line – the
business case is unclear and so it was hard to push through CSR/HR
This paper helped support
this. In fact, as mentioned in point 4 below, if anything the reaction was
“too” positive – people got overexcited about it and said that the paper proved
that CSR improves firm value (when it only looked at one dimension, employee
welfare, and only in the US).
I came up with these
findings as follows. I take the list of the 100 Best Companies to Work For in
America (and in the second paper, similar lists worldwide). 
Then I calculate the return
to these Best Companies starting from one month after the list was published
(to ensure my results aren’t driven by reverse causality). 
I compare the returns of
the Best Companies not only to the overall market, but also to companies in the
same industry. For example, Google is frequently in the Best Companies list,
but its high returns could be due to the tech industry doing well, rather than
its employee satisfaction. 
I also compare each company
to peer firms with similar characteristics (e.g. size, dividend yield, recent
performance, valuation ratios). 
In short, I try to control
for as much as possible, to isolate the effect of employee satisfaction. 
I also remove the effect of
outliers, to ensure that any superior performance of the Best Companies isn’t
due to a few star performers such as Google.
TW: Your new paper looks
at 14 countries. It shows that the original results do hold in a global
context, but only in countries with high labour market flexibility, since
employee welfare is particularly beneficial for retention, recruitment, and
motivation where labour markets are flexible. Tell us which countries that meet
this criteria and a little more about why you believe your findings are
AE: Countries with high
labour market flexibility include UK, US, and Canada. 
We use two measures of
labour market flexibility, both of which have been used in prior research (and
thus accepted to be good measures of LMF). 
One is the OECD Employment
Protection Index, the second is the labour market flexibility categories of the
Fraser Institute’s Economic Freedom of the World index. Under both measures of
LMF, we find that the return to being a Best Company is increasing in the level
of LMF. 
We believe the findings are
accurate for two reasons: 
1) They hold under both
level of labour market flexibility. 
2) We control for other
country-level differences, such as GDP growth, the size of the capital market,
the rule of law etc. 
This ensures that it’s LMF,
rather than other country-level factors, that are driving the results.
TW: So what about
countries without high labour market flexibility, does this mean that it’s
harder to make the case for higher employee welfare activities by
AE: The results suggest
that, on average, the returns to having above-average employee satisfaction are
This makes sense – in
countries with rigid labour markets, regulation already guarantees companies a
minimum level of employee satisfaction, so perhaps there’s not as much need to
go above and beyond. However, note that this is only an average result. 
It doesn’t mean that
companies in countries with low LMF should never invest more than the minimum
There will still be
initiatives to increase ES that are also beneficial to firm value – it’s just
that the company should be more circumspect at evaluating these
By analogy, taller soccer
goalkeepers tend to be better than shorter goalkeepers. 
But, that doesn’t mean that
a team should never sign a short goalkeeper, just that a team might need to
evaluate a short goalkeeper more carefully when deciding whether to sign him.
TW: You argue that this
paper shows the importance of the institutional environment for the value of
CSR. Why?
AE: The first paper was
fortunate to be met with a positive reaction. 
The prevailing view was
that CSR is at the expense of shareholder value – a dollar invested in other
stakeholders is a dollar taken away from shareholders. 
The first paper overturned
this conventional wisdom, and so made a splash. 
However, some readers may
have got over-excited about it, and interpreted it as “proving” that investing
in employees necessarily improves firm value – thus all companies should simply
invest more in employees and their value will automatically rise. 

In science,
you can prove things. Hydrochloric acid in the UK
is the same as hydrochloric acid in Brazil, so if you combine it with sodium
hydroxide, you’ll get salt in both countries. 

But, social science is
about people, and people are different across countries, so you can’t
necessarily extrapolate the findings in one country to another. While the
original paper did find an interesting result, it was only based on US data.
This new paper shows that the results in the first paper do hold in other
countries – but only those countries with high labour market flexibility.
The institutional
environment is important because business decisions that work in one country
may not work in another country. 
That’s true for non-CSR
decisions – for example, a restaurant in China will often have private dining
rooms because business is often conducted over dinner in China, whereas this is
rarer in a restaurant in the UK. 
So, it’s logical that it’s
true for CSR decisions as well. Investing in high employee welfare is valuable
if labour markets are flexible and thus having good working conditions can
allow you to hire new workers. 
If labour markets are
flexible, you face constraints on hiring, so there are fewer benefits of having
high employee welfare.
TW: You also suggest
that this is the first academic study to investigate the profitability of an
SRI strategy in a global context. Why do you think this area is under-studied?
In my experience a lot of research has been done in the ‘business case for
responsible capitalism’ space in the last 20 years. 
AE: The “business case for
responsible capitalism” has indeed been well-studied over the last 20 years,
but primarily by researchers in Management or Strategy. 
These papers typically
study the relationship with profits or other measures of firm value. However,
it’s difficult to ascribe causality. 
If CSR is positively
correlated with profits, it could be that CSR leads to higher profits, or only
profitable firms can spend on CSR.
I’m from Finance. In
Finance, we look at stock returns, rather than profits. The advantage of
looking at stock returns is that this can address reverse causality
For example, for the UK
list published in April 2012, I study the returns of the listed companies
between May 2012 and April 2013. 
If high satisfaction in
April 2012 were the result, rather than cause, of good performance, the stock
price would already be high in April 2012, and so you should not expect
superior stock returns going forward. 
However, because CSR has
not historically been a Finance topic, few people from finance had studied CSR.
In particular, the prevailing wisdom in finance was so clear that CSR could not
lead to high stock returns. 
Milton Friedman famously
said in 1970 that “the social responsibility of business is to increase
profit”. In addition, many finance academics believe markets are efficient and
you can’t beat the market with any trading strategy – especially not a “fluffy”
one like social responsibility. 

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