Do Happy Employees Make for Happy Shareholders? (Revisited)

The research seemed unanimous: Happy employees translate to higher stock returns.

Or do they?

Back in January 2012, fellow Fool John Maxfield uncovered a growing body of academic research upturning decades-old notions about employee satisfaction and shareholder return. Why, then, did Maxfield find that the happiest companies in 2011 actually underperformed the stock market in 2011? 

It all comes down to your time horizon. Now, with three years of hindsight, here's how well these happy companies have performed relative to the S&P 500.

Source: Flickr.

Happiness takes time
As Maxfield points out, conventional wisdom says that employees are a group of stakeholders that compete with investors for the company's coffers. So if employees win, shareholders lose out.

That certainly seemed true when Maxfield looked at the stock returns of CareerBliss.com's top 10 happiest companies. Back in 2011, CareerBliss.com compiled 100,000 employee reviews incorporating factors like work-life balance, relationships with bosses and co-workers, compensation, and growth opportunities. While these companies' rankings are impressive, their stock market returns are not. As Maxfield details, "While the S&P 500 returned 0.85% in 2011, the average stock in the table below suffered a loss of 3.48% for the year."

But that's not always the case.

This year, the Russell Investment Group showed that Fortune's "100 Best Companies To Work For" list returned an average of 10.8% a year since 1998, while the S&P returned only 3.3%. Using the same list, Wharton professor Alex Edmans found that, by 2005, a value-weighted portfolio beat the market by more than 200%! 

What explains the difference?

Simply put, it's the time frame. While the Russell Investment Group looked at 13-plus years and Edmans looked at seven years of data, Maxfield could then only look at the one-year return. Now that it's been almost three years, you can see that CareerBliss' returns are beginning to correspond to the findings of academic studies.

Source: Fellow Fool John Maxfield. *Denotes data from Google Finance with December 2010 start date.

While you may have lamented these stock choices back in 2011, you won't now. Had you created a portfolio of the eight publicly traded companies (two of the companies aren't available on the open market), you'd be beating the S&P 500 by 5 percentage points today! Moreover, if you had chosen stocks individually from the list, you'd have a 60% chance of beating the S&P.

Of course, returns like these won't come quickly. In addition to investing in companies with great competitive advantages -- like happy, productive employees -- you must have patience. Luckily, patient investors win. Just look at Charles Schwab and TRW Automotive. Both companies ended 2011 as the worst-returning happy companies with returns of -35% and -39%, respectively. Yet both have seen major comebacks.

Just last week, Charles Schwab reported its biggest quarterly profit since 2008, posting $1.37 billion in net revenue and earnings of $0.22 a share -- $0.02 per share more than analyst estimates. That's all thanks to incredible, companywide growth, including 63% more brokerage accounts in its investment advisory business. Similarly, TRW Automotive has raked in the cash since the National Highway Transportation Safety Administration has pushed increased vehicle safety, generating roughly 89% of its sales from the safety division. As the NHTSA rolls out new mandates like the 2011 requirement for vehicles to have electronic stability controls, TRW's safety technology products will become ever more important for manufacturers.

With that said, investing with a long time horizon takes courage -- even when you're looking to buy a winner. Luckily, when you're analyzing Google and 3M, you can instinctively understand the simple reason why both have been, and remain, great stocks.

Google and 3M give their employees time to work on projects of their own, thereby providing an outlet for work creativity, productivity, and innovation. Called "20 percent time," the perk has led to products like Gmail and Adsense. Not only have these products helped drive Google's third-quarter sales and earnings past Wall Street estimates, but they have also helped the Big G top $1,000 per share. Meanwhile, the 15% "bootlegging" time 3M allows its employees has spawned innovations like Post-it Notes and Scotch Pop-Up Tape. Providing space for innovation will become more important as 3M makes waves in health care. While the health care segment only accounts for 16% of net sales, it contributed 25% of the company's total operating income in the recently reported third quarter, and profitability is growing fast.

Happiness and patience are important, but competitive advantages are key
When all is said and done, happy employees can make for happy shareholders. While conventional wisdom says employee happiness comes at the cost of shareholder returns, realize that fostering employee satisfaction can make a more productive workforce -- just look at the products Google and 3M have pushed out in their "free time." Of course, the returns won't come this year or even next year. As in the case of Charles Schwab and TRW Automotive, you sometimes have to be patient. And even if you can wait, no stock comes with a guarantee.

As I noted earlier, patience can make you rich, but you have to be invested in the right companies -- companies with strong competitive advantages. Having happy employees is just one of them. If you can find more, well, you may be on your way to beating the market for a long time.