Employee Satisfaction, Labor Market Flexibility, and Stock Returns Around The World

The following post comes to us from Alex Edmans, Professor of Finance at London Business School; and Lucius Li and Chendi Zhang, both of the Finance Group at the University of Warwick.

In our paper, Employee Satisfaction, Labor Market Flexibility, and Stock Returns Around The World, which was recently made publicly available on SSRN at, we study the relationship between employee satisfaction and abnormal stock returns around the world, using lists of the “Best Companies to Work For” in 14 countries.

Theory provides conflicting predictions as to whether employee satisfaction is beneficial or harmful to firm value. On the one hand, employee welfare can be a valuable tool for recruitment, retention, and motivation. For the typical 20th-century firm, the bulk of its value stemmed from its physical capital. In contrast, most modern firms’ key assets are their workers. Employee-friendly policies can attract high-quality workers to a firm and ensure that they remain within the firm, to form a source of sustainable competitive advantage.

On the other hand, employee satisfaction can represent wasteful expenditure by management. Taylor (1911) argued that workers should be treated like any input—management’s goal is to extract maximum output from them while minimizing their cost. Under this view, satisfaction is an indicator that employees are overpaid or underworked, both of which reduce firm value. Indeed, agency problems may lead to managers tolerating insufficient effort and/or excessive pay, at shareholders’ expense.

The relative importance of the above costs and benefits will depend on the institutional context. In flexible labor markets, firms face fewer restrictions on the contracts they can offer. When hiring constraints are weaker, the recruitment benefits of employee satisfaction are stronger. Since one’s rivals also face few hiring constraints, the retention benefits of employee satisfaction are also more important. Flexible labor markets also feature fewer firing constraints. Since it is easier for firms to dismiss underperforming workers and replace them with superior ones, the recruitment benefits of employee satisfaction are again greater. Separately, the motivational benefits are also likely higher. Under the efficiency wage theory of Shapiro and Stiglitz (1984), workers exert effort to avoid being fired from a satisfying job, and thus employee satisfaction has greater motivational impact when the likelihood of firing is stronger.

In regulated labor markets, hiring and firing are harder, and thus the recruitment, retention, and motivational benefits are lower. In addition, expenditure on employee satisfaction is likely to exhibit diminishing marginal returns. When labor market regulations already ensure a minimum level of worker welfare, companies with high satisfaction relative to their peers may be exceeding the optimal level: the marginal benefit of their expenditure may not justify its cost.

Edmans (2011, 2012) shows that companies with high employee satisfaction, as measured by inclusion in the list of the “100 Best Companies to Work For in America”, outperform their peers by 2-3% per year. These results suggest that satisfaction is positively correlated with firm value and that these benefits are not immediately capitalized by the market. However, these papers only study the U.S.—a country with particularly flexible labor markets—and so it is unclear whether these results are generalizable to other countries, especially those with less flexible labor markets.

This paper addresses this open question. We find that the alphas documented by Edmans (2011, 2012) for the U.S. are not anomalous in a global context. An equal-weighted BC portfolio generates a Carhart (1997) 4-factor monthly alpha of 22 basis points in the U.S. from 1998-2013, statistically significant at the 1% level. This alpha is only the 10th highest out of the 14 countries that we study. High returns to Best Companies are not limited to the U.S., although the alphas for most other countries are not statistically significant due to the smaller sample size. For example, the monthly alpha is 77 basis points in Japan from 2007-2013 and (an insignificant) 81 basis points in the U.K. from 2001-2013. However, we also document significant heterogeneity across countries. For example, Germany exhibits an insignificantly negative alpha of 45 basis points.

We next show that the abnormal returns to the BCs are significantly increasing in their country’s labor market flexibility, measured using both the OECD Employment Protection Legislation index and the Fraser Institute’s Economic Freedom of the World index. Controlling for other firm-level determinants of stock returns and country-level differences, we find that the returns to being a BC are significantly higher in countries with higher labor market flexibility, using both measures.

These results suggest that the association between employee satisfaction and stock returns depends critically on the institutional context, and results have important implications for both managers and investors. Starting with the former, managers should not necessarily increase expenditure on employee-friendly programs in countries with low labor market flexibility. Moving to the latter, it suggests that investors can only expect to earn alpha from investing in firms with high employee satisfaction in countries with high labor market flexibility. In particular, existing studies on socially responsible investing (“SRI”) typically focus on U.S. data, but the value of various SRI screens—employee welfare, gender diversity, animal rights, environmental protection, and whether the firm is in a “sin” industry (such as tobacco, alcohol, and gambling)—likely depends on the institutional context, such as regulations and cultural norms. To our knowledge, this is the first paper to study the investment performance of a SRI screen in a global context.

The full paper is available for download here.

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