Animal Spirits Podcast - Talk Your Book: Investing in Human Capital

Episode Date: April 25, 2022

On today's Talk Your Book we talk with Dan Ariely and Kristof Gleich about investing in human capital and corporate culture.   Find complete shownotes on our blogs...‍ Ben Carlson’s A Wealth of Common Sense‍ Michael Batnick’s The Irrelevant Investor‍ Like us on Facebook‍ And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.‍ Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Harbor Capital. Go to harborcapital.com to learn more about their fund that invest directly in corporate culture and human capital. Again, harborcaptal.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's wealth management. All opinions, expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. On today's show, we have a very

special guest. Michael and I were very excited about this one. We talked to Dan Ariely, who is like one of the OGs of behavioral finance. His book, Predictably Irrational, is one of the first behavioral finance books ever read that just kind of taps into the fact that we're all a little bit crazy. And I think it's not really our fault. It's just human nature. And Dan has taken all of his studies that he's done at Duke University and not only turn these into books, but turns them into insights in how companies can get better. And Dan has a lot of insight into corporate culture and how to improve it, how to make employees happier, how money impacts people, like how they actually interact with their jobs and their bosses. And Dan teamed up with the team at Harbor Capital

to actually create a fund to do just that. So we talked to Dan as well as Christoph Gleisch, who we've talked to before from Harbor Capital and how they came together to marry behavioral finance with an investment strategy that looks to find companies where employees are actually happy in how that improves our culture. So here is our interview with Dan and Christoph. We're joined today by Christoph Glash. Christoph is the president and CIO of Harbor Capital. We're also joined by Dan Ariely. Dan is a professor at Duke University and author of predictably irrational, the first behavioral economics book that I ever read. I don't know if it's been 15 years, but it feels like a long time since I first read that book. And that definitely opened my eyes to holy cow, really something

else, these people. So, all right, Christoph, before we get into it, can you just describe the nature of the relationship? What are we all doing here? Okay, great to see you again. Quick recap. So Harbor Capital, we're an asset management firm. And what we do is we partner with external thinkers and investors, in this case, Dan Ariely, that have a particular expertise and where we think that expertise is going to be value added and essentially produce better risk at adjusted returns. We partner with them and we bring that expertise to the market in an ETF. And in this case, it's all about human capital investing through the Harbor corporate culture leaders, ETF with a ticker happy. Great ticker. All right. I'm excited to get into that. But before we

do, Dan, I read your book predictably irrational, as I just said. And it's been 15 years, however long it's been. And unfortunately, investors are predictably irrational myself. I am guilty as charged. I am fearful when others are fearful. And one of the challenges that I have with behavioral finance is not the conclusions, but there's got to be something. Something we can do. If we are predictably irrational and we are, how can we not prescribe medicine to investors? What are we supposed to do? I'd love to hear you riff on that. The main guilty party in lots of our mistakes is human nature. We can't fix human nature. We have lots of years of evolution, lots of external forces. It's not as if you would read a chapter in one of my books

and you would be cured. It doesn't work like this. The key is to design better environments. And And the key is to have the environment set up in a way that is more likely to get us to behave in a better way. So think about as an example, your refrigerator. If the things when you open the refrigerator, if the unhealthy stuff is at eye level and the fruits and vegetables are hidden in a drawer, odds are the fruits and vegetables will go rot, will rotten and you will eat the unhealthy stuff. On the other hand, if the fruits and vegetables are at eye level and they're easy to deal with,

and the unhealthy stuff is in the draw, that would be a different setup. Now, it will not fix things 100%, but the real issue is how do we design an environment that gets people not to be too emotional and too fearful and too exuberant and think in a very different way. I'll give you one example from investing. To me, it's very surprising the kind of surveys that people feel to measure their attitudes about risk. These surveys are meaningless.

They don't do anything. We're an anti-survey podcast. You're preaching to the choir, Dan. Well, there could be better surveys, but the ones that people are doing are just meaningless. To ask the question of how would you feel if the stock market dropped 20%, that's just ridiculous. And of course, if you have a ridiculous opening statement, you'll have garbage in, garbage out.

So I think that most people's strategies in the stock market are basically garbage because they start with a meaningless random starting point. So we could do better. Or here's another example. I don't know why when I opened my investment portfolio, I see the situation of where the market is today. I have no control over what the market is today. It has to do with Putin and what's happening. What should happen is that when I open my portfolio, that I should see what steps have I taken. In everything in life, there are things that are under our control and things that are not under our control. We want to reinforce the things

that are under people's control. Have I opened the savings account for my kids? Have I increased my saving for retirement? The things that are under my control. But instead, what we do is we show people what the market is like today or tomorrow that has nothing to do with what actions people should be taking.

So the environment that actually people have created is very unhelpful for better decision. It seems like, so we have more information, available at our fingertips today than ever before, but things also seem to be moving faster and it's like we move on from one thing to the next. So do you think that that environment that we're currently in, it seems for sure like markets are moving faster because of all this information flow. Is it almost harder to make good decisions today than it was in the past? It is not harder from a physical perspective. It's a press of a button. It's actually easier,

but the information makes it much more likely that would regret it. So think about what's called anticipated regret. Imagine a situation where you go to buy something in a store. You go, you have a shopping cart, you buy something. You're unlikely to leave your shopping cart in the store and say, I'll come back in two weeks, maybe. But when you buy something on Amazon, you're very likely to not act now. In some sense, it's easier to act on Amazon and in a physical store. But on Amazon, you're also much more likely to regret something. You're much more likely to come back the next day and say, oh, why did I buy it yesterday? You can find out the prices all the time and regret an action. And we regret much more action than inactions. The availability

of information, the ease of getting into it actually promotes procrastination. It promotes procrastination because we don't want to be in a situation. We would log in tomorrow and say, ah, I shouldn't have done that. It's a question again of are people acting badly? Absolutely. Can we fix human nature? No. Can we create tools that would be better off. to help people make better decision. The answer is absolutely yes, just somebody needs to want to do it. Why do you think the stock market is such fertile ground for studying human behavior and our bad decisions?

Is it because all of the emotions involved? Is it because of the instant feedback that we get what we think is information when a lot of it is just noise? What is it about the stock market that breeds all of this behavior? First of all, I think the stock market, sadly, is not the ideal place to study decisions. And it's because it's very hard to create a control condition. When we run experiments, it's very important to create condition one and condition two. And with the stock market, it's a little hard to create an alternative reality with the stock market.

I wish there were two that we're randomly assigned people to one or the other, and we would see which one is better. See, I want to do this with the Fed. So the Fed raises rates in one world and they don't in the other world. And we see what it really happens. Exactly. Or stock splitting. Such a fascinating question. What happens when stocks split?

Is it really? Is the demand higher? and what reason, or the question about weather and people's choices. I mean, there's just a million interesting question that we can't really answer in a satisfactory way because we just have one stock market. At the same time, it's very clear that big decisions are being made in that environment, and it looks like there's lots of very odd things happening. For example, variants, where you say to yourself, what happened?

Why did things go up so much and down so much the other day? Where's the variants coming from? I'll tell you about one experiment I did, and of course it was in the context of the stock market, but not on the stock market. I took a group of MBAs. In this case, there were MBAs from Harvard, and I presented with them with a pundit that reflected on what happened in the stock market the day before. The pundant gave opposite stories.

Some people, he said things like IBM bought some of its shares, and that's why the stock market went up and sometimes they said the opposite. IBM sold some of its shares and that's why the price came up. So the pundit gave opposite stories to describe the same thing. And it turns out that no matter what stories the pundit told, people bought into those stories. And for me, the stock market is an amazing example of us seeing patterns in the cloud. You watch the clouds for a minute and you would say, oh, this big cloud is chasing the little cloud because it's evil and we have all kinds of stories, causal stories about what's happening. We're just really wired to do that. We're wired to take random information and tell a causal story and we do that in the stock market all the time.

Mandelbrot has a great quote. He said, patterns are the fool's gold of financial markets. Yes. It's not just patterns. It's a causal model behind it that gives you the sense that you understand what is going on. Maybe this is not human behavior, but there are things inside the stock market and maybe specifically inside of businesses that actually can be measured and quantified and potentially acted upon. One of those things that we're here to talk about today is corporate culture, which is definitely a timely discussion to have given all of the things going on inside of Twitter, which we'll definitely get to.

But I'd be curious to hear about the genesis of this idea. What were we trying to accomplish here? So very quickly, I had quite a few chapters in my life where I did research on human capital. I started as a lab person, and I would bring people to the lab and charge them higher taxes and lower taxes and give them compliments and do all kinds of things. and I would see how performance changes the function of that. Then I moved to questions of working with companies. I would go to companies, Intel, for example,

and I would change things about the incentives and the structure and try to measure productivity. And it was actually very easy to improve productivity, a little too easy to improve things. And the next step, this is when David and I started irrational capital, was the question, initially it was just an open question. and it's easy to go to one company at a time, measure what they're doing, change things, and then see improvement.

Could we measure at the stock market level performance of very different companies and how they treat their employees, how the employees feel about the company? And would that be a predictor of alpha? And I didn't know the answer. Now, I didn't know the answer because this was about collecting all kinds of measurements that other people have collected or have been collected on public. sites and so on, I was quite confident that it's incredibly important to measure employee motivation, but I didn't know if I could create good measurements of that. So we went into a long period

when we basically looked for good data, because that's the essence. And we found lots of good data that actually had quite good predictive power in terms of what would happen to stock market performance. And we found things that are predictor, and we found things that are not predictive. We expected such. So, for example, let me ask for the two of you, Michael and Ben, what do you think, salary, companies who pay people better, do they have a measurable improvement in Alpha? Yes. Ben? Is this a trick question?

My brain says yes, my heart says no. Okay. This is a guy who either can't commit or is a hedge. Ben is always on the fence. He is the most born podcast host of the history of podcasts. This is one of my questions I had for you because I don't know. The answer is that it's a little bit of a trick question. It turns out that absolute levels of salary don't matter.

Perceived fairness of salary matters a lot. So it's relative. Yeah, it's not just relative because if somebody else is paid more, but I understand why, it's a different story. It's perceived fairness. We find lots of things, by the way, all of them fit very much the finding from social science. We find that lots of things matter.

And we also find that the things that really matter are very, personal. It would be things that would be very hard to measure from a quarterly report or even any kind of objective measure. For example, one of the things that matter the most is whether people feel appreciated. How do you quantify that? Is this glass door? Like, what are we looking at to get to the bottom of this? We get lots of things. We get some proprietary data from surveys and so on that companies are doing. We also look, of course, at glass door and sources like that. and then we create a composite measure of all the things that we found to be important. And not everything is important, but we take all the things that we found to be important

over the years, and then we create a composite measure, and then we hand it off to Christoph and his team to create an index based on that. How did you go from your initial findings to quantifying to then turning this into portfolio management so Christop can take over and pick the actual companies? I'll jump in. So, look, what attracted us to this in the first place was you hear every single corporate leader in the world in any industry. They all say the same thing. Our most important asset is what?

Our people. Our people. Exactly. And when you think about it, we don't record people from an accounting perspective as an asset on balance sheets. So if you had two identical companies, they were identical in every way except one invested, lots in retaining, developing, training their people and creating a good culture and one that did not. From an accounting perspective or a balance sheet perspective, they would look the same, but in reality, they would be very, very different. And as an investor, we're in the business

of finding underdiscovered value and bringing that to our clients. And so finding this sort of anomaly that existed. And then obviously with Dan's unique lifetime experience of studying this phenomenon, understanding what motivates people in the workplace. It was a very attractive from us to have we found a new factor. Now, factors that exist that we all know, momentum, quality, value, but no one talks about human capital as a factor. And so we spent about a year working together with Dan and his partners at a rational capital, kicking the tires, doing our due diligence, testing Dan's hypothesis, looking at all of

the data independently to figure out, like, is this legit? And I have to tell you, we talked about some of the behaviors that maybe we need as investors. I think we should all be cynical to a certain degree. And I was pretty cynical when we started looking at this. I thought this was going to be maybe a bit of momentum and quality kind of repackaged with a nice narrative. But actually what we found when we ran this is this was a, what we call an idiosyncratic return stream that wasn't explained by other factors, which is really valuable for clients, like uncorrelated quality return streams in a low return environment is what all investors need of all stripes. And so we did a lot of work on this. We did our own sort of validation on this. And then we worked to create an index,

which is pretty simple. It just takes the output of irrational capitals research. and equally weights across about 70 businesses into an index that rebalances every quarter and then it reconstitutes, so i.e. some companies leave and some new companies kind of come in about once a year. Is this a kind of ranking system where you could also take the companies in the bottom decile or whatever and say everyone who works at Goldman Sachs is miserable? Is there the opposite here too where you could find the companies that don't score very high on any of these things? Ben, why did you pick Goldman's right when I first started talking to Dan as well. I wonder why you picked Goldman's text.

I think that one out of thin air. I don't know. The answer is that, yes, there is a very, very strong signal for shorting companies who do poorly. And Glass Door is an amazing source of information that leads to. You have to know what to look for, but yes, but it is. but we decided not too short. I feel like Glassdoor might be like legal inside information. And I guess to quantify, I'd be curious about this.

Like maybe there's no signal here, but employee turnover. Not every company discloses that. Is that predictive or is that, would you put that in like the noisy pile? So I think it's a question of who is turnover. I think if you just look at the general turnover, probably not as informative. C-suite, for sure. Well, some people you want to leave. But I think the real issue is imagine that you have how important people are for the organization

and what happened when they leave. I could easily imagine very, very useful approaches of measuring it, not easy to measure the kind of things we want. But if you have somebody, let's think of it as a star system. You have like a star from a connection perspective. But you have one person who lots of people look up to them or get their guidance on something like this, somebody who is the center of a network, them living could be very hard. And if they live to a better place, so imagine somebody is living from a company that we think of as a class B company to a class A company.

That's probably not because of class B company. It's probably attractive. But if the opposite happened, that's probably a negative signal. So I think turnover is a good signal, but it's, I would want something that is even sooner. If you think about the kind of data you have when you get people's sense, sentiment, it's a little bit like getting rain for coffee. If you're trying to predict coffee, you can do quite well when it's the season for coffee and you can start seeing how the flowers are and whether how much coffee yields there would be. But what about predicting it earlier?

If you get satellite pictures of rain and weather and so on, you can predict it even before something takes place. And sentiment is a predictor of then departure and all kinds of other So in some sense, it's a really good early signal. And remember, in this game, what you want is to get an early signal as much as possible, so it has longevity. If somebody is disappointed because their project was terminated in a unpleasant way, the market probably already knows that. So you want an early signal and sentiment is a really good early signal. I'd be curious to learn about if there's any variants from sector or two sectors. So, for example, I'm guessing that investment bankers has been alluded to or not the happiest bunch, but what

about people in Silicon Valley, especially companies that are so capital efficient or labor efficient that they can generate so much more in revenue per employee? Like, how does like industries play into all of this? So we have a model, just to make things simple, imagine that we say how fair the salary is perceived and how good is the relationship with their direct manager and do you feel aligned with the company's incentive? and you have all of those things that matter. We kick out the things that don't matter,

like salary and foosball tables and quality of coffee and so on. We have an equation that has all the things that matter. And you can say, what if we ran this equation separately for different sector? Would the equation include different things or have different beta weights, different coefficients? And the answer is no.

Very surprising, by the way. I have to say that when we started, I kind of imagined engineers programming and I said, oh, their human capital is really important. But in manufacturing, how much human capital is important, this was a very, very bad prejudice on my part. In the years since we did this, I learned a tremendous about manufacturing. There's a tremendous room for human capital in manufacturing. I can tell you tremendous stories of people going the extra mile and saving their companies, tremendous amount of money, recognizing mistakes,

finding errors, finding improvements, and so on. We tend to have this model of Google engineers who create something, but it's true for people who work at Sam's Club. The moment you start caring, lots of good things happen. So answer number one to your question, we don't see a reason not to run the same model in different sectors. Like it's not as if fairness in salary doesn't matter in one or psychological safety. Matters more as in some or another.

The model seems to be quite similar. and it also doesn't seem to be sensitive to generations. So older people like me say, oh, millennials are just like this or they're just like that. We have all kinds of prejudice and they say other things about us. But no, for example, millennials too feel very different at work if they feel connected to the mission. And the reality is that the things we're measuring are really about deep human motivation, feeling appreciated. Maybe in manufacturing,

feeling appreciated is different than if you work at Facebook. But people want to feel appreciate. I'm curious how much, maybe Christoph can talk to this about the turnover in the portfolio, but Michael mentioned Elon Musk at Twitter. So if he takes over Twitter,

how hard is it to change a culture overnight? Like if someone comes in and they bring in a new CEO or new leader or you have a hostile takeover like that, how often does that happen or does it have to be a really slow slog to get in there? And maybe Christoph,

he could start with like how much turnover there is in the portfolio and Dan could talk to like how hard it is a change of culture. I'll jump in then. So on average, the holding period for each company is about two, two and a half years. There are companies and businesses where they stay in the index on a more persistent basis with more kind of consistency. But if you back that out to a turnover, it's about 30 to 40% per year.

And we update the index membership. This is obviously a big data initiative. You don't want to overreact necessarily just to the last kind of data. point, in terms of that signal, we rebalance and reconstitute the index on an annual basis so that you kind of capture the alpha associated with the membership of the index without kind of creating too much turnover. In terms of how long it takes culture to change, Dan, why don't you take that one? The first question is, do people want to change the culture? We have to understand that there's lots of mechanisms that are designed to maintain the

culture, the legal department, for example, or all the procedures in place. Changing anything is tough. Changing culture takes a long time, and the first thing you need to know you want is to change it. You need to want to change it. But maybe one of the best example is what happened with Microsoft. You remember Microsoft had a CEO that was basically came from the world of operations. Didn't really think about human motivation. He thought about people as factories producing in a particular away and then Nadella came and had a very different approach and the company changed quite dramatically quite quickly. Now that was a big change and they wanted a change and they hired him because they wanted the change. Not every CEO is being hired to make a change, but I think it is possible

to change some fundamental things about culture quickly if there's a will, but the will has to be there and you have to fight a big resistance. I do want to say one other thing which I have say because I have a little soapbox. We talked about the things that create motivation, fairness, belonging, feeling appreciated. What do you think is the number one thing that companies do to destroy motivation? Ben, I know not to expect an answer from you by now, so Michael, how about you? Oh, man. Talking down to employees, like, you just talked down to me. No. Well, well, I don't know. Micromancement, this is definitely not the answer, but having them show up five days a week in the current environment? I don't know. What's the answer?

Bureaucracy. The answer is bureaucracy. Office space. The movie Office space. He's got 10 bosses asking for the TPS reports, of course. Exactly. The thing about bureaucracy is that it's the best way that companies show their employees, they don't trust them. And they don't care. It says, because when you have a bureaucratic procedure, it doesn't fit all things all the time. And you basically tell people, we don't care about your time, we don't care about your goal, our hierarchy is about paperwork first and other things later, and that's an amazing way to destroy goodwill and motivation. My experience, so this is kind of COVID, I think COVID has increased bureaucracy a lot.

I think people have, of course, worked remotely, a lot of things went online. You don't call somebody from HR and have a discussion about how to solve something. You have a form now, so the amounts of online forms have increased a lot. of discussions in the hallway how to resolve problems have gone down. So from just talking to companies, but I haven't collected official data about this, I think that bureaucracy has increased. And when we look now at the big resignation, there's again a tendency to say, oh, it's these young people and they're lazy and so on. I think the workplace has changed as well. I think one thing is to look inside into the workplace and say, how have we changed? What are we doing now?

So I joined Duke 13 years ago. And when I joined Duke and I had a problem, I would just walk to the office next door to solve it. Now there's online form. And not only that, it's a secure online form. And I need to log in and I need to do a two-step verification and something needs to call my number. By the time it's over, I don't feel as connected to the mission anymore. Do you get a sense that employees as a whole are collectively more unhappy now than they were in the past? Is there a sentiment shift, or you think that's pretty stable?

So I think people are less happy as a whole, but I think it's mostly affecting the newcomers. Again, I'll give Duke as an example. Because I joined such a long time ago, I still remember the early days where things were very different. And I'm not penalizing, like, when you fall in love with somebody. You remember the period where he fell in love with them, even if they change. It's still, the first impression still matters. If I think about people who join now an organization, they don't have a personal relationship, it's lots of bureaucracy, they don't feel connected to the mission. So I think if all of us switch jobs right now, we would feel a bureaucratic burden on one hand and not enough care on the other one.

That would certainly create lots of dissatisfaction. One of the biases that are inherent in money managers, especially active ones, are the tendency to closet index. You can be an active strategy and have a correlation of 0.999 to the S&P because you don't want to get fired. Credit to you guys, because I'm looking at the holdings of Happy, what does it take for Happy? H-A-P-Y. I'm looking at the holdings and you guys look nothing like the index. And I mean that in the best way possible.

So talk about, I guess as a way to wrap up this conversation, let's talk about the index itself. Is this a replacement for the core? Is this, would you describe this as more of a satellite? How do you think about people allocating to this particular strategy? I'd say this is definitely, despite the fact it's being delivered as an index, this is active management. At Harbor, we lean into active management. We think done very well.

It can add value to client portfolios. And like you said, I couldn't agree more that the curse of active management are the ones that charge active fees, but don't take enough active risk. So this is much less constrained, concentrated in 70 to 100 stocks. That's going to result in a tracking error of probably in the range of 5 or 6% versus an S&P 500. So in terms of how to use it in a portfolio, it would be more as part of a satellite rather than that sort of low-cost index ballast that people sort of tend to gravitate towards now. We think of this certainly as a potential alpha solution for reasons that we discussed earlier.

So we do think it's going to produce different outcomes from the index, but also within an ESG context, the S within ESG, we're of the belief that we're shifting towards a more stakeholder view of capitalism rather than the purely shareholder view of capitalism that we all kind of grew up in. And obviously, we think there's a cohort of investors out there that want to invest in businesses that do right by their employees because that's ultimately going to deliver better outcomes for all stakeholders, including shareholders. and employees. And if I can add something, I would like everybody to hold a tiny piece of that, not just for the investment, but just for the mindset. I mean, imagine people who say, I'm investing in a strategy that values human capital. What effect would it have on people's behavior? Imagine the two of you, Michael and Ben, starting to invest in that. How would you start thinking about your own activity, about the people who work with you in all kinds of ways? I'm hoping that in addition to the alpha and the ESG and the investment and the new factor, that people would

also start thinking more about the role of human capital in their own businesses and their own lives. Well, one of the things that Ben and I are both very bullish on is the idea that if you have a portfolio of holdings that you believe in, you're more likely to do the right thing, which is to stick with them through thick and thin. So definitely with you on that. Guys, this has been a real blast. Dan, a big thrill for us to get to speak to you after admiring you for all these years.

Christoph, you're okay, too. Thank you very much for coming back on. We really appreciate the time. Thank you. All the best. Thanks again to Christoph and Dan for coming on today. Remember, check out harborcapital.com and send us an email, NL Spearspot, at gmail.com.

Thank you.