Lead v lag indicators: quantifying intangibles

“We can put a value on lower paper usage or lower energy costs or reduction in staff turnover, but it is much harder to put a value on the deal that you’ve won because you’ve signed up to the Kyoto principles, or the honours graduate that joined you because you’ve supported Westpac helicopters for 30 years, or the business referral you get from supporting Indigenous Australians in Cape York.

“There is enormous value here and I see it every day, but the real value is not in this year’s earnings.

“The real value you will see in the consistency and the resilience of our earnings in the medium and the long term.”

What Morgan is referring to is what is increasingly being termed lead indicators of company performance. In other words, the things that a company is doing to ensure its robust financial success in the medium to long-term. The usual yardstick of an organisation’s success, profit and loss statements, by comparison could be called lag indicators. Financial results at best can tell you: you’ve just gone over a cliff. The obvious appeal of lead indicators is that they may be able to let a company know that it’s approaching that cliff before it goes over the edge.

While the upside of lag indicators can be a victory analysis involving a high degree of self congratulations, the reverse can be more akin to a grisly traffic accident investigation. Similarly, hindsight is wonderful thing. National Australia Bank can tell you all about it. Upon closer scrutiny, the banks culture, particularly around its foreign exchange desk, was a scandal waiting to happen.

How nice it would have been if that financial institution could have fingered the problem and remedied it well before the now infamous rogue trading scandal occurred. While the work of Elizabeth Hunter, head of people & culture, since the debacle has been chronicled in Human Resources previously, the adage prevention is better than a cure rings true.

The key issue for the bank was that its reputation only took a beating after the scandals were revealed even though the cultural issues that it faced were present well before this.

Peter Vlant, director, IxP3 Human Capital, says that analysts have typically selected and rated equities on the sum total of all of the information they can access. The information has predominantly been financial as this is the extent of the information organisations report. “Financial information is the outcome of many leading indicators – it is a lag indicator of success. Leading indicators such as staff turnover, brand equity, employee engagement are often not collated, and not published to analysts and shareholders.”

Vlant points out that over the past three decades, Australia, as with many other first world countries, has changed from being an industrial age economy to being an information and services economy. This in turn has meant that there has been a shift in the key metrics used for measuring an organisation’s success and its future prospects. Most organisations now have fewer fixed assets (they are now leased), carry less inventory (due to Just In Time manufacturing) and have better logistics systems resulting in faster inventory turnover.

“Organisations are now often made or broken on their ability to effectively harness the full potential of their human capital, not on the traditional metrics of return on assets or capital employed,” says Vlant.

So in a new world where success of an organisation is now more reliant on non-financial metrics, the question is how can organisations be fairly rated by analysts? “Where can an analyst get information on non financial metrics if the organisation does not publish this information? Why don’t organisations publish this information to analysts and shareholders? Which lead indicators should be collected and published? How much information should be published?”

Matthew Williams, portfolio manager, Perpetual Investments, says that as an investor the realities of assessing less tangible factors are very hard. “One of our stock selection criteria is a sound management test. We spend a lot of time talking about company management – usually confined to the CEO, CFO, and to a lesser extent, the board.

“The factors we usually discuss are the track record of management, their passion and enthusiasm and so on. In terms of less tangible aspects we are always on the lookout for anecdotal evidence about management. This usually consists of some insight into their character that give us better understanding of them as people.”

However it is the lack of solid evidence around good people management, strong leadership and healthy organisational culture – that do result in superior performance by companies – that make lead indicators difficult to factor into a share price.

“All senior management espouse [these qualities] but for us it comes down to assessing whether what they are saying is true combined with any scrap of anecdotal feedback we can gather. It is therefore a highly subjective process.”

As a result most analysts see these so-called soft skills as a lag indicator. “The analyst community is happy to follow the management line until the company begins to falter financially. A good example would be [leisure and gaming organisation] Aristocrat where the previous management team talked a strong story, but the whole culture was laid bare when the company imploded financially.”

Williams compares it to doing a jigsaw puzzle. Getting all the information together about an executive’s personality and character to give you some feeling on the intangible asset that really is very important, particularly when it comes to smaller and mid size companies where the people are so important to the whole thing. “You’re really backing the people rather than the business model itself.”

“In our game we’re very much interested in putting all the puzzle pieces together, getting all the anecdotal evidence together, having contacts within a company, customers, competitors, suppliers to try and get another view to test the management speak you get from a lot of MDs.”

Ultimately, says Williams, the view is that companies with bad cultures get found out because everything turns up in the numbers. Getting that information before an impending disaster is the hard part. “It’s hard for us to drill down to that level, and in a lot of cases the companies themselves are reluctant to share information that may find its way into the public domain.

“I get the impression that they’re quite important, and if you can get some insight into them it’s quite valuable; to us it can end up a gut feel. As to how you measure these things effectively, well, good luck.”

William Ammentorp, Macquarie Research Equities analyst points to employee engagement as another particularly difficult thing to measure.

“You can do a great deal of numerical analysis on the quantitative aspects of a bank, but qualitative things are more difficult to analyse and value. That’s one of the reasons I quite like the Hewitt and Gallup research – it’s longitudinal, rigorous and seems to show good correlation with performance over time, as opposed to a bank simply saying: we estimate our intangibles are worth ‘X’, therefore you should value us more.

“When we looked at NAB and ANZ, we saw it was difficult to see how NAB could outperform ANZ, given NAB was still working on getting their people all working in tune. That’s not to say they couldn’t do it, but it took ANZ a long time to get there and, as such, they had a comparative advantage. I don’t think you want to make your investment decisions purely on intangible factors, but I do think engagement is one of a number of key factors.”

Ammentorp points to the example of how the regulators look at banks in the US. They use the CAMEL (Capital adequacy, Asset quality, Management, Earnings, and Liquidity management) model. Here, management is a critical thing. A financial institution can be growing very rapidly and doing a great job, but management really need to be on top of all the risk and systems issues and make sure everything is being run properly during fast growth phases. “In financial services, maybe more so than other sectors, it’s the little things that go wrong that can cause major financial problems.”

Compared to engagement, satisfaction doesn’t seem to have a strong correlation with anything, argues Ammentorp. “Satisfaction can go up and performance can go down, while satisfaction can go down while performance goes up. In a softer, more qualitative science, you need to have good correlations between things, and the research I’ve seen so far suggests satisfaction doesn’t seem to correlate with anything.”

In assessing management capability, Ammentorp warns against the use of gut feel as this is where you can be overtaken by charisma. “Even the most objective individual can be overtaken by charisma. That’s where metrics need to come into it.

“It’s more about getting the metrics out there and getting the companies to talk about it. It’s good to see when ANZ talks about it, they look at engagement across all parts of the bank. When engagement was struggling in Institutional Banking, Steve Targett, who heads up that area, stood up and said his scores weren’t too good. But he acknowledged his scores were low and he was working on it. That’s one thing I’ve always been quite impressed with –when an organisation, particularly a bank, says ‘this is what we got it wrong, but this is what we’re doing about it’, rather than saying: everything’s great, don’t you worry. It’s difficult in an organisation of 40,000 people to say that everything’s going great.”

Similarly, it takes time to improve the intangibles. These aren’t things you mandate will turn around after one or two quarters. It takes years.

“What you find in most organisations is what gets measured gets done. If there are metrics that say you have to deliver on ‘X’ and ‘Y’ to determine your pay and future in the organisation, when times get tough and resources are scarce, if engagement isn’t on the list it can get put to one side. The first step is to make sure it’s linked to remuneration and other performance systems in the bank.

“CEOs and CFOs are spending a lot of time making sure this message gets through internally, but they also need to spend a lot of time doing the same thing externally. It gets tough because it is seen as “pink and fluffy”, but it’s not getting the traction it really deserves.”

IXP3’s Vlant says the answer lies in several different areas. Voluntary reporting through the ASX means Australian organisations have not been required to publish this information and therefore don’t. Analysts and shareholders have extreme difficulty obtaining this information as a consequence.

Similarly, most Australian organisations are not able to produce non financial lead indicators as they don’t have systems in place to do this.

“CEOs and CFOs intuitively know that non-financial metrics are very clear lead indicators of future success but due to the lack of systems to capture this information, default to measuring success from financial systems: lag indicators.”

When you look at the average Annual Report for Australian listed companies, Human Capital appears (if you are lucky) as a one-line statement in the Profit and Loss statement, Employee Expenses. Some times this expense line is buried in Operational Expenses. Commentary in the annual report normally under a People page generally reads something like “our people are our most important asset, we value them and they undergo some development each year” and this is the extent of the commentary.

Next issue: What can HR do to bring lead indicators to the fore?