How we use “Pinpricks of light” to illuminate Human Governance

Learning financial shoots 2What does the reporting of a seemingly innocuous measure like training hours tell us about a company’s management quality and material value generation from human capital?

Picking up on the theme of the recent post by my colleague, Stuart Woollard, about ‘pricing governance’ into company valuations and the general issue of what companies choose to include in their annual reports, I demonstrate below just how much insight can be gained from these so called “pinpricks of light” and how they affect the underlying value of an organization.

Let’s start with the the most obvious question: why do companies produce any reports for public consumption? We generally assume they do so either because they are required by company law or choose to report on matters that they believe presents the company in a favourable light. The pinpricks tend to be from areas they are least willing to reveal. If these assumptions hold true then anything a company chooses to tell us about its ‘human capital’ is probably something they are happy to publicise. So why is there so little mention of human capital data in the vast majority of annual reports from our OMI listed companies?

One pinprick regularly included is the number of training hours per employee.  In the case of the Nestlé’ in Society Report for 2014 we find that their “Average hours of training per year per employee per category” was 28.8. So what can we deduce or infer from this statistic?

First, it is worth asking how that particular figure was determined because measuring training hours is highly problematic and misleading. Nestlé’s note tells us that it “Covers approximately 85% of all employees through a combination of manual submission from the markets and the training system.” In reality, their training hours figure probably only refers to specific hours recorded for those who attend courses; either in a classroom or in front of a screen.  Also, its reference to a “training system” is likely to refer to a computerised booking system of who went on which courses.  This is where illumination really begins.

If Nestlé employs learning and development professionals, then it should use more precise language to explain what it is spending on ‘training’. For example, “teaching” and “training” are two entirely different processes. Teaching is primarily about imparting knowledge, while training is about giving people skills to do a job. ‘Training hours’ does not reveal anything about how well an employee has been taught, whether it has given them the capability to do their job better or what value it has added. Ironically, Nestlé’s voluntary reporting here turns out to be a negative indicator of human governance when put under an OMR analyst’s microscope.

So what could reassure shareholders’ about Nestlé’s governance and human capital management capability in this respect?

Rather than measuring input (training cost) and activity (hours) Nestlé should be measuring outcomes (what did employees do with what they learned?) and value (how much has Nestlé’s financial performance and market value likely to have increased as a result of its investment in learning?).  More importantly, does Nestlé know what a learning system is and how this drives value?  If they reported that they had recently created one, and it satisfied our standards, then this would immediately improve their OMR (currently BBB-).

One key element in that system would have to be a business appraisal of all investment in employee learning.  For example, OMS advises on how company employees can improve margins. A company can utilise a basic introduction to simple tools, which takes no longer than 2 hours, and has a very specific aim of ensuring every single employee learns how to work together to improve the company’s operating margin by 1% point.  If Nestlé dedicated just 2 hours, out of its average of 28.8, to this objective how much value would it add? Our view is already published in OMS’s a very recent Nestlé Research Note.  Here is just a short extract:

“Nestlé’s current operating margin is 11.80%[i]. Chart 1 below highlights operating margin among other comparator firms. Reckitt Benckiser currently receives our highest rating for this sector and produces the highest margin (Op Margin 25.39%; BBB+). Even companies on the same rating, such as Unilever, currently produce significantly more margin (Op Margin 16.38%; BBB-)[ii]

Nestlé’s big opportunity

From 2013 to 2014 Nestlé’s operating profit margins fell from 14.18% (CHF 13.068 billion) to 11.90% (CHF 10.905 billion). Research conducted by OMS LLP, in conjunction with the Maturity Institute[iii], shows that organizations below a BBB- level of maturity have huge gains awaiting them if the Executive team adopts a strategy to utilise mature HCM practices. In Nestlé’s case, we are confident that an extra 5-10 percentage points on operating margins are achievable within 2 to 3 years. Based on Nestlé’s 2014 figures, a 16.90-21.90% operating margin would equate to an additional operating profit of CHF 4.58 to 9.16 billion.”

It should be of great concern to all investment researchers and analysts, that the default rating for companies on OMS’s scale is a ‘B’; a lowly point 8 on a 22-point scale that mirrors standard credit ratings. When it comes to training practices, over 95% of companies adopt the same methods and still choose to measure training hours rather than anything meaningful in terms of company valuation. Any investment managers with holdings in Nestlé (or indeed for most other companies) might want to raise this point.

Of course, training hours is just one among a myriad of pinpricks that we analyse in this way. If you would like to know more then please contact us.



[ii] Yahoo Finance at 3 November 2015