Asset Pricing – Should Employers Pay Their Employees Better?

Sebastien Valeyre

John Locke Investments

Denis Grebenkov

CNRS; Ecole Polytechnique, PMC; PMC, CNRS – Ecole Polytechnique

Qian Liu

John Locke Investments

Sofiane Aboura

Université Paris XIII Sorbonne Paris Cité

Francois Bonnin

John Locke Investments

February 2, 2016


Should employers pay their employees better? Although this question might appear provoking because lowering production costs remains a cornerstone of the contemporary economy, we present new evidence highlighting the benefits a company might reap by paying its employees better. We introduce an original methodology that uses firm economic and financial indicators to build factors that are more uncorrelated than in the classical Fama and French setting. As a result, we uncover a new anomaly in asset pricing that is linked to the average employee remuneration: the more a company spends on salaries and benefits per employee, the better its stock performs, on average. We ensure that the abnormal performance associated with employee remuneration is not explained by other factors, such as stock indexes, capitalization, book-to-market value, or momentum. A plausible rational explanation of the remuneration anomaly involves the positive correlation between pay and employee performance.

Asset Pricing – Should Employers Pay Their Employees Better? – Introduction

This article is the first attempt to report the real effects of employee remuneration on asset pricing. Remuneration — defined as the annual salaries and benefits expenses (e.g., wages, bonuses, pension expenses, health insurance payment, etc.) per employee — is the cornerstone of any employment contract. For instance, pay was shown to explain, on average, 65% of the variance in evaluations of overall job attractiveness (Rynes et al., 1983). Classical theory states that profit-maximizing firms choose the level of labor pay by setting the marginal cost of labor (i.e., the wage rate) equal to the marginal revenue product of labor (i.e., the marginal benefit). Beyond this paradigm, we provide strong evidence that firms that pay their employees better tend to overperform on the stock market.

Our objective is to examine whether remuneration is an anomaly that can be priced in asset pricing models. Schwert (2003) defines anomalies as “empirical results that seem to be inconsistent with maintained theories of asset-pricing behavior (the CAPM). They indicate either market inefficiency (profit opportunities) or inadequacies in the asset-pricing model. After they are documented and analyzed in the academic literature, anomalies often seem to disappear, reverse, or attenuate.” Anomalies are typically identified either by regressing a cross-section of average returns (e.g., the seminal Fama and MacBeth (1973) approach uses the capitalization and book-to-market values), using a panel regression of the cross-section of returns with different factor returns through the F-Statistic (Gibbons et al., 1989), or by using a portfolio-based approach that segregates individual stocks with similar capitalization and book-to-market values into different style portfolios (Fama and French, 1993). In the latter case (which we refer to as the “Fama and French approach”), the factors formed on small minus big market capitalization portfolios (SMB) and high minus low book-to-market portfolios (HML) explain an important part of the identified anomalies (Fama and French, 1996). Over recent decades, the growing number of discovered anomalies suggests that the standard asset pricing models fail to explain much of the cross-sectional variation in average stock returns. Meanwhile, the effect of remuneration on company performance has surprisingly never been tested, despite the fact that employers pay particular attention to labor costs in attempting to maximize profits.

This research contributes to the asset pricing literature by introducing remuneration as an observable firm characteristic that can be a potential anomaly. More precisely, we focus on remuneration as a priced factor. Indeed, it remains unclear whether remuneration can explain the cross-section of returns. Based on the impressive list of anomalies analyzed by Harvey et al. (2015), we found only one paper that highlights income as a potential factor. Indeed, Gomez et al. (2015) analyze the relation between U.S. census division-level labor income and the cross-section of returns using the standard Fama and French (1993) approach. More specifically, these authors use per capita personal income (from the Bureau of Economic Analysis) as a new candidate factor and conclude that the cross-section of stock returns depends on the census district in which the headquarters of the firm are located. Unfortunately, as Harvey et al. (2015) has noted, “most of the division level labor income have a non-significant t-statistic. We do not count their factors”. In other words, despite its promising research question, the findings are not convincing. In the present article, we introduce a new methodology to build factors that are closer to principal component analysis (PCA). This methodology presents many advantages compared with the conventional multi-factor approaches developed by Fama and French (1992, 1993). Moreover, we use remuneration at the company level to generate results that are more relevant from an asset pricing perspective, which contrasts with Gomez et al. (2015), whose scope was limited to income per state and per division.

The remainder of the paper is organized as follows. Section II offers a literature review. Section III describes the methodology. Section IV presents the data, whereas Section V presents the empirical results. Section VI summarizes the main findings and concludes.

Asset Pricing

Asset Pricing

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