Chapter 17
Human Capital—The Real Data to Watch

While Michael Milken is best known for his pioneering work as a financier and philanthropist, he has also been a longtime proponent of recognizing the value of human capital. Early in Mr. Milken’s career he formed a lasting friendship with Gary Becker, the University of Chicago economist and Nobel laureate, who is credited with bringing the term “human capital” into the academic mainstream. Mr. Becker estimated that at least three-quarters of a nation’s wealth was in the knowledge and skills of its people. Mr. Milken emphasized that you can invest in human capital and advocates for three major ways a nation can build human capital: through education, health (extending the length and quality of lives), and immigration.54

Mr. Milken’s prosperity theory formula was originally written during his time as a student at Berkeley and Wharton:

The formula states that prosperity is equal to financial technology (Ft) multiplied by the sum of human capital (HC), social capital (SC), and real assets (RA). This recognizes that human capital is as important to a country’s, or a company’s, success as physical and financial assets, and that financial technology has a multiplier effect on these assets.

Through his charitable organizations Mr. Milken emphasizes the long-term returns on investments in human capital, which he refers to as “the world’s largest, most important asset class.” Through the Milken Institute55 he has also tried to affect change with projects including a joint venture with the International Finance Corporation56 supporting finance professionals from developing regions, and the Milken Scholars program supporting high school graduates who have overcome significant personal hardships.

The quality of human capital in an organization and its ability to develop this asset can be critical to the success of an investment. This is true at the corporate level and all the way up to the national level. It is a major factor in how well the infrastructure of governments and markets operate. Tools to measure the quality of human capital have been evolving but tend to focus on a national basis not as much on a corporate basis.

Analysis of a company will include studying the quality of the physical plants, brand value, or the software code. However, there is not as much emphasis on analyzing the quality of management and employees—the human capital. There is some analysis of ratios such as a company’s revenue per employee or employee turn-over, but typically there is not a more complete assessment of human capital in the investment selection process, even though it is critical to an investment’s success. Human capital may be less scrutinized at the corporate level because of the higher level of subjectivity that needs to be involved in the analysis and the more qualitative than quantitative characteristics of this type of analysis. It can lend itself more to checklists and matrixes than financial ratios. Examining human capital also requires in-person visits rather than computer screens and financial statement analysis.

A pragmatic analysis of human capital is an important part of an investment decision. At Shenkman Capital, Mr. Shenkman established (mentioned in Chapter 2) a credit approval process that has been in place for over 30 years. It requires that credit analysts meet with managements and must continuously reevaluate management. The credit report contains a management assessment checklist and credit score. When you make a decision to invest in a company, management is the caretaker of your invested capital; hence, a prudent manager must judge, rate, and monitor that caretaker.

It is also not just the management and the track record that is important; it is the institutional and structural factors that are in place that allow an organization to get the best out of human capital. This includes corporate governance, organizational structures, education, training, recruitment, and retention of quality employees. Despite developments of analytical tools, much analysis in this area remains soft and needs to be done with company visits, conversations, and observations in a hands-on process. Turning around the culture of how human capital is managed in a corporate structure can take time just like rebuilding a plant. Any turn-around in which you are investing is not likely to happen rapidly and needs to be monitored.

The development of human capital at a national level is more widely followed. When making investments across-borders you will want to analyze the differences in the ability of nations to get the best from their human capital, it is a much more far ranging analysis than for a corporation. Even a well-managed company in a difficult national or regional environment will have problems.

Mr. Milken often cites Abraham Maslow’s hierarchy of needs,57 which turns out is a good framework for considering a nation’s ability to develop human capital. This hierarchy outlines that in priority order people need (1) to meet their most basic needs, such as food and security; (2) safety, employment, and health; (3) friends, family, and intimacy; (4) self-esteem, achievement, and respect, and (5) self-fulfillment through achieving their fullest potential. The simple point is that a nation must be able to provide the basic needs first before it can truly tap into its human capital potential.

In assessing the ability to maximize returns on human capital in a country metrics can include health, access to nutrition and shelter, education, and general safety. Political stability and institutions that allow for transactions to occur without exorbitant costs also help tap into human capital. Increasingly the communications and transportation infrastructure is critical as well. Finally, cultural issues can make a difference, how people treat each other and how much of the population has access to tools with which they can enhance their human capital. Under the leadership of World Bank Group President Jim Yong Kim, a former medical doctor that redirected his career to finance as a way to help countries, the World Bank has developed a Human Capital Index and has undertaken a Human Capital Project that helps countries emphasize these types of investments rather than just physical plant investments.58

In all of these matters there is the tendency to look at averages and as always averages are dangerous because they are too easy. Averages on measures of human capital do not often capture levels of inequality. Levels of inequality and the percentage of the population actively involved and engaged in productive endeavors can make a large difference in the stability of a country and poor numbers in this area indicate a nation is not probably maximizing the return on human capital.

Alan Krueger has written about the Great Gatsby Curve that shows that when a country has high inequality in one generation financial mobility on an intergenerational level is lower in the next.59 He argues that if the return on education increases over time, and higher income parents invest more in their children’s education than at other income levels, inequalities can grow. This can get exasperated if networking and family connections are a major factor in career success and the Great Gatsby effect could be more severe.

The focus on human capital goes back at least to the writings of Adam Smith, the father of modern economics. In the 1776 classic Wealth of Nations he writes about, “… a man’s skills being his fortune.” and “… the value to a person’s fortunes in honing skills and education.”60 There is also a proverb that appears in many cultures that predates Mr. Milken and Mr. Smith and sums up all the scientific research on the topic, “Give a man a fish and feed him for a day, teach a man to fish and feed him for a lifetime.”

Inclusion is a vital ingredient in how well a company or a country uses human capital. If any groups are excluded from being able to contribute then the maximum potential of an organization is not close to being reached. It makes sense that if someone had an incredible set of tools everyone should want to see them get used not just left on a shelf.

Productive workers in this modern era appear to be requiring more varied benefits than in the past in developed countries. Certain softer aspects of attracting employees get a fair amount of publicity because they are so different than traditional methods, these newer benefits might include being able to bring your dogs to work or a free Friday beer keg to share with coworkers. While some of these may seem extreme, they are indications of organizations trying to improve their human capital and should not be ignored in any assessment of a company. However, when looking at a company’s approach to human capital flexibility can be the key. Corporations need to remember there are excellent team-oriented employees that would prefer to go and have a pint somewhere other than the office or perhaps they would prefer to get some extra training on new software.

Improvements in human capital can skew more recent data from historical statistics in categories like employment, wages and productivity. These changes have to be considered when running historical time-series on this type of data, especially in more developing countries and industries where changes might be more rapid and extreme.

In assessing human capital, it is important to examine that a company or a nation is focused on creating the support and infrastructure to allow human capital to flourish. The environment that is created can be critical to be able to maximize this form of capital. As company formation happens more quickly assessing the management of human capital prior to investing is important. In the rush to get started, it is all too common to focus on gaining revenue and market share and not realize how important human capital is to sustain and succeed in a business.