Happy Employees, Happy Stocks?

Looking for a way to pick winning stocks? Maybe you should consider how well companies treat -- and motivate -- their employees. That's one of the tools Richard Bayles, manager of Excelsior Equity Core (symbol UMECX), uses to pick stocks. He makes a powerful argument for his approach and tells some terrific stock stories to back it up.

Bayles, 62, says he's simply using common sense. Employees who are treated well, and whose interests are aligned with those of the company, will be more productive. "If you look at almost every successful start-up -- whether it's Google, Starbucks, Costco or Hewlett-Packard -- they all respected their employees. If you can create a business that preserves the feel that we're all in it together, you do really well."

It's no accident, he maintains, that Costco "beats the dickens" out of Sam's Club given that Costco pays for health insurance for employees and has much less employee turnover. And taking care of employees, he argues, has also been a big part of Starbuck's continued success.

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"They don't teach this in business school," Bayles says. "From a crass stock-market point of view, one of the reasons this works is that nobody believes in it or pays attention to it. But over a reasonable period of time, it's decisive. Companies where only the CEOs get rich aren't going to do well," he says.

Philip Fisher, in the classic 1950s book Common Stocks and Uncommon Profits, argues for the kind of approach Bayles espouses. But few investors pay much attention to such incentives.

For an investor, Bayles says, the trick is to identify companies that have systems that give employees the incentive to be loyal and productive. For a company to succeed, it has to be deeply committed to such policies. They have to be part of the company's culture.

Bayles has spent most of his career managing institutional money. He now manages three funds for U.S. Trust, including Excelsior Equity Core. The fund has handily beaten the SP 500 in its two full calendar years and is comfortably ahead again this year. It's too early to come to firm conclusions on the fund, but some of the stocks it holds are intriguing.

Motivating firms

One is Brazil's Aracruz Celulose SA (ARA), which Bayles has held for years. The company cuts down eucalyptus trees for pulp that's turned into paper. Bayles says that while visiting work sites, he found three separate teams using high-powered machinery to cut down the trees, strip the leaves and small branches, cut the trees into 15-foot sections and then stack the sections onto trucks. At the end of each month, the team that cuts down the most trees gets a small bonus. "Labor isn't a huge cost of this company, but management has spent time thinking through how to motivate their employees." Aracruz Celulose's American depositary receipts trade at about five times cash flow (earnings plus depreciation, amortization and other noncash charges), Bayles says. While the business is cyclical, he expects the amount of paper the company produces to increase about 10% annually.

A favorite in the oil patch is Apache (APA), an oil producer. All work crews are on variable pay. "It's a formula everyone at the company understands." Employees are paid based on the amount of cash flow their teams produce as a percentage of the company's capital they spend. "You've got people in charge of their own destiny." The stock, also very cyclical, currently trades at eight times this year's anticipated earnings of $8.23 per share.

Another cyclical company on Bayles's buy list is Nucor (NUE). The most profitable steel company in the U.S., it groups workers into teams, which are paid largely on how many tons of high-quality steel they produce. "They get a modest annual wage and a big bonus if they do a good job," says Bayles. The bonus goes into a profit-sharing account. "Making steel is hot, hard work." It's not something most people want to do until they are in their mid 60s. The tax-deferred accounts allow employees to retire in their late 40s or early 50s and use their profit sharing to open small businesses. "There are guys with $1 million in profit sharing," Bayles says. This highly cyclical company's stock trades at 11 times the average analyst's earnings estimate for this year of $9.53.

Life Time Fitness (LTM) runs large fitness centers. "They're very focused on their members' experience," says Bayles. Every employee is on a variable-compensation program. Sales people, of course, work mainly on commissions. But people who teach weight-loss classes get paid more if they sign up more people to take their classes. And so on. The goal is clear: To instill in employees the desire to please customers. The stock trades at 34 times analysts' estimated 2006 profits. That's a rich price-earnings ratio, but not unreasonable given estimated earnings growth of 25% annually over the next three to five years.

Bayles is also keen on Timberland (TBL), the maker of boots and shoes. Bayles is impressed by how quickly the company collects bills that are owed it. This is a boring, unpleasant job for employees -- sitting in cubicles, dialing stores and reminding them to pay their bills. To help motivate employees, Timberland gives each employee one week annually to work on any type of community service they choose -- at full pay. "That's something employees can be really proud of, and it makes them feel better about their employer." Timberland has stumbled of late, but analysts anticipate it'll earn $1.81 per share this year, giving it a P/E of 15.

Opinions expressed in this article are those of the author.