How to Trade a Company Scandal

08/07/2012 9:15 am EST


Looking to turn the latest PR misstep into your personal portfolio turnaround story? Stephen A. Simpson shares four issues to consider when looking to profit on other businesses' misfortunes.

There is really no question “if” there will be another public relations scandal that taints a publicly traded company. The only questions really revolve around "when," "how bad," and whether the next bad PR event will create a buying opportunity for shareholders.

Like most other kinds of turnaround investing, though, trading in the face of bad PR can be a high-risk/high-reward situation. Accordingly, it is a good idea for traders to do what they can to tilt the odds in their favor.

When approaching a stock that looks cheap because the company has made a very public gaffe, there are a few key constituencies to keep in mind. Ultimately, the reactions of these groups will go a long way toward separating the wounded-but-will-recover from the permanently maimed.

1. Impact on Customers
It probably seems obvious that the first place to check for fallout is among the people the company depends upon for its business—if a company alienates its customer base, and they do not come back, the company is doomed. Likewise, if a brand's cache or premium positioning is tarnished, the company may never again be able to charge similar prices. On the other hand, if customers really just do not care about the problem, it will likely not have any lasting impact.

Take the example of the tobacco industry. Most people who smoke are brand-loyal to the extreme, and they know the product is dangerous. Consequently, it is difficult to imagine a scenario that would alienate a large percentage of the customer base enough to prompt a switch to a new brand or stop altogether.

The so-called scandals that involve the tobacco companies back in the late '90s may have inflamed non-smokers, but there is scant evidence that many (if any) smokers said something along the lines of "they lied to me? That's it. I quit!"

On the other hand, a car company that fails to deal with a dangerous design flaw or quality-control issue will quickly find itself in trouble. Likewise, a deadly food poisoning incident would be a serious matter to customers sending them to other chains.

2. Impact on Politicians
It is one thing to make customers mad enough that they abandon a company; it is an altogether different matter when customers are outraged to the point where they pressure politicians to "do something."

Once politicians get involved, the cost of doing business can skyrocket. In fact, in some cases, politicians can drive a company or industry out of business entirely.

Consider the calls from some that the government should have nationalized BP (BP) as punishment for the Gulf oil spill in 2010. Alternatively, consider the dizzying array of consumer protection laws in the United States, laws that came about largely because companies did things that hurt people.

Since the companies did not do enough (in the public’s eye, at least) to ameliorate the damage and prevent reoccurrences, politicians stepped in and said "since you will not fix this, we will." Not surprisingly, Congress's fixes always cost more.

That is something to keep in mind with industries like airlines or pharmaceuticals, where bad press is a little more commonplace. Do airlines risk re-regulation if they push fees too high and customer service too low? Would another crash lead to expensive new maintenance regulations? Do drug companies risk government price controls if they try to charge too much for essentials like insulin?

Whatever the case, make sure to gauge where the winds are blowing in Washington, DC before investing in the face of bad PR. The securities and banking industries got off relatively light, but disgruntled Congressmen basically killed legal online gambling in the US.

3. Impact on Profits
Ultimately, a company pays for angering customers and Congress at its bottom line. If customers get mad—and stay mad—revenue suffers.

If Congress makes it more difficult to operate, that can affect revenue as well. Of course, politicians can also impose regulations, rules, taxes and fees that meaningfully increase the cost of doing business—all of which ultimately flows through to the bottom line.

It is also important to assess whether the PR problem with the company is something that management can isolate and prevent from spreading across the brand. For example, automobile problems could cause a recall, but might not be enough to sink the company.

But if these types of problems persist throughout the years, or are not handled quick enough, some people will worry about whether the company has a larger problem with all of its cars. History suggests most people simply avoided problem models when considering a new car.

On the other hand, investment banks really never paid much of a price in the wake of the PR scandals that followed the tech bubble and crash of 2000. Likewise, few suffered long-term damage from the outcry about their behavior causing the subprime meltdown of 2009.

Simply put, regular people do not deal with most of these institutions, and their real clients (the institutional fund managers and other large banks) either do not care much or are not going to punish themselves by refusing to do profitable business with tarnished firms.


4. Impact on Shareholders
One underappreciated detail to consider is the extent to which a company's problem has alienated the professional investor community.

Although popular mythology suggests that institutional investors are unemotional and care only about whether they can make money, reality is a little different. Though there are a few rare individuals who do not carry grudges, many fund managers will permanently cross off certain companies and executives because of past problems and refuse to even consider the stock.

The key here is usually how honestly a company's management team handles a problem. Institutional investors are (somewhat) forgiving when it comes to mistakes if they are handled quickly and if management is honest about details like the root cause, the scale of the damage, and the time line to fixing the problem. When managements lie, though, that can be the end of that company's credibility with a manager or institution for some time to come.

Consider the case of the BP Gulf oil spill of 2010 again—while the ongoing presence would likely have antagonized customers and irritated US officials, it may not have been the final word. It is entirely plausible that the board was ultimately swayed by large institutions telling them that BP CEO Hayward's credibility with them was shot and that a recovery in the stock could only happen with new leadership.

The Details Always Matter!
When assessing the cost-benefit tradeoffs of a PR turnaround idea, make sure to be detail-oriented when it comes to the math. Bad PR has a way of traveling together with lawsuits, recalls, and redesigns—all of which cost a great deal of money.

On top of that, there is the cost of rebuilding the brand equity and the company's image. This is probably why "bad PR" turnaround stories do not work so well with consumer-oriented stocks—the costs of repairing the damage can be a great deal higher when you have millions of potential customers, as opposed to specialized businesses with smaller customer bases.

The Other Side of the Trade
Although there has been focus on playing the long side of a company under a black cloud, there is no reason the same process cannot work for those looking for stocks to short. If a company that has not permanently alienated its customers is a candidate for recovery, it stands to reason that a company that has irreparably harmed its brand is a candidate to keep spiraling downward.

In any event, bad news is part of trading and investing. The challenge for traders, then, is to separate the cases where bad news has permanently reduced a company's value below the value of its stock from those where the slide is temporary and the stock is cheap relative to the company's long-term value.

Stephen Simpson, CFA, can be found at Kratisto Investing.

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