How to protect your investments from reputation fallout

Shares in the UK’s BSkyB dropped around 10 per cent over the past week as investors saw the World of the News newspaper hacking crisis as a potentially fatal blow to its proposed takeover by Rupert Murdoch’s News Corporation. Along with the entire editorial staff of the News of the World, investors in the satellite broadcaster, became innocent victims of a spectacular piece of crisis mismanagement – by another company.

They should not have been caught unawares, though. Sometimes events come out of the blue but not these. It is two years since the phone hacking scandal broke, two years during which News International has failed to take control of the story, act decisively, accept responsibility or indeed do any of the things that someone with a lifetime in newspapers should have understood to be a minimum response. As Warren Buffett said, it can take 20 years to build a reputation and only five minutes to ruin it.

Reputational risk is one of the biggest threats any company faces and, therefore, one of the most important things for an investor to assess. The problem, however, is that while it is easy with hindsight to see what damage has been done to a reputation, it is much more difficult to measure the extent to which a company is, or is not, in control of its public image ahead of time.

There are at least three risks an investor should consider. First is the extent to which customers will vote with their feet at the first whiff of impropriety. Rupert Murdoch finally acted because he made the (correct) judgement that revenues would evaporate – because readers would boycott the paper and because advertisers would not wish to be associated with such a tarnished brand.

Arthur Andersen found to its cost that for a professional services business, the perception of integrity is a firm’s greatest asset. The accountancy firm went from Big Four to annihilation in the blink of an eye in 2002 because its customers walked.

Unfortunately, it’s not a simple correlation. At about the same time Enron was consigning Andersen to history, Shell was reeling from the revelation that it had overstated its oil reserves. Today, few would associate Shell with that episode or, probably, even remember it.

Another key risk for investors is that companies (like BSkyB) are not always in control of their own risks. Last year, BP found that when the oil washed up on its beaches America did not care whether the fault lay with the British company or Transocean, its drilling subcontractor. BP paid the price. Likewise, Walmart may not have employed illegal immigrants to clean its floors, or even known about it, but that didn’t stop the US Government suing the retailer for its supplier’s lapse.

A third risk is political. The Gulf of Mexico has an awful lot of water and it has recovered from the Deepwater spill with surprising ease. But the political capital to be gained from a knee-jerk ban on offshore drilling in America was too tempting for the politicians. And that meant that one company’s disaster spilled over to the rest of the industry’s investors.

This kind of collateral damage is common. A striking recent example has been the slump across the board in the share prices of US-listed Chinese companies after a handful of high-profile fraud allegations.

So what can you do to protect yourself from this kind of reputational fall-out?

There are three things you can do. First and most obviously, ensure that you are adequately diversified. A 50 per cent fall in a share’s price is a catastrophe if it’s the only one you own. But if the stock is one of 50 in a portfolio the damage might hardly be noticed.

Second, make sure that you invest in companies which have fixed the roof while the sun was still shining. Ten years ago, Coca Cola faced bans across Europe after an outbreak of poisoning cases. Within a year it was the biggest selling drinks company in the region again thanks to the goodwill and trust it had banked over the years.

Third, talk to a company’s suppliers and customers. Talking to different stakeholders may help you to see an early warning of reputational risks ahead.

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