SRI Notes

Three Resources on Product Recalls

If you're interested in the ongoing product recall issue, Jennifer Toney at Haas, who knows this material as well as anyone, recommends the following readings:

• Widmer, Lori.  “When Your Name Is at Risk" BNET Research Center.  November 2000.
• N. Craig Smith, Robert J. Thomas, and John A. Quelch.  “A Strategic Approach to Managing Product Recalls” Harvard Business Review, 1996.
• Chu, Teng-Heng, Che-Chun Lin, and Larry J. Prather.  “An Extension of Security Price Reactions Around Product Recall Announcements.”  Quarterly Journal of Business and Economics, Summer-Autumn, 2005.

There is a reasonably thorough literature around stock price reactions to product recalls, but it seems to me to mostly miss the point.  The real damage of a recall is likely to be reputational, so any impact on the stock price is going to occur over time.  I think it would be better to try and focus on the long-term valuation effects. 

Johnson & Johnson's response to the Tylenol incident (good briefing here) is regarded as the classic blueprint for how to handle a safety problem.  But not all companies do so successfully.  Perrier's leadership in the premium bottled water segment once seemed unassailable, until small amounts of benzene were found in the product, prompting the recall of 160 mm bottles.  But in both cases the ultimate impact on firm value wasn't apparent until long after the fact.

I don't know if recalls can be studied quantitatively - the big ones are rare enough that it might be better to use the case study method.  One thing that seems apparent is that each situation has its own logic.  At a minimum the analyst needs to consider:

• The direct economic impact of the recall (usually small)
• How well the recall was handled
• The completeness of the recall (is there still potentially dangerous product out there)
• The company's brand and reputation before the recall
• The company's reputational exposure (consumer-facing companies might have more sales risk)
• The initial impact of the recall on the brand
• The potential for follow-on news (reports that the company hid problems, etc.)
• The likely efficacy of the company's damage control measures

This is a probably a good example of something that can't be measured, but matters.  I doubt we'll ever have an 'R' score that quantifies the impact of lost reputation of firm value.  But analysts ignore reputational effects at their peril.

Another One

Recall fatigue?  RC2 recalls additional toys.

Mattel Apologizes...to China?

Just a couple more quick links on the toy safety situation:

According to some press reports (e.g., this one) Mattel has apologized...to China.  This Washington Post article, however, says there are two sides to the story.  (Also note the analysis in the article by Eric Johnson at Tuck, which sounds on-the-mark to me.)

And Again

Yesterday Mattel announced that it was recalling another 800,000 toys due to lead paint issues. 

A couple of additional observations:

• According to the article, China makes about 80% of toys sold globally.
• The toy business is highly seasonal - the September and December quarters accounted for 69% of Mattel's 2006 sales - so we won't have a strong sense of how much fundamental impact this is having until the current quarter is reported.
• Despite this latest announcement, MAT stock has performed about in-line with the market over the past five trading days.

Reputation Update

Another day, another lead paint recall...

Both toy manufacturers that announced recalls this summer - MAT and RCRC - have been down significantly, both in absolute terms and vs. the market (green line is S&P 500, red line RCRC, blue line MAT):

If you are a business student looking for an interesting paper topic, this situation has plenty of material to work with.

A brief but good backgrounder from Forbes.

News today:  China Issues Food, Toy Recall Rules to Tighten Safety, from Bloomberg.

More Reputational Effects

Mattel is announcing today the recall of 9.58 million more toys due to safety issues, following the recall two weeks ago of 1.5 mm.  On Monday an executive for a Chinese manufacturing company working with Mattel committed suicide. 

Mattel stock seems to be holding up reasonably well.  It is down -2.4% today, and has been a weak performer with the Consumer Discretionary sector over the past month, but has actually outperformed the market over the past five days.  So initial impact seems contained - it will be interesting to see what happens on their next earnings release.

(Note - These are just my observations on the market's reactions to recent news...  I don't own MAT, haven't analyzed it, and have no opinion on its investment merits...!)

Putting a Price on Reputation

Steve Miller, former CEO of Waste Management, once commented that "a reputation is an incredible asset, one you can't appreciate it until you lose it." 

There are still plenty of people in the financial profession who are somewhat dismissive of the impact of reputational effects, despite many cautionary examples.  The negative impact is greatest for firms in competitive businesses where the consumer is willing to pay up for quality or safety.  Perrier, once the #1 vendor of bottled water, never fully recovered after having to recall the product due to benzene contamination.

I have not seen a good study of these things recently, but it's not hard to see recent examples in the market.  (Let me pause here to say that I do not own or cover either of the two stocks that I am about to discuss, nor do I have any views on their investment prospects.)

One timely example is Mattel, which is down today after recalling millions of toys that might be contaminated with lead paint. 

This comes on the heels of a similar recall of toys sold by RC2.  The RC2 situation has been going on longer, so we have a little more information on which to make inferences about reputational impact.  The first thing I'd note is that the stock didn't crack down much right away (the original press release is dated June 15), despite the fact that millions of toys would have to be recalled.  The stock's high for the year was $46...it dropped to $40 in the weeks following the announcement.  It fell from $40 to $36 yesterday, and after a weak quarter and guidance cut yesterday, it's $29.

I know there are many factors in play here, but the slowdown in sales and the safety recall may not be entirely unconnected.  Another data point - some outlets are discounting the premium priced 'Thomas' toys, something I haven't seen before.

And, of course, there are lawsuits.

For those interested in studying this situation (I think it would make a great case study), The New York Times has covered the RC2 story aggressively.  A Times reporter was actually detained at the factory where some of the toys were made for nine hours, as described here.  It appears that RC2 has since cut all ties with the vendor - a Times update story is here.

One final comment, a quote from the Book of Buffett.  Warren Buffett has been known to pay close attention to financial matters.  But when he took over Salomon following their bond trading scandal, he didn't emphasize the numbers.  He told employees:  "If you lose dollars for the firm by bad decisions, I will be understanding.  If you lose reputation for the firm, I will be ruthless."

Who Are These Guys?

A bit of a shock from Financial Times this morning:  "Large ethical companies consistently outperform the market, according to a survey of corporate social responsibility by Goldman Sachs, the investment bank."

Well, not really.  The report actually asserts that SRI indexes have historically underperformed, and offers this comment:  "one explanation for the historical relative underperformance of various SRI and/or ethical investment indices is the lack of integration with financial analysis". 

I'm sympathetic with the thought - social factors do need to be better-integrated with mainstream securities analysis.  But there's actually not much evidence to support what they're saying about performance.  Social investments haven't historically underperformed (for a long discussion of this see my 2005 Journal of Investing paper), and despite a rough three years the Domini Index is still ahead of the S&P 500 from inception.  If you're keeping score, it's currently Domini +12.1% (annualized return) vs. S&P 500 +11.5% from inception (5/90).  Major variations in performance appear to be explained by the Fama & French factors.  When you adjust for those factors, the big problem is explaining why the Domini index seems to have positive alpha. 

[Non quantitative readers can skip this note.  But if you're quantitatively inclined you can do your own analysis of the Domini numbers using the Fama & French factors from Ken French's website.  William Bernstein gives excellent step-by-step instructions here.  If you're in business school, ask your finance professor why the intercept is positive.  You'll get some interesting answers.]

The report is saying that certain companies Goldman Sachs likes have outperformed, and it introduces the GS SUSTAIN methodology to identify these companies going forward.  The report says that "our methodology is not designed to be comprehensive, nor is it designed to be prescriptive in judging what is good or bad practice."  (If you don't have access to Goldman research, this Associated Press article is a good backgrounder on the report.)

Peter Kinder has usefully divided social investors into three groups:

• Values-based investors - investors whose values drive portfolio construction with relatively little attention to the financial impact of those decisions
• Value-seeking investors - investors seeking to improve investment performance through the use of social or environmental variables
• Value-enhancing investors - investors that use shareholder engagement to increase shareholder value, but do not otherwise view themselves as 'socially responsible'

The Goldman report falls under the second heading.  They are not trying to make distinctions about what is right or wrong, or to serve a particular type of social or environmental investor.  The SUSTAIN project instead represents a serious effort to integrate stakeholder analysis with securities analysis, with a view toward improving investment returns.  That's a smart thing to do, and mainstream portfolio managers should take a hard look at it.

Two Perspectives on Our Significance

If you're over thirty, you're accustomed to a world in which the U.S. was a dominant, or even the dominant economic player.  For all the talk about the emergence of economies like India and China, on official statistics, they still pale in comparison to the U.S., as this intriguing map shows.

But the standard GDP comparison is flawed for many purposes.  By most intuitive measures of wealth, China and India should rank higher than they do on that map.  It turns out that one reason for the discrepancy is exchange rates.  If you compare apples to apples using purchasing power parity (a nice apartment in Beijing vs. one in San Francisco, for example), you get a very different picture, as this list from the CIA World Factbook shows.

I suppose there are important reasons why a dollar should buy three times more stuff in, say, Malaysia, than it does here.  Many Asian governments don't mind a weak currency vs. the dollar because it's good for exports.  America, meanwhile, has a lot of rich older consumers who like buying good stuff cheap.  So, in an odd sense, even though cities like Singapore, Hong Kong, and Kuala Lumpur are as 'developed" as, say, Albany, we set our terms of trade as if they were not (if you haven't seen it lately, here is a fairly recent picture of Kuala Lumpur). 

Economists have taken to calling this state of affairs "Bretton Woods II" - a reference to the de facto fixed exchange rate system of the post-WW II era.

The world view you choose to believe depends a lot on how long you think the Bretton Woods II arrangement will last.  Some view it as benign, even optimal (as this paper suggests).  Others have a darker view.  I  believe it is unravelling gradually - most Asian countries have already abandoned their dollar pegs (China and Hong Kong are big exceptions).  And a money manager we know recently reported that a nice house in downtown Hanoi is running about $1 mm.

We Americans are used to being listened to.  Other countries benchmark against us and look to us for value-added products and know-how they have not yet developed.  As things progress, it's unlikely we'll remain the largest economy in the world.  We may retain our technological edge, but the gap will likely narrow.  And in some instances, the rest of the world will get ahead of us, and we will find that we have something to learn.

Independence Day is a good time to think hard about what we understand well and what we don't - what we have to teach the world, and what the world has to teach us.  But I wouldn't take that map too seriously.  As the proverb goes, "do not make yourself so big, you are not so small."

Costing the Atmosphere

I'm a bit behind in my reading, but enojyed this piece from The Economist's special report on business and climate change, particularly the graph (sourced from the Swedish utility Vattenfall). 

The Economist correspondent drily observes that "people buy houses not because they have good insulation but because they have pretty views."  One might say the same thing about why (most) people buy stocks and mutual funds - which might, in turn, explain their results (the mutual fund version is here).