What do Corporate Scandals Mean for Investors?

It seems that with every passing day another corporate scandal pops up. Today it was Valeant acknowledging “fake sales” on their accounting books; yesterday it was Volkswagen installing “defeat devices” to bypass emission tests in their cars; tomorrow it will be different characters but the same plot. The murky divide between Main Street and Wall Street is without a doubt ever-present. Investors’ minds are consumed with visions of CEO’s traveling the world in luxurious yachts and employees taking limousines to and from work. So how do we, as investors, move past such scandals and feel comfortable investing our hard-earned money in the stocks of these companies? To many, finding an undervalued investment is harder than finding a needle in a haystack and that is prior to the added potential of corporate manipulation of the stock price. How can it be, that even after finding that elusive “needle,” a person could have been looking in a faulty haystack the whole time and really found a manipulated stock? Before answering, it’s important to take a step back, look at some cases and differentiate between them.

In 1982, after the death of seven people who had taken Tylenol Extra Strength tablets made by parent company Johnson & Johnson, it was discovered that someone had laced them with cyanide. Although the company wasn’t actively in the wrong, a scandal like this still had the potential to devastate their brand and cripple their ability to generate sales. This almost happened, as their stock fell 15% in the following days. As touched on earlier, a little over a month ago, Volkswagen was discovered to have installed “defeat devices,” a software that detects when a car is being tested, thereby producing inaccurate emission levels and bypassing inspections. Volkswagen could then advertise their cars as a never-before-seen combination of fuel efficiency and high-speed capabilities. To many of the close to eleven million consumers, such a feat seemed inexplicable, but they had faith in the system.

“We've totally screwed up.” “Broken the trust of our customers and the public.” "My most urgent task is to win back trust for the Volkswagen.” These are just some of the remarks that current and recently-fired Volkswagen upper management publicly professed. However, to the people who lost millions of dollars after the stock fell from about $38 to $23 in the following days, not to mention the scores of consumers who now possess cars they didn’t intend to buy, this is hardly consoling. It doesn’t put money in their bank accounts nor does it buy them a new car.

Although it is still too early to pass judgement on Volkswagen, it is important to note that there is consensus on appropriate ways of dealing with such scandals. Many laud Johnson & Johnson’s response to their Tylenol scandal and frame it as the textbook example. It immediately recalled $100 million worth of medications from store shelves, offered to replace already purchased ones, and were, most importantly, fully transparent throughout the investigation. Their stock was thus able to recoup these temporary losses. This directly contrasts with the behavior of many other companies, including Enron that artificially produced sales and maintained their deceit until bankruptcy, and GM that knowingly sold cars with “faulty ignition switches” resulting in an estimated 124 deaths.

As an investor, it is easy to come to the conclusion that anyone who has any affiliation with Wall Street is corrupt by default and will do anything to make an extra buck. However, operating under such a belief could result in losing out on a potential money-generating opportunity. I think that it is important to take a step back and look at several factors when dealing with such a scenario. The first is to assess the company at fire and determine whether or not what has happened is a harbinger of more scandals, or just a one-time speed bump along an otherwise smooth path. Sometimes, it only takes one person to taint and even ruin the reputation of a company. On the flip side, the stock could deviate from its underlying value by plummeting in the interim and therefore be a stock to potentially purchase since it could eventually rebound. Additionally, an investor with a well-diversified portfolio isn’t susceptible to one company ruining his/her investments as a whole. This only goes so far though. As much as this may pain some, there is a leap of faith that an individual must take. You must put your faith in the accountants, the SEC, and the company’s own management. Lastly, it is important to keep in mind that despite the seeming rampancy of such actions, this is not the case; the media are just good at making it seem like these scandals are more prevalent than they actually are. But at the end of the day, one could just stick to the sidelines and not participate in the stock market altogether, as his/her odds are higher in rocks-paper-scissors.

www.nytimes.com%2F2002%2F03%2F23%2Fyour-money%2F23iht-mjj_ed3_.html&usg=AFQjCNGGqYmpeXTH_aVIzN7dJ5ZHa_S7sQ
[ii] http://www.usatoday.com/story/money/cars/2015/07/13/gm-ignition-switch-death-toll/30092693/
http://www.kiplinger.com/article/investing/T052-C008-S001-should-you-buy-shares-of-a-scandal-tainted-company.html