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, investing in the face of bad PR can be a high-risk/high-reward situation. Accordingly, it is a good idea for investors to do what they can to tilt the odds in their favor.
TUTORIAL: Investment Valuation Ratios

Assess the Situation Across Four Metrics
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.

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. (Companies balance the interests of owners, customers and employees. Find out who comes out on top, read Whom Should Corporations Please?)

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 (NYSE: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 the 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? (Learn how to find a healthy pharmaceutical investment in a market full of weak drugs, see Measuring The Medicine Makers.)

Whatever the case, make sure to gauge where the winds are blowing in Washington, D.C. 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 U.S.

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. (For more check out Financial Regulators: Who They Are And What They Do.)

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.

Likewise, 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. (Take a look at the factors that caused this market to flare up and burn out, check out The Fuel That Fed The Subprime Meltdown.)

Impact on Shareholders
One under-appreciated 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 something 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. (To maximize the sales potential of any business, a public relations program should be part of the master marketing plan, read Public Relations: Offering Businesses A Competitive Advantage.)

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 U.S. 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 trade-offs 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 investing. The challenge for investors, 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. (Intangible assets don't appear on balance sheets, but they're crucial to judging a company's value, check out Intangible Assets Provide Real Value To Stocks.)

Related Articles
  1. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  2. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  3. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  4. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  5. Forex Education

    Explaining Uncovered Interest Rate Parity

    Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
  6. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  7. Economics

    Understanding Tragedy of the Commons

    The tragedy of the commons describes an economic problem in which individuals try to reap the greatest benefits from a given resource.
  8. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  9. Forex Education

    Time Value Of Money: Determining Your Future Worth

    Determining monthly contributions to college funds, retirement plans or savings is easy with this calculation.
  10. Investing

    Understanding High Yield Fund Performance

    For exchange traded fund, not all high-yield ETFs are the same. So, we take a look at one high yield investment in particular to set the stage for you.
  1. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  2. How can I use a regression to see the correlation between prices and interest rates?

    In statistics, regression analysis is a widely used technique to uncover relationships among variables and determine whether ... Read Full Answer >>
  3. How do I calculate a modified duration using Matlab?

    The modified duration gauges the sensitivity of the fixed income securities to changes in interest rates. To calculate the ... Read Full Answer >>
  4. How do I calculate the rule of 72 using Matlab?

    In finance, the rule of 72 is a useful shortcut to assess how long it takes an investment to double given its annual growth ... Read Full Answer >>
  5. How do I calculate the standard error using Matlab?

    In statistics, the standard error is the standard deviation of the sampling statistical measure, usually the sample mean. ... Read Full Answer >>
  6. How do I adjust the rule of 72 for higher accuracy?

    The rule of 72 refers to a time value of money formula that investors use to calculate how quickly an investment will double ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center