Not all bad news is created equal. Patient and savvy long-term investors can leverage short-term setbacks into long-term winnings by realizing that the most likely outcome of a so-called disaster is not nearly as bad as the market assumes. However, some kinds of bad news are so toxic that prudent investors simply stay away entirely. How then should investors separate the "bad news in wolf's clothing" from the real bad news? Here are five key factors that may indicate when bad PR is too serious to ignore.
IN PICTURES: 8 Signs Of A Doomed Stock
- When the Company Causes Death
When a company's missteps result in actual deaths, there is a virtually inevitable spiral of events - none of which are positive. Not only will the news likely be full of warnings about the dangerous product/service, but follow-up stories detailing the aftermath and fallout will keep the mistake (and its perpetrators) in people's consciousness. Afterwards, there are expensive lawsuits and settlements, recovery and mitigation efforts, and press campaigns designed to make consumers forget about the incident.
Indevus Pharmaceuticals (known at the time as Interneuron) thought it had a blockbuster with the weight-loss drug Redux - that was until severe side-effects led to numerous product liability suits and the FDA ordered withdrawal from the market. All told, Wyeth, which licensed the drug from Indevus, paid out more than $20 billion in legal settlements to those who took Redux or Pondimin (another Wyeth weight loss drug), while revenue of the two drugs topped out at about $300 million in 1996.
In comparison, Toyota (NYSE:TM) is almost certainly going to survive its fatal accelerator debacle. Although Reuters reported that Safety Research and Strategies, a Massachusetts-based consultancy, had counted more than 2,000 incidents of apparent unintended acceleration in Toyota vehicles since 1999, including 815 crashes and 19 deaths as of February 2010, the recall itself is likely to cost Toyota about $2 billion (versus a market capitalization of over $110 billion). Analysts expect that sales will rebound by 2012. (Learn more in Recall Recoil: Will Toyota Recover?)
What separates the survivors from the doomed? In most cases, it is a question of size - if a company is big enough, or the misstep is small enough, it can ultimately wait for consumers to forgive and forget.
- When the CEO Bails
While many decry the "key man fallacy" and claim that most companies could continue on just fine without their current high-priced CEOs, clearly that is not always the case. Take Steve Jobs for example. The founder and CEO of Apple (Nasdaq:AAPL) is often heralded as a key component of the company's success. Although Apple's stock did nearly triple while Steve Jobs was away from his post between 1985 and 1996, that was a robust time for the market and Apple's less-than-200% appreciation trailed the 300% gain in the S&P 500 and the roughly 350% gain in the Nasdaq.
However, many investors and industry experts attribute much of Apple's early and recent success to its charismatic and hard-driving CEO. (What can you learn from him? Find out in Hype It Like Steve Jobs.)
In some cases, these leaders truly are visionaries with unique perspectives on product design and/or marketing. In other cases, they may simply have an unusual grasp on corporate culture. Whatever the case, be wary when successful, long-tenured CEOs pack up their office, particularly when they also happen to be the company's founder.
- When Valuable Assets Are Lost
If a company loses essential operating assets, recovery can be a very difficult process. For example, since Venezuelan President Hugo Chavez took power in 2008, his socialist government has nationalized many companies and taken possession of their assets. According to a July 2 Reuters report, companies in the energy, mining, cement and power sectors are involved in arbitration cases against Venezuela's state-run oil company PDVSA. The companies are seeking compensation for assets that were nationalized, with claims running into the billions of dollars.
Likewise, mining and energy companies often face shady dealings with governments in the developing world. Canadian mining company First Quantum (OTCBB:FQVLF), for instance, wrangled with the Democratic Republic of the Congo for years until it finally suspended its operations in that country in August when the government said it had taken over the mine's titles, according to the Canadian Press.
Although the company has stated that the loss of income from the mine won't affect projects in other countries, the company invested more than $200 million in the mine, and several Canadian analysts felt it would impact earnings estimates in 2010 and 2011.
- When New Laws Target the Company
If the government decides your company has got to go, it is a good idea to get out of the way. For example, telemarketing still exists, but it is only a shadow of what it was before the "Do Not Call" law of 2003. Likewise, America's failed experiment in prohibition in the early 20th century may not have killed the likes of Anheuser-Busch, now part of Inbev (NYSE:BUD), or Coors, now part of Molson Coors (NYSE:TAP), but many brewers did go bankrupt. (Learn more in Beer Nation.)
There is certainly money to be made in some kinds of "sin stocks" or "nuisance industries", but investors in industries like payday lending should be careful - once the government decides your industry is a threat to the public good, there is rarely a happy ending to the story.
- When a Product Is Universally Panned
If customers really don't like your product, you are in trouble. The Sharper Image had muddled along for years by selling quirky gadgets, but a very public row with Consumer Reports over an air purifier that began in 2002 seemed to mark the beginning of the end. When Consumer Reports reviewed a number of air purifiers and gave the Ionic Breeze Quadra model produced by The Sharper Image a failing grade for air purification. The Sharper Image unsuccessfully sued Consumer Reports for defaming its product, and when Consumer Reports reviewed The Sharper Image's products again in 2004, it stated that the purifiers could be dangerous to consumers' health because they produced trace levels of ozone.
The Sharper Image ultimately went into bankruptcy in 2008 as a result of declining same-store sales which is believed to have been aggravated by the bad publicity the company's received over its air purifiers.
On the other hand, Toshiba's (OTCBB:TOSBF) HD-DVD product, a now-defunct disc format for high-definition video, cost the company billions in unrecoverable R&D and shutdown expenses, to say nothing of losing the chance at leadership in the high-definition DVD market. Unfortunately, the format lost out to Sony's Blu-ray technology. (Find out more in 6 Reasons Why Products Fail.)
Despite this, Toshiba still stands as a major consumer electronics company. This is partly because large companies like Toshiba can afford to lose sales and fix the damage. For a smaller company with a limited number of products, the risk is high and investors need to be ever-vigilant to signs of trouble.
The Bottom Line
There are plenty of situations where investors can profit by taking a long-term view of short-term bad news. An overreaction to an earnings miss or a product launch delay can take much more out of a stock than it takes out of a company's real operating value. In other cases, investors would do well to steer clear of bad news. After all, with thousands of stocks to choose from, there is no point in sticking with a company that has a fatal flaw.
Catch up on your financial news; read Water Cooler Finance: The Ups And Downs Of A Double-Dip Recession.