Dr A C Valsamakis

Sunday Tribune: Business Report on Sunday

5 December 1999

THERE IS GROWING evidence of a direct and quantifiable link between risk management and shareholder value. Time and again we see evidence of companies with poor risk management destroying shareholder value when faced with a crisis, while those with sound risk management policies actually adding to shareholder value when faced with similar crises.

Until recently, risk was typically defined in terms of its downside potential and offset in the insurance market. But it has now been shown that insurance as a financial provision will not be sufficient to protect the company against the impact of catastrophe on the share price.

Indeed, a company’s insurance strategy should not be viewed as a substitute for high quality risk management and contingency planning and systems.

The penalties for companies that fail to contain or manage risk are dire. This is clearly illustrated by a recent Oxford University study by Deborah Pretty which I believe is one of the most important contemporary papers published on strategic risk management and which establishes a link between management’s handling of catastrophe and shareholder value.

A case in point is Johnson & Johnson, which in 1982 was forced to recall 31 million bottles of Tylenol capsules after an employee injected cyanide into some capsules, resulting in the deaths of seven people. On examination, fewer than 75 capsules were found to be poisoned. Advertising and product distribution were halted.

A tamper-resistant pack was designed and the product was relaunched a few months later. In 1991, the families of the seven victims reached an out of court settlement with the company. The cost of the recall was estimated at $100 million and $50 million for business interruption losses. The company sued its insurers for $67,4 million in 1986, but lost the case.

Again in 1986, the sale of Tylenol capsules were suspended after a woman died of cyanide poisoning. Capsules were recalled from 14 countries at an estimated cost of $150 million. The market discounted the cost of the recall and bid down the stock.

In a similar case at Source Perrier in 1990, carbon filters intended to remove cancer-causing benzene became clogged, a situation which went undetected for six months. No one suffered as a result of drinking the benzene-infected water, but management was forced to recall 160 million bottles from 120 countries. There were contradictory statements from management regarding the extent and cause of the contamination. Eighteen months after the crisis, Perrier’s share of the sparkling water market declined from 13 percent to 9 percent in the US, and from 49 percent to less than 30 percent in the UK.

The cost of the recall was $262,9 million. The company did not have product recall and guarantee insurance. The stock price fell and the company became an attractive takeover target. In July 1992 it was taken over by Nestle and 750 people in the mineral water division were made redundant.

It was a different story at Heineken where defective glass, manufactured by Vereenigde Glas, was found to splinter when export beer bottles were opened or transported. Management recalled, destroyed and replaced 15,4 million bottles, warning the public of the dangers through the media. No one was injured.

The estimated loss from the incident was $50 million. In 1994, the glass manufacturer agreed to compensate Heineken for an undisclosed sum. The proactive handling of the incident by management resulted in little initial loss of shareholder value, followed by an increase in value.

Among those companies that did not recover quickly from the catastrophe, there was an initial 10 percent drop in market capitalisation. The non-recoverers typically suffered fatalities in the first two to three months, and this seemed to govern market reaction during the period. Whether the losses were fully covered by insurance did not appear to have significant influence.

The impact of catastrophe on companies’ share prices came from two sources. The first was the direct financial cost of the catastrophe in terms of cash flows, with the market adjusting the stock price accordingly. The second cause was indirect as the market adjusted the share price in accordance with its assessment of management’s handling of the crisis.

The Oxford University study shows that the market can read a corporate catastrophe either positively or negatively. The result will be positive where the benefits of what is revealed about management outweigh the net financial loss.

In conclusion, it is interesting to note that it is the indirect factors which dominate the impact on stock returns.

The above is an excerpt from a speech by Anthony Valsamakis, the chairman of London-based Eikos Risk Applications, to the Institute of Directors in Southern Africa’s 1999 Risk Management Conference. 

This article is reproduced with the permission of the publisher.