Should You Buy Shares of a Scandal-Tainted Company?

Can a scandal be a buying opportunity, or does it taint a stock for years? That’s the question surrounding News Corp. (symbol NWS) as it attempts to work its way out of a phone-hacking scandal that shuttered the 168-year-old News of the World, scuttled its $12 billion takeover of British Sky Broadcasting, and threatens to shred the fabric of media baron Rupert Murdoch’s empire of newspapers, cable-television operations and movies.

It’s also a question that dozens of companies have faced in the past -- from Toyota (TM) to British Petroleum (BP) -- with vastly different outcomes. In some instances, the scandal turned out to be nothing but a speed bump that created an opportunity for investors to buy a great company at a bargain price. In others, it was the harbinger of systemic problems that were just starting to surface.

Yet the best advice for investors in the early days of a corporate scandal is the same, no matter whether the damage is likely to prove lasting or fleeting: Get out of the way, at least at the outset. “These things take time to unfold, and you want to step to the sidelines until the problem is well known by everybody and people have stopped caring,” says Karl Mills, president and chief investment officer of Jurika, Mills & Keifer, a San Francisco investment firm that specializes in fallen franchises. “Think of it as a reflection of the human condition. There’s a fall from grace; a purgatory period; and then, possibly, a redemption.”

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During the first two stages, the stock is likely to go nowhere but down, he says. After that, the desirability of the stock (or lack thereof) depends on two things: whether the problem is fixable and whether the share price dropped enough to compensate investors for the risk of buying a tarnished franchise.

The key, says Mills, is quantifying how big the problem is relative to the stock-price decline. If the issue proves to be temporary or less serious than meets the eye but the stock price plunged, you may well be looking at a great moneymaking opportunity.

Consider, for example, the BP oil disaster. In April 2010, BP’s Deepwater Horizon drilling rig exploded in the Gulf of Mexico, killing 11 workers and causing the worst offshore oil spill in U.S. history. BP’s stock, selling for more than $60 before the disaster, began to slip immediately after the explosion and continued to fall through June of that year, hitting a low of $27.02 just a few weeks before the well was finally capped.

In the meantime, BP fired its chief executive officer and launched a massive clean-up and reparations campaign aimed at restoring both the Gulf ecology and the company’s muddied reputation. Oh, and by the way, the company posted a $17 billion loss in the second quarter of 2010.

The company and the Gulf economy are likely to feel the repercussions of the spill for years to come. But value-oriented investors, including Kiplinger columnist Whitney Tilson, started recommending the stock in the summer of 2010 on the theory that the oil spill had done more damage to BP’s stock price than its business (the $30 share-price decline represented a $100 billion loss of stock-market value). See Why We Like BP's Stock and 2 Other Comeback Picks.

Investors who followed in the footsteps of Tilson and others who carefully analyzed the impact of the disaster on BP’s future have been well rewarded. The stock now trades at $44.34 (all prices and related numbers are as of the July 14 close).

Much the same thing happened in the early 1980s, when seven people died after taking Extra Strength Tylenol, a product made by Johnson & Johnson (JNJ). Although analysts at first thought the company’s reputation was shot for good, Johnson & Johnson’s response actually became the textbook example of how to handle a corporate scandal.

The company conducted a rapid and thorough investigation, which found that the deaths were caused by outside tampering -- someone had laced the Tylenol capsules with cyanide in a relative handful of bottles. Instead of trying to save money with a limited response, J&J spent $100 million pulling the drug from retail shelves, and the company offered to replace Tylenol capsules that consumers had in their own medicine cabinets free.

The company’s share of the market for over-the-counter pain relievers, which had fallen to 7% from 37% when the news first hit, rebounded within the year. So, too, did the price of J&J shares, which fell 15% in the days after the deaths but started to rise within weeks and kept advancing for years afterward. “In this day and age, there isn’t a lot of time to dillydally,” says Peter Hillan, a senior vice-president at the public-relations firm of Fleishman–Hillard, who specializes in crisis communications. “You need to figure out the facts and then respond big and fast -- no matter how painful it might be. The longer a story persists, the more damage it does.”

Ironically, J&J’s response wasn’t nearly as laudable three years ago, when consumers started reporting that their Tylenol smelled musty. The company eventually announced another broad-based recall of Tylenol, Motrin and Benadryl. But by that time, the Food and Drug Administration had issued a warning letter and was publicly critical of J&J’s foot-dragging. Analysts say that quality-control issues at J&J’s McNeil Consumer Healthcare unit are a major reason the stock has lagged the overall market for most of the past two and a half years.

Toyota offers another look at how to handle a scandal badly. The Japanese carmaker, which built its reputation on quality, failed to disclose that some of its models had been experiencing inexplicable acceleration problems for years. The news hit headlines in August 2009, when a San Diego Highway Patrol officer and his family were killed in a run-away Lexus. The driver’s desperate efforts to stop the car were recorded on a 911 call that reverberated in news reports around the world.

As the scandal continued to unfold with dozens of additional reports about crashes caused by sudden-acceleration issues, Toyota blamed the problems on heavy floor mats and driver errors. Over the course of two years, Toyota has launched a series of recalls aimed at resolving the problem. In the process, the company repaired some eight million vehicles and caused lasting dents in its once-polished image. In a period of generally rising share prices around the world, Toyota’s stock fell from $91 in early 2010 to $84.28 today.

The News Corp. hacking scandal has the potential to be a similarly long-lasting debacle, says Hillan. The initial problem -- revelations that the company’s Sunday tabloid News of the World had hacked into a kidnapped girl’s cell phone to listen to her messages -- was horrible. But it would not have dealt a body blow to the company had it been an isolated incident. Since then, however, other enterprises run by News Corp., which is controlled by Murdoch, have been implicated in similar illegal hacking and spying activities. Outrage over the company’s initial denials and capitulations, and the continuing revelations of additional misdeeds, spurred England’s Parliament to launch an inquiry. It also led Murdoch to table his plans to buy British Sky Broadcasting, better known as BSkyB, in a $12 billion deal, acknowledging that the deal couldn’t win approval in the midst of this maelstrom.

And the news has only gotten worse. On July 14, the FBI launched an investigation into whether other enterprises owned by News Corp. had hacked into the cell phones of 9/11 victims. “This now threatens the whole enterprise,” says Hillan.

News Corp. shares closed at $15.99, down 14% from the July 5 close. Are they a bargain? Maybe, but if Mills is right about how these kinds of scandals typically play out, this is probably not the time to be a hero. Better to let the dust settle first.

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