Corporate scandals – what investors can do to avoid them

History is littered with corporate scandals that have cost unsuspecting investors billions of pounds.

Arguably the most famous was US electricity turned energy trading firm Enron. The company used an array of fraudulent accounting techniques to appear hugely profitable, even on projects that had barely begun. When the company’s misdeeds became public knowledge in 2001, it collapsed, taking its auditor, Arthur Anderson, with it.

But corporate scandals aren’t consigned to the history books. In 2015 Volkswagen was revealed to have cheated US emissions tests on its diesel engines. They used software that could detect when they were being tested and change performance to improve results. The company’s share price fell almost 40% in the wake of the scandal. It also lost more than $30bn to fines, financial settlements and buyback costs, with several lawsuits still ongoing.

Even before the scandal, lots of investors had concerns about a lack of accountability at the company. The voting shares were mostly held by the founding families, the local government and the government of Qatar. These groups also dominated the company’s board.

As recently as July this year, fast fashion company Boohoo was also embroiled in scandal. A Leicester-based garment factory in its supply chain was found committing serious health and safety breaches and paying its workers below the national minimum wage. The company’s share price later fell more than 40%, wiping £2.1bn off its valuation. Although it has partially recovered since then, it’s yet to hit pre-scandal levels.

Boohoo is famous for selling celebrity-endorsed clothing for as little as a few pounds. On average, such products are discarded by customers after just five weeks. Aside from the obvious sustainability issues this raises, some investors had concerns over just how Boohoo could sell clothing so cheaply well before the scandal broke.

How can investors avoid scandal?

Investors can reduce their chances of being exposed to corporate scandal by carrying out analysis on the environmental, social and governance factors surrounding a business. This should be considered alongside the more traditional financial analysis.

From an environmental perspective, investors should consider each company’s emissions intensity – is it reducing or increasing over time? Do the company’s managers have a policy to bring down emissions? Does the company have any obvious sustainability issues that could cause negative publicity in the future, like Boohoo and the broader fast fashion industry?

There are also a variety of social factors investors can take into account. Does the company have a bribery and corruption policy? What’s their stance towards discrimination and freedom of association? Do they have robust supplier standards? Is there a history of social incidents within that company or its broader industry that you should be aware of?

Governance is arguably the most important ESG factor when it comes to avoiding corporate scandal. If a company is well-managed and managers receive adequate challenge, that reduces the potential for individuals to get away with acts of fraud or deceit. It also means managers are more likely to take action to limit the company’s environmental and social impacts.

We think there are a number of questions investors can ask themselves to work out whether a company is well managed. Firstly, does the company have a reasonable amount of diversity in management and in the workforce? Diverse groups of people, with a wider set of experience and expertise, generally make better decisions.

You should remember that while ESG analysis reduces the probability of being exposed to corporate scandal, it doesn’t eliminate it completely. That’s why we always suggest investing in a diverse portfolio with investments in lots of different companies, industries and countries. This should reduce the overall impact of any one area performing poorly.

This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Remember that all investments fall as well as rise in value, so you could get back less than you invest.

(Article by Hargreaves Lansdown)

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