The True Dangers of Risk

Investors who ignore the many manifestations of risk are making a huge mistake. Companies with poor corporate governance policies, and executives who indulge in selfish behavior, create a serious risk that shareholders too often overlook.

Some risks are more costly than others
As the recent, horrible tragedy at Massey Energy's (NYSE: MEE  ) West Virginia coal mine demonstrates, no one should have to tell corporate managers to place employees' safety and lives ahead of potential profits. CAPS blogger lemoneater recently asked whether investing in the coal miner was really worth it, noting the ethical red flags the company had raised. 

Massey had also racked up a shocking number of environmental and safety violations. Furthermore, investors who took enough time to research the company would have also found a Supreme Court ruling that Massey Chairman and CEO Don Blankenship's campaign contributions had influenced a West Virginia Supreme Court judge several years ago, creating a serious risk of bias.

Yesterday, the corporate governance watchdogs at The Corporate Library said they had long warned about some of Massey Energy's policies. Massey's CEO retention bonuses lacked performance targets, and in 2008, the company -- wait for it -- lowered the bar for other compensation-related performance targets. If you can't meet the standards, just bring them down to your level, right? Clearly, Massey gave investors ample reasons to steer clear of its stock.

Sure, your company's managers may seem harmless, and their failings insignificant, in the short run. What's a little self-serving behavior as long as they keep hauling in the profits? But by turning a blind eye, you might embolden executives to pursue far more unethical and damaging deeds. In Massey Energy's case, the company's dubious policies now endanger not only its investors' portfolios, but also their ability to sleep at night.

Same old risk, different day
In the wake of the financial crisis, Bank of America (NYSE: BAC  ) , Goldman Sachs (NYSE: GS  ) , Citigroup (NYSE: C  ) , and their fellow financial firms should have more than earned investors' skepticism, at least until they proved their disaster-prone behavior was a thing of the past. Instead, their burgeoning stock prices over the past year suggest to me that investors are either incredibly naive, or just have really short attention spans.

Lo and behold, according to The Wall Street Journal, the Federal Reserve Bank of New York revealed that a group of 18 banks, including the ones named above, have been hiding debt for the last five quarters. They've temporarily lowered debt levels right before reporting to the SEC, then ratcheted it right back up by midquarter, making their balance sheets look more safe and sensible than they actually are. One suspects that the accounting infractions recently revealed at now-defunct Lehman Brothers weren't exactly an anomaly on Wall Street.

Wake up, suckers -- I mean, shareholders! By all appearances, these big banks remain more concerned with their own well-being than the honesty, transparency, and prudence of their businesses. I can't believe I'd ever even have to explain why that's not OK. Companies have a responsibility to be truthful with their shareholders, so that investors can properly assess the risk involved.

Trust: a major asset
If a corporation's managers give ample indication that they're only in it for themselves -- paying themselves handsomely for failure, or exhibiting dishonesty about real business concerns -- shareholders should brace for bad news. Executives' bad behavior is an intangible liability, however much it may generate in short-term paper gains.

Fortunately, good companies and managers do exist. Berkshire Hathaway's (NYSE: BRK-B  ) Warren Buffett hasn't done too badly for himself (to say the least!) by focusing on solid businesses with high-quality management teams. He has also been an outspoken critic of many abusive policies in corporate America, and he always seems to make honesty a strong point in his own dealings.

Harris Interactive's recent Reputation Quotient survey named Berkshire Hathaway one of America's most trusted companies. Not surprisingly, financial companies like Goldman, Citigroup, and AIG (NYSE: AIG  ) ranked among the least reputable, with Freddie Mac (NYSE: FRE  ) at the very bottom.

Truly sustainable long-term profits spring from real, hard-earned trust between managers and shareholders. If your company's leadership can't grasp that concept -- or exhibits reckless behavior -- it's up to you to recognize the danger.

Berkshire Hathaway has been recommended by both Motley Fool Inside Value and Motley Fool Stock Advisor. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters free for 30 days.

Alyce Lomax does not own shares of any of the companies mentioned. The Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (21)

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  • Report this Comment On April 09, 2010, at 4:54 PM, lemoneater wrote:

    Alyce, thanks for drawing more attention to the bad management at MEE and using it for an example of companies shareholders need to beware. I want MEE to get enough bad press that they will change their practices. I appreciate the compliment of being linked in an article:). Have a great weekend!

  • Report this Comment On April 09, 2010, at 6:45 PM, TMFLomax wrote:

    Thank you for posting about it, lemoneater! It was very much related to the concept of risk, and the research to conduct that leads to the conclusion of a stock to avoid. Have a great weekend too! :)

    Alyce

  • Report this Comment On April 09, 2010, at 6:47 PM, plange01 wrote:

    will massey energys top executives be put on trial for murder in the deaths of the 25 miners

  • Report this Comment On April 10, 2010, at 10:00 AM, catoismymotor wrote:

    It is because of "accidents" like this that I can't invest in coal miners. If that means I miss some outstanding returns then so be it. I will not knowingly enable a company that engages in such risky practices.

  • Report this Comment On April 10, 2010, at 12:47 PM, letsfly wrote:

    After I read Ms. Lomax's column, I read the 3 related comments, which, to my great surprise, were followed by advertisements, some repeated, totally unrelated to her article.

    Three comments on the article and then a series of repeated ads for merchandise, a post (illiterate) re: cougars, which sounds like something the WWF should be looking into.

    What gives? Does no one monitor comments?

  • Report this Comment On April 12, 2010, at 9:35 AM, aj485 wrote:

    Alyce,

    You said "One suspects that the accounting infractions recently revealed at now-defunct Lehman Brothers weren't exactly an anomaly on Wall Street."

    While I am sure that there have been and are other accounting fraud scandals going on (Madoff, Enron, WorldCom, etc.), the Lehman accounting issues are actually an issue of fraud. If you read volume 3 of the Lehman Examiner's report http://lehmanreport.jenner.com/ you will find a significant number of 'colorable claims' (claims that have a reasonable chance of being found valid in a court of law) against Lehman officers relating to incorrectly accounting for their transactions. One of the biggest issues is that what they were doing with the Repo 105 transactions is that they could not legally account for them under US law, so they moved the transactions to their British subsidiary, but then still used US accounting rules to account for the transactions. That's fraud.

    What the Wall St Journal is describing is legal under both GAAP and US law, and is not unusual, even among non-financial companies. It's otherwise known as "window dressing" - and the issue is really a bad measurement system. It's human nature to try to make yourself/your organization look as good as possible under the rules you know you are being measured by. And it's not just companies that do this - google "teaching to the test" if you want an example of other types of organizations that do this.

    I'm actually surprised that if you find legal 'window dressing' to be a huge issue that you mention Berkshire Hathaway as being a good investment to avoid this issue. BRK is known to have invested in Goldman Sachs (specifically mentioned as participating), American Express and Wells Fargo (not specifically mentioned, but when most lists of 'large banks' are trotted out, they make the grade). So, while BRK itself may not be 'window dressing' it's clear that at least some of the companies it has invested in are, so investing in BRK is going to result in taking on some of this risk.

  • Report this Comment On April 15, 2010, at 4:54 PM, model70lh wrote:

    As a salesman traveling our nation's highways I am much more likely to die on the job than a coal miner.

    If that sounds silly cut and paste the following:

    http://www.forbes.com/2007/08/13/dangerous-jobs-fishing-lead...

    My paternal side are coal miners, no one feels for these MEE families more than ours. Take it from somewone that has witnessed this life, the risk of death isn't the worst part of mining and that is not the midset. Just like when I head out in the morning, I have to believe I'll be home again soon.

    No one is calling for extra safety for us sales persons, yet our risk of job related death is higher than the coal miner. Loose a salesperson and the stock doesn't tank.

    What is best; morn, pray and get back to life for those that need support in this tough time. Remember the mining act of 1977 needs to be followed, but we all live life with risk and not buying a company because you feel the risk is too high is fine, but armchair morality doesn't make mines safer, capital does.

    Let's pray and support the company because they need to prosper to provide long term support for the families of those lost and to better the conditions for the moles we love.

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