Nestle's Stomach-Churning Horsemeat Problem

All the money that consumer goods companies spend on advertising to build their brands can be made meaningless when a quality control issue breaks in the news. Especially now, in our world of unwieldy Internet media and a consumer preference toward moral and upstanding companies. This is especially so in the food industry, whose products we put into our bodies, and whose products typically have relatively smaller profit margins that can be easily affected by a small drop in sales.

As investors, what can we look for to prevent being stung by something like the 40% weekly drop in British frozen beef sales after a study found it contained a higher-than-typical amount of horsemeat?

Safety and brand
To evaluate the risk of scandal at food companies, both the cost to the brand and the safety repercussions need to be studied. For example, in 2007, ConAgra  (NYSE: CAG  ) recalled its Peter Pan peanut butter because of salmonella contamination. It spent $78 million fixing the issue of $1 billion in contaminated product, on top of a yearly decline in sales of more than 60%. The contamination was eventually linked to poor quality control in the factory, specifically from a leaky roof..

To improve quality control at companies, one needs to begin to measure it. Companies, of course, have their own standards that they can choose to measure. For example, after having to recall tainted beef in 2008, Whole Foods  (NASDAQ: WFM  )  now requires additional E. coli tests that go beyond regular government requirements. With Whole Foods' additional scrutiny of suppliers, it gives me confidence as an investor that they have a firm handling of control systems, and it's unlikely that the company would be caught up in selling horse as beef.

But, as Nestle's horsemeat scandal proves, even if a company issues reports on, or commitments to, safety and quality, it may not mean much. To have an outside perspective on how companies are performing, there is the "Business Benchmark on Farm Animal Welfare." If you are wondering what animal welfare has to do with quality control, take Whole Foods as an example, once more. It demonstrates that a stress on environmental and sustainable values can serve as a signal for quality control. To make sure its suppliers meet its organic standards, Whole Foods must visit the farms and conduct annual audits. If suppliers are properly vetted, and regulations are adhered to, systems have less of a chance of breaking down.

So, how does this independent study rank companies?

Confidence in control
The report breaks up groups of companies into six tiers, from the top of showing leadership in animal welfare to not having any animal welfare strategy on a business' agenda.

Unilever  (NYSE: UL  ) tops the list of publicly traded firms, with animal welfare measured as an "integral" part of its business. Unilever has a "Sustainable Agriculture Code" (link opens PDF file) that spells out very specific requirements that suppliers must or should follow; for instance, disposing fertilizer in rivers, streams, and other water is prohibited.

The next tier of companies have established, strong commitments to animal welfare, and includes McDonald's  (NYSE: MCD  ) . The report highlights McDonald's "Farm to Front Counter" program, which explains to consumers policies like the banning of beef from deforested land in Brazil since 1989 or the Environmental Scorecard for its potato suppliers, which measures water, air, energy, and waste impacts.

At the bottom of the list, three tiers down, however, is Burger King  (NYSE: BKW  ) . And, in a perfect example of how strict and comprehensive auditing of suppliers is good company policy, Burger King had to drop a supplier linked to the horsemeat controversy, while McDonald's has avoided any controversy because of "keeping [their] supply chain simple and transparent." Burger King noted that, because of the decision to drop the supplier, some of their products may be temporarily unavailable.

A U.K. VP of McDonald's summed up the argument for a tight control on suppliers when noting, "trust is hard won and very easily lost."

Quality investing
The animal welfare report concludes:

[W]e will be able to much more clearly delineate between those companies that are using farm animal welfare as a source of competitive advantage, those that are effectively managing the risks to their businesses, and those that are not taking effective action on this issue. We also expect that, as understanding of the risks and opportunities presented by farm animal welfare grows, investors will see the Benchmark as enabling them to draw increasingly robust conclusions about the quality of companies' management.

With antibiotic resistance increasingly a factor in agriculture, a growing desire for natural and organic selection, and a belief that companies should be leaders in sustainability and similar values, focusing on how well a company manages its supply chain could give you insight into future performance. And, it  could save you from grabbing shares in what you think is an Angus, when it's really an Appaloosa. 

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