LONDON -- Over the past few weeks, I've been looking at how a number of FTSE 100 companies are addressing -- and communicating -- the risks that they face.
In short, I've been asking:
- How many risks does the business deem significant enough to warn shareholders about?
- Which are the biggest risks facing the business?
- What is the business doing about those risks?
- And how well is the business communicating those risks -- and their treatment -- to shareholders?
It's been a fascinating series to research, and it's been interesting to see how businesses of a broadly comparable scale can come to some very different conclusions about how to deal with risk.
On your marks
Today, I'm going to score five of those companies on their treatment of risk. The companies in question: BAE Systems (LSE: BA), Tesco (LSE:TSCO), Diageo (LSE:DGE),GlaxoSmithKline (LSE:GSK), and Unilever (LSE:ULVR).
And the three measures that I'm going to use? In short, how well is management communicating to shareholders:
- the nature of the risks that they face?
- the potential impact of those risks?
- what they're doing about those risks?
And the example that I have in mind as I make these assessments? BP's annual report from 2009, which covered the subject of risk in just three pages, awarded some risks no more than a paragraph -- and gave no hint as to the scale of the potential downside that investors faced, following the Gulf of Mexico disaster in early 2010.
Here are the salient words, under the heading "Process safety":
Failure to manage these risks could result in injury or loss of life, environmental damage, or loss of production, and could result in regulatory action, legal liability and damage to our reputation.
Just last month, BP agreed to pay a fine of $4.5 billion -- the largest in American history -- in relation to the Gulf of Mexico disaster. The latest estimate that I've seen is that fines and compensation will cost the oil giant at least $42 billion. And the business that BP's shareholders own is undeniably a much smaller one than it was when those words were written.
So, on each metric, I'll award each company marks out of three. A top score, then, is nine points -- and a business awarded just three points (or fewer) has serious room for improvement. For something really distinctive, I'll throw in an extra bonus point.
How they fared
BAE Systems is difficult to fault. The company does a decent job of enumerating and describing the risks that it faces (2 out of 3), and an equally decent job of communicating to shareholders what those risks mean in terms of performance (2 out of 3).
Finally, BAE does an excellent job (3 out of 3) of describing what the company is doing in mitigation -- both at overall governance level, and at the level of the individual risks. Total score: 7 out of 9.
Tesco communicates clearly and concisely. Risks are clearly described, in easy-to-understand language (3 out of 3), and while the analysis of what those risks might mean to the business is a little sparse, it's competent enough -- so 2 out of 3 there.
What's it doing about those risks? Detailed bullet points tell the story, so 3 out of 3 there. Finally, against each risk there are arrows, indicating the board's current assessment as to whether the risk is increasing, decreasing, or staying the same. For that, a bonus point. Total score: 8 out of 9, plus a bonus point.
Diageo fails to impress. The company does a creditable job of enumerating and describing the risks that it faces, so it gets 2 out of 3. What might they mean for shareholders? Wade through dense text -- including paragraphs of quite stupendous length -- and there's some indication, but not much (1 out of 3).
And what's it doing about those risks? Your guess is as good as mine (0 out of 3). All in all, very disappointing. And not a bullet point in sight. Total score: 3 out of 9.
GlaxoSmithKline is competent, but no more. The company does a reasonable job of describing and enumerating risks (2 out of 3), and a creditable job of analyzing and communicating the impact of those risks (2 out of 3).
But again, mitigating actions are difficult to figure out -- although clues are provided elsewhere in the report. So 1 out of 3 there, then. Overall, disappointing, and a total score of 5 out of 9.
Unilever communicates clearly and effectively. The risks are well explained and enumerated, so 3 out of 3 there. Likewise, the impacts are made clear, if a little briefly, so 2 out of 3 there.
What is the company doing about those risks? It's difficult to fault the carefully laid-out bullet points detailing the mitigating actions the company has in place, so 3 out of 3 there. The total score: 8 out of 9.
The overall "winner," if that makes sense, is Tesco -- due primarily to its bonus point for telling shareholders if their risks had increased, decreased, or stayed the same. That apart, it would have tied with another consumer-facing business, Unilever.
The losers? Diageo and GlaxoSmithKline. I own shares in GlaxoSmithKline, and am disappointed in its treatment of risk, especially after the Avandia disaster and similar issues. Even so, it scored better than Diageo, with its pages of torrid legalese and dense paragraphs.
Risk vs. reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend re‑invested basis over the 15 years to Dec. 31, 2011, Neil Woodford delivered a return of 347%, versus the FTSE All‑Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.
Each, as it happens, is the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.