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: Royal Dutch Shell (LSE:RDSB), Aviva (LSE: AV), Marks and Spencer (LSE:MKS), ARM Holdings (LSE: ARM), and British American Tobacco (LSE:BATS).
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.
And in November last year, 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
Shell disappoints. It's less than 10 years since a major scandal saw Shell fined 17 million pounds by the Financial Services Authority, and the ousting of then-chairman Sir Philip Watts, after the company was caught misstating its proven reserves. And arch-competitor BP, what's more, in a very similar line of business, then left many investors flat-footed with its own treatment of risk. So while the company clearly articulates the risks that it faces (2 out of 3), the communication of those risks leaves something to be desired (1 out of 3), especially when it comes to communicating how risks might impact performance.
Equally disappointing is Shell's treatment of mitigation: the similarities to BP in terms of the business that the company operates in are such that simply side-stepping a discussion of what it is doing about risk shouldn't be an option (1 out of 3). Total score: 4 out of 9.
Aviva wins plaudits for clear communication. Aviva, like BP, is a business that has in recent times delivered a portfolio-sapping reduction in wealth to its shareholders. So its upfront and clear communication of the risks that it faces is a distinct plus (2 out of 3), although its assessment of those risks on company performance disappoints (1 out of 3).
But there's no mistaking how serious the business is about communicating its plans for mitigation: clear, bulleted actions are made explicit, with special emphasis on those applicable to the current year. 3 out of 3, then, yielding a total of 6 out of 9 overall.
Marks and Spencer is simply superb. For a role model on how to communicate risk to shareholders, it's difficult to beat Marks and Spencer. So far, the highest score in this series has been Tesco's 8 out of 9 (plus a bonus point for use of graphics for emphasis and added clarity).
Marks and Spencer beats that. Clear assessment of communication of risks faced? 3 out of 3. Clear assessment and communication of how those risks may impact the business? Again, 3 out of 3 -- aided by the report's excellent "risk radar" graphic. Mitigating activities? Again, impossible to fault -- so 3 out of 3, once more. Overall, 9 out of 9 -- a perfect score.
ARM Holdings does a decent job. While not enumerating as many risks as most of its FTSE 100 peers, ARM makes a reasonable fist of delineating and describing the major risks that it reckons it faces. Interestingly, too, it is open to the opportunities posed by risks, and includes a section of text specifically addressing these.
For communication of risk, I awarded the company 2 out of 3. For describing the impact that these risks may have on the business -- including any associated opportunities -- ARM scored 3 out of 3. Mitigation was slightly weaker, but still a creditable 2 out of 3. ARM's total score, then was 7 out of 9.
British American Tobacco is hard to fault. In this series, I haven't so far awarded a 9 out of 9 -- until today, when Marks and Spencer merited the score. And now, a second company also makes the grade: British American Tobacco.
Whether it's communicating the risk, or assessing its impact on the business, or detailing the mitigating factors that the company is putting in place, British American Tobacco can't be faulted. So that's 3 out of 3 for each, making a total score of 9 out of 9 overall.
Of the five companies, Shell was the biggest disappointment -- a firm "must do better" there, then. Aviva surprised on the upside, as did ARM.
But the overall winner in this group of five, by a nose, is Marks and Spencer -- even though its score is the same as British American Tobacco's. That said, of the two businesses, Marks has the more checkered history, and so may be considered to have the most to prove.
Risk vs. reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend reinvested 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.