As April came to a close, Walmart Stores Inc. (NYSE:WMT) received bad news. The United States Court of Appeals for the Ninth Circuit, in San Francisco, ruled that the plaintiffs alleging unfair labor practices against female employees (read, unethical practices) can head to court as a class action. This decision transforms a nine year old matter into the largest class-action employment lawsuit in U.S. history.

Besides being a welcome break from the headline risk crises on safety, quality and ethics facing BP (NYSE:BP), Toyota (NYSE:TM), and Goldman Sachs (NYSE:GS), the issue provides an opportunity to test a central hypothesis held by the Society and described in detail in the book, Mission Intangible. This is it.

Reputation value is the sum of the value contributed by six key intangible assets (business processes) governing ethics, quality, innovation, safety, sustainability, and security. The assets create value cooperatively like the stones in a Roman arch; loss of any one key stone can destroy significant value.

Let’s also recap what is value. Market capitalization is the obvious one. More to the point, companies with superior reputations have enhanced pricing power, lower operating costs, lower credit costs, and higher earnings multiples. It's that simple.

Walmart has invested significant time and effort into building authentic credentials and a reputation for excellence in sustainability practices. Is its reputation for sustainability sufficient to compensate for its less-than-stellar reputation in labor (ethics)? The hypothesis would suggest that they are independent, and that failure in either could erase the reputation value created by the other. Let’s look at the numbers.



The Steel City Re Corporate Reputation Index, also described in greater detail in the book, Mission Intangible, shows that Walmart’s reputation ranking has slipped from the coveted #1 slot of the 100th percentile among 39 peers in the multiline retail sector. Over the past 16 months, Walmart has moved from the top ranking to the 94th percentile. Economically, its return on equity has underperformed both the median return of its peers (by 42%) and the S&P500 benchmark index.



In contrast, Target Inc. (NYSE:TGT), a rival whose charting in this Mission Intangible blog back in June 2009 has been the most popular post ever, raised its reputation ranking among this peer group from the 46th percentile to the 94th percentile. At the same time, it outperformed the median of its peers (by 27%) and the S&P500 index.



Also for contrast look at Walgreen Co. (NYSE:WAG). During this period, their reputation ranking rose from the 69th percentile to the 81st percentile, and it outperformed its peer group by a narrow 2%, but comfortably beat the S&P500 Index.



Last, note that the multiline retail sector, as a group, slipped in its median reputation ranking relative to the broad market. Furthermore, the variance among the individual companies comprising this sector narrowed. The sector's median reputation ranking drop stands out dramatically in contrast against Target's reputation ranking rise.

Because this week two of the major monotheistic religions celebrate holidays, and because on 9 April our Mission Intangible Monthly Briefing  explores the value of ethical behavior, today we take a break from headline risk to look at ethics.

Ethics comprise prescriptions for fairness. As we discuss in the Society’s latest book, Mission: Intangible, ethics are the moral principles by which a company operates; integrity is the act of adhering to those moral principles. For executives in a perpetual search for competitive advantage, the existence of fairness in the general population may be a puzzle. In a dog-eat-dog world, what possible biological advantage could accrue to those who behave in a trusting and cooperative manner with unrelated individuals?

There are two answers: financial and anthroplogical. From a financial perspective, our data show that companies with superior reputations for ethical behavior outperform their peers. And while that should be sufficient and compelling for any senior executive or board member, anthropological data suggest that fairness is an adaptive social construct.

The Economist reports in the 20 March issue that research from the University of British Columbia indicates that the variance of fairness found in difference societies has a cultural explanation -- a response to the development of trade. According to work by Joseph Henrich and colleagues,

…those societies that most resemble the anthropological consensus of what Paleolothic life would have been like (hunting, gathering with only a modicum of trade) were the ones where fairness seemed to count least. People living in communities that lack market integration display relatively little concern with fairness or with punishing unfairness in transactions. Notions of fairness increase steadily as societies achieve greater market integration. People from better integrated society are also more likely to punish those who do not play fair, even when this is costly to themselves.

Which explains the wisdom of the 1998 observation by Alan Greenspan that “in a market system based on trust, reputation has a significant economic value.

Heads Up - Date Change

As noted above, the Mission: Intangible Monthly Briefing for April 2010 will be held one week later than usual in deference to those who celebrate Good Friday. On 9 April 2010 at 12h00 EDT, the second Friday of the month, we will host a conversation featuring incoming Integrity and Corporate Responsibility Committee Chairman Paul Liebman from Dell (NASDAQ:DELL) and IA Value Signaling Committee Chairman Jon Low from Predictiv. The title for the one hour moderated discussion is: Ethics - A valuable intangible asset? Mary Adams from Intellectual Capital Advisors hosts.

As always, registration for this popular series is complimentary and slides will be available for download in advance of the event. To register now, click here.

Join Us

If the above intrigues you or challenges you to learn more, look no further. The Intangible Asset Finance Society wants to be your business resource. Join us and be part of an organization that provides a wealth of educational materials, including a new book, to further your executive career, and exciting monthly conferences such as the upcoming one on ethics mentioned above.

It is water under the bridge, of course, but it is worth noting that insiders at Lehman (NYSE:LEH) thought that Repo 105 reeked of “headline risk.” And headline risk, as we have observed before, can snowball.

According to Jennifer Hughes writing in today’s Financial Times, Martin Kelly, global financial controller, warned his bosses about the “headline risk” to Lehman’s reputation if the deals were to become public. And now that the issue is public, it is snowballing.

Ms. Hughes further writes, “Lehman’s Repo 105s have attracted attention because attempts to hide assets by shifting them off the balance sheet are associated with dodgy accounting and best known for the interminable tangle of vehicles created by Enron, the failed US energy group, to hide its debts. But the reason this issue keeps rearing its head in so many guises is that the question lies at the very heart of accounting, which was originally intended to give a company’s owners a fair report of its business activities. Therefore, what goes on, and what stays off, the books is a permanent area of debate.”

Perhaps. But there is also a reputation angle to this story. In our opinion, the reason this issue is rearing its head and snowballing with the inevitable pile on of ‘litigators, regulators and Mommy bloggers’ is that it speaks to a central driver of market liquidity—trust. As former Fed Chairman Greenspan noted in October 2008, in a market system based upon trust, reputation has significant value. Linking ‘trust’ to ‘reputation’ is the ephemeral intangible asset of ‘ethics,’ for which accountants have yet to find a home.

Which is not to say that ‘ethics’ does not impact financial statements. As reported in the Intangible Asset Finance Society’s latest book, Mission: Intangible, companies with superior reputations deliver superior long-term shareholder returns by enabling (i) stronger pricing power, (ii) lower operating costs, (iii) greater earnings multiples, (iv) lower beta and (v) lower credit costs. And as for companies that do not foster conformance with ethical best practices, there are always alternatives to being a going concern. Just ask Lehman.

It is significant that there is little public gloating from other auto manufacturers as Toyota Motors’ (NYSE:TM) leadership globally offers mea culpas. Although it is Toyota’s reputation that is melting under the heat of headline risk, competitors are only too aware that the next tolling of the bell could be for them.

This is why. While the damaged intangible assets are three of the big six: ethics, safety, and quality, the underlying problem is the global supply chain. According to Bob Rittereiser, CEO of Zhi Verden, a supply chain systems and information management company, “the stark reality today is that the global supply chain is a business operating system with global reach, thousands of participants, established practices, government requirements, blazed paths, known bottlenecks and many known risks, yet no one is in charge!” Or, said differently by John Hurrell, Chief Executive, Association of Insurance and Risk Managers, “The complexity of supply chains puts your reputation in the hands of the lowest common denominator.”

Reputation drives intangible asset value. As reported in Mission: Intangible -- Managing Risk and Reputation to Create Enterprise Value (IAFS with Trafford Press, March 2010), research shows that superior reputations pay off with (i) pricing power , (ii) lower operating costs, (iii) greater earnings multiples, (iv) lower beta (i.e., stock price volatility) and (v) lower credit costs. And when reputation is damaged, these benefits are lost. All told, we estimate the reputational impact, so far, to be a $2 billion cost to Toyota's earnings and a $25 billion cost to its market capitalization.

Previously we shared Toyota's reputation metrics from the Steel City Re Corporate Reputation Index. We take time out from our membership drive to offer this financial breakdown shown at left.

Legend. Income Statement Impact (values in $‘000). Lost sales and a 3% loss in pricing power will reduce Toyota’s gross profit by around $900 million. Costs associated with the worldwide recalls, litigation, insurance subrogation, and regulatory compliance will cost at least another $500 million. The lower credit ratings will increase borrowing costs by at least another $71 million, and non-cash depreciation expenses associated with a 3% write down of Toyota’s automobile asset base will reduce earnings by another $540 million. Data source: Steel City Re.

Join Us

If the above intrigues you, frightens you, or challenges you to learn more, look no further. The Intangible Asset Finance Society wants to be your business resource. Join us and be part of an organization that provides a wealth of educational materials to further your executive career.

Innovation: Hot Policy and Practice Issues

Be sure, by the way, to register for a complimentary seat at the 5 March Mission:Intangible Monthly Briefing, held by phone at 12h00, EST. It's an innovation smack down. Athena Alliance President and intangible asset policy expert Kenan Jarboe goes head to head with Steel City Re's Judith Giordan, Managing Director of IA Finance and former senior technology executive with Pepsi, Henkel, International Flavors & Fragrances, and Polaroid. Yes, as always, registration is complimentary and slides are already posted on the website events page.

The IAFS launched its 2010 membership drive this past week. This is why. On February 28, new US SEC regulations will drive into the boardrooms risk, reputation and intangible asset management. 

You have a decision. Will you be at the table or on the menu?

These regs mean that every board member, in fact every top executive, can expect major new challenges. Members of the Intangible Asset Finance Society (IAFS) will be prepared. Here’s how:

1. Thought Leadership. The IAFS is the only interdisciplinary Society of professionals committed to the financial exploitation of intangible assets. That translates into enhanced pricing power; lower operating and credit costs; and higher net incomes and earnings multiples.

2. Risk Management. A lost reputation can destroy a firm overnight. IAFS can keep you up to date with risk management strategies for ethics, innovation, quality, safety, environmental sustainability, and security.

3. Preferential Pricing. Society members receive preferential rates for IAFS products at our new store and discounted registration to various professional meetings. Discounted registrations for the March ICAP Ocean Tomo meeting in San Francisco and the June IP Business Congress in Munich, for example, are now offered.

4. Incentive Premium. Sign on for your academic or corporate membership including payment by March 15 and receive a complementary copy of the IAFS’s latest book, Mission: Intangible. Managing risk and reputation to create enterprise value (a $29.95 value).

Click here to learn how our strengths in Thought Leaders and Risk Management, financial benefits such preferential pricing, and premiums such as the book shown at right make joining the Society today an offer you can't refuse.

Headaches. In case you've been unplugged this past year, Toyota Motors Corp (NYSE:TM) is experiencing an intangible asset value meltdown. Highly valued behaviors that became watchwords for Japanese manufacturers—ethics, quality, safety—appear to have recently fallen out of favor at this iconic firm.

It's been a few weeks since we looked at the automobile sector, and we will give this topical sector a robust treatment in our regular corporate reputation series in IAM Magazine issue 41. For now, a teaser.

At the of end of Q1 2009, the Steel City Re Corporate Reputation Index showed a precipitous decline in Toyota’s reputation relative to a sample of large publicly traded firms on the US exchanges. Honda Motors (NYSE:HMC), a Japanese-headquartered competitor, is one of the reputational beneficiaries. Its all relative. Shown in the charts below, the Reputation Index metric for TM drops from the 80th percentile to the single digits and generally holds there for the balance of 2009. HMC, on the upswing from early 2009, peaks at the 90th percentile before ending the year 30 percentage points net up at around the 50th percentile.

As for economic returns over this same period, TM rewarded its shareholders with a 45% ROE (S&P was up ~21%). HMC rewarded its shareholders with an 80% ROE.

Today’s note is an extract from a recent posting on bigfatfinanceblog that was brought to our attention by Jim Catty, chairman of the board of IACVA which is a new partner of the Society. The blog note was written by Deloitte LLP chairman of the board Sharon Allen and addresses social media and reputation risk. Here is the take home message:
 
… I believe that our primary focus should be on the powerful role that corporate culture can play in encouraging appropriate social networking. A good place to start may be with business leaders whose personal example promotes the time-tested principles of ethics and values. In fact, in our first “Ethics & Workplace” survey that I commissioned two years ago, 77 percent of those polled cited the behavior of management or a direct supervisor as the top factor influencing their conduct. While creating and maintaining that “tone at the top” is an important first step, the key is to establish a culture that ensures that an appropriate moral compass is in place — in the office or out, online or off…

Thank you, Jim.

Late last year, it was Tiger Woods. For the new year, it is the company that held the top 2009 reputation ranking by both the Harris Interactive Survey and the Steel City Re Corporate Reputation Index – Johnson & Johnson (NYSE:JNJ). What happened this time?

There were early hints with FDA letters in August and September 2009. But the big stories broke last Friday when the U.S. Justice Department announced that it is suing the drug giant for allegedly paying millions of dollars in kickbacks to geriatric pharmacy company Omnicare Inc. (OCR) to induce the company to buy and recommend Johnson & Johnson drugs. That same day, the Company widened its voluntary recall several of the company’s top selling over-the-counter brands across the country. There is a concern that a chemical called 2,4,6-tribromoanisole is causing an unusual odor in select brands. The smell is due to the breakdown of the chemical that is used to build wood pallets that transport and store product packaging materials. The expanded recall was announced after the FDA reprimanded the Company for waiting close to a year to remedy the well-documented problem.

In short, two reputational issues: ethics and quality. We expect repercussions. Turning to the Steel City Re Corporate Reputation Index, we focus on Aug and Sept when JNJ received FDA warning letters. Here we see a slight dip in the reputation index and correspondingly, a lack in equity growth while both the pharmaceutical sector and the S&P were rebounding. See arrows marking Aug/Sept window on both the reputation index (red) and the equity returns (blue diamond/red outline). The full reputational and financial effects are yet to be recognized.


To be fair, JNJ’s overall ROE underperformance of 23% relative to the Pharmaceutical sector can be explained, in part, by JNJ’s resilience during the 2008 crisis. A two-year ROE in the chart below from Bigcharts.com shows that at the low point of the market in December 2008, JNJ had lost only 20%. The sector had lost 30%, while the S&P lost 40%. In march of 2009, JNJ 'caught up' with the industry and has followed the sector mean since. The ‘cost’ of that historic resilience is poorer apparent performance in the short term this past year. The gain is lower volatility and therefore lower cost of credit. Provided that the effects of the latest disclosures do not materially shave reputation value. The year is still young.

As financial intermediaries, brokers play a crucial role of matching buyers and sellers. Central among those role is facilitating price discovery. This is especially true in markets for bespoke, less liquid products. Having a reputation for ethical behavior is valuable—as are the underlying business processes that foster ethical behavior.

Faking trades to distort pricing could threaten the commercial viability of a broker were the practice found to be widespread. At the very least, it is fraud. On Friday 18 December, ICAP Securities USA LLC reached a settlement with the United States Securities and Exchange Commission (SEC). The company, a US subsidiary of ICAP plc (LON:IAP) and winner of a Queen’s Award for Enterprise, is alleged to have posted fictitious trades in 2004 and 2005 on some Treasury brokers’ screens to encourage trading by attracting those brokers’ attention.

ICAP is active in the wholesale markets in interest rates, credit, commodities, FX, emerging markets, equities and equity derivatives. ICAP has an average daily transaction volume in excess of $2.3 trillion. In June 2009, ICAP purchased the intellectual property markets division of Ocean Tomo thus becoming one of the largest market makers in a class of bespoke intangible assets. Intellectual property markets have suffered chronically from price discovery challenges.

ICAP Securities has agreed to pay the SEC disgorgement of $1 million and a penalty of $24 million as settlement to end the investigation. The settlement includes the concept of non-intentional fraud. ICAP Securities has also agreed with the SEC that ICAP Securities will appoint an independent consultant to review the improved control environment that is now in place. Shares of ICAP ADRs fell 46 cents or 3.37% in Friday’s session in New York to close at $13.19 a share. The S&P 500 index was up 0.58% and the financial services sector average was up 0.68%

Six weeks have passed since the Chairman of the Galleon Group, the hedge fund at the center of a suspected insider trading ring, and several executives, have been charged. Three of the companies caught in this scandal are going concerns. Their executives are accused of divulging confidential non-public information. Those companies are McKinsey & Company, IBM (NYSE:IBM), and Intel Corporation (NASDAQ:INTC).

Of the three, McKinsey & Company has a widely held reputation for discretion – an intangible asset that is essential to their operational effectiveness. Last month, we hypothesized that this reputation would help mitigate McKinsey’s headline risk. Evidence of this mitigation would be fewer articles in the business and legal press relative to the other two firms.

Once again, Society member Jim Singer of the Pepper Hamilton law firm and author of the blog IP Spotlight, helped us with the analysis. Lexis Nexis searches were conducted combining 2 comprehensive databases - Business News Publications and Legal News Publications for the dates 9/3/2009-11/22/2009. The first search was for the pairing of “Galleon OR Rajaratnam.” Jim then searched the resulting articles for the additional terms of McKinsey, IBM, or Intel. 

There were no citations meeting the search criteria prior to the government announcement of allegations. Following the announcement, the data show that McKinsey’s name is less frequently associated than the other two firms with the disgraced hedge fund. This observation is statistically significant for the first three weeks of the alleged scandal.



While the findings are not conclusive—McKinsey is privately-held whereas the other two are public—these data are consistent with our general observation that companies with strong reputations based on rigorous business processes make for sympathetic actors that are treated as victims rather than culpable agents when adverse events occur. In short, reputations arising from superior intangible asset stewardship help mitigate headline risk.

NB: Statistical analysis using the Chi Square test for the five weeks of data yields a p<.03, p<.001, p<.01, for the first three weeks, respectively, and then not statistically significant differences thereafter.