The chairman’s letter in the annual report, signed 6 March 2012, is clear. “The board set three priorities for BP,” wrote Carl-Henric Svanberg. “Safety must be enhanced and embedded. Trust must be regained. Value must be created through a clear strategic plan”

Safety, now a factor in the executive bonus plan, is tangible evidence of the company’s strategic priorities of reinforcing safety and risk management, rebuilding trust and reinforcing value creation of its intangibles. At group level, the safety and risk management component includes targets for recordable injury frequency, loss of primary containment and implementation of change programmes. Rebuilding trust is focused on external reputation as measured by external surveys and internal morale as measured by surveys.

BP’s board considers reputation from two perspectives – the reputational risks to the group and the processes the company has in place to manage these risks. In 2011, the board reviewed external reputation data which looked at BP’s reputation in the UK and US. It also discussed the group’s communications strategy and its reputation management plan.

To assure that stakeholders know that BP is serious about reputation and its risk management, the annual report offers up the term 20 times in the 10k section 1A-Risks. The term also appears liberally throughout the balance of the document for a total of 45 mentions over twenty different pages in the 300 page document.

In what appears to be a growing trend first announced formally at UBS, but clearly preceded by BP, both reputation measurement and reputational risk are major issues at the Board level. This is why: as reported here earlier, firms that have superior reputations newly discovered can pickup an average of 6% of market cap, while firms that experience a reputational crisis can lose an average of 7%. Anything that can precipitate a 13% swing in value is bound to get the attention of a corproate board.

The Steel City Re reputation metrics for BP this week show the following trends: BP’s reputational value metric, a non-financial indicator of reputational value, is stabilizing with a near median volatility relative to its peers, and a long term forecast of stability. The company’s corporate reputation ranking, an indicator of relative standing, places the firm in the 81st percentile. Since the volatility indicators are neutral, the data do not yet indicate a near term boost in equity returns above the median for the peer group. After years of reputational volatility, it appears at this point that equity investors are waiting for further evidence of material risk reduction in RepRisk -- reputation risk. Nevertheless, considering where things were two years ago, BP has come "a long way baby."

Mathew Philips, writing for Bloomberg Businessweek (March 7), is perplexed. After recounting recent history including the Securities and Exchange Commission's $550 million fine for misleading clients on securities that were "built to fail," the swaps engineered for the Greek treasury that went bad and exacerbated the nation's financial distress, and the apparent conflict of interest in the sale of El Paso to Kinder Morgan, he is faced with a troubling fact. "Goldman’s sullied reputation doesn’t appear to be negatively impacting its business. In fact, Goldman is outpacing its Wall Street competition recently in key areas of business. In 2011, Goldman was the top adviser for both global M&A and equity IPOs. A Bloomberg survey of traders, investors, and analysts last May showed that while 54 percent of respondents had an unfavorable opinion of Goldman, 78 percent believed that allegations it duped clients and misled Congress would have no material effect on its business."

Two quick charts on reputational value and reputational rankings based on Steel City Re data reinforce his observations: the reputational rank and reputational stability of Goldman Sachs are both in the top quartile of all 267 firms in the banking and financial services sector.





















By five of the key "vital sign" reputational metrics shown at left, Goldman Sachs is looking good. Yet its return on equity -- reward to its long suffering investors -- is the the 17th percentile within this peer group. Contrast Goldman Sach's reputational standing with another full-service investment bank, UBS. UBS with a market cap of $50B compared to Goldman's $57B, has a corporate reputational ranking in the mid 40th percentile even though its return on equity is slightly less negative. Goldman's PE is excess of 26 while UBS's is around 11.

We call this reputational resilience, and having tracked and measured Goldman Sach's reputation for the past three years, we are not surprised. Notes Philips, "There’s a reason why firms keep doing business with Goldman, and it’s not because of its sterling ethical reputation."

Indeed, it is not. The six key business processes that underpin reputational value are ethics, innovation, quality, safety, sustainability, and security. In the investment banking sector, it is hard to argue that one firm is more or less ethical than the other. That makes other drivers of reputation more valuable, and the evidence suggests the most important of them is innovation.

Opines William Cohan who studied Goldman Sachs and their culture and was interviewed by Philips: “This gets back to the advantages that Goldman has had for years over its competition. They attract the best and brightest people. They consistently have the best risk-taking culture on Wall Street. No one understands the markets as well as Goldman.”

Concludes Philips, "In short, if you want the smartest bankers, there’s a price to pay." The reputational value metrics and corporate reputation ranking data concur.

Bonds and equity are two very different animals. Bonds have few surprises. They have a defined coupon, a termination date, and if held to maturity, usually perform as expected. Equity has none of that, but everyone knows that equity comprises embedded options, intangible assets, that have value. Enter Ireland, which has married the surprise value of options -- real options at that -- with the bland expectations of  bonds.

According to Bloomberg (Feb 28, Flynn), "under proposals to be laid out next month, the government will offer the visas to investors who spend at least 2 million euros ($2.7 million) on a new “low-interest” security, 1 million euros on property or invest in an Irish company. The sale is aimed at people from outside the European Union (EURR002W) who need permits to live and work in the 27-member bloc." That's right: Visa Bonds. Bloomberg adds that "The government hasn’t yet set the coupon, the rate of interest payable to bondholders. Buyers will be able to bring family members with them, the Justice Ministry said."

Huygens gives a tip of the hat to Ireland for innovative intangible asset monetization.

Social Capital: A New Strategic Play for Investors
Look for Companies with Heart and Soul

Barbara Gray, CFA, Equity Analyst, Brady Capital Research

For those of you who participated in the Monthly Briefing last Friday “Sure, They Say They're Socially Responsible: ESG meets CSR”, with Rick Frazier (Founding Member and Research Director of Concinnity Advisors LP) and myself, you probably got the sense that neither Rick nor I are big fans of ESG or CSR. Although it is important for investors to incorporate ESG (Environmental, Social, Governance) factors into their analysis and valuation process, we believe that ESG is only one piece of a company’s risk/growth profile. And while it is encouraging that more and more companies are starting to undertake CSR (Corporate Social Responsibility) initiatives, we view this as more of a defensive politically correct move. We are more interested in how a company actually treats all of its stakeholders (customers, employees, suppliers, community, environment).

As I stated on the call, I believe social media is leading to the creation of a new form of equity called social capital with the following four investment characteristics:

• Liquidity - Facebook, Twitter, and LinkedIn are global, dynamic, 24/7 social exchanges that convert a company’s stakeholder relationships into highly intangible liquid assets and/or liabilities called social capital.
• Time Horizon - Social capital is a new form of equity that we expect to appreciate in value as Facebook, Twitter, and LinkedIn’s user bases continue to grow, new social exchanges such as Google+ emerge, the number of user connections within and between different social exchanges grows, and corporate penetration and usage increases.
• Unique Characteristics - Social media empowers the individual with a platform to influence, expose, and disseminate.
• Regulatory and Legal – Social media provides concerned citizens with a platform to self-organize, increasing their bargaining power to push for regulatory and legal changes and reform.

As evidenced by the fact that Time’s Person of the Year for 2011 was “The Protestor”, I believe social media is the catalyst that is ushering in the era of the Social Revolution. I expect the Social Revolution will lead to a rise in legal and regulatory reforms, which will in turn, erode the economic moats of companies whose competitive advantage is derived by exploiting constituents in their stakeholder base. This will increase the company’s risk profile, reduce its future growth opportunities, and result in the creation of negative social capital. A company’s negative social capital with its stakeholders is an intangible liability that, unlike goodwill, does not show up on a company’s balance sheet. However, from a discounted cash flow (DCF) valuation perspective, the simultaneous increase in a company’s assumed discount rate and decrease in its expected growth rate will lead to a negative multiplier effect and contraction in the company’s value.

On a more positive note, as I explored in the research report I published in November titled: “Social Capital: A New Strategic Play for Investors – Look for Companies with Heart and Soul”, I am excited about how the Social Revolution will foster in a new source of competitive advantage for companies with heart and soul that are focused on making a positive difference in the world. I believe the strong and authentic stakeholder foundation of a heart and soul company will convert into a high velocity of social capital as the company leverages the high level of enthusiasm and deep psychological attachment to the company’s brand and greater purpose.

If you are interested in finding out more about my Social Capital investment thesis, I would be happy to send you a copy of my in-depth research report. I recently launched Brady Capital Research as an investment research platform to pursue my Social Capital investment thesis with the vision to: “build a community connecting investors with heart and soul companies and leading-edge business strategists”. I would love to share and discuss my ideas with you from the Intangible Asset perspective. You can reach me at barbcfa@gmail.com.

Editor's Note:

Blog readers may purchase an audio file of the Mission:Intangible Monthly Briefing (MIMB) program, "Sure, They Say They're Socially Responsible: ESG meets CSR," from the IAFS store. Members of the Society receive fabulous discounts on these and other products. Click here for details.

From the time of the pioneering work by Fombrun and others in the 1990's, market observers generally agreed that reputation was a source of equity value. When good, it drove customers to buy more at higher prices, employees to work harder for less, vendor and creditors to offer superior terms, equity investors to bid up multiples, and regulators to cast a more benign eye. Since then, punters have sought methods for linking to concepts into an equity strategy.

The dominant challenge has been the inherent nature of reputation. It is an epiphenomenon of the interplay between culture and operational matters on one hand, oversight and governance practices on the second, and allowing for a third hand -- how the package is presented and delivered to stakeholders. The latter is recognized as being generally in the domain of marketers, and since it represents the "last mile" to the stakeholder, it has received the lion's share of attention.

Reputation value can be teased out of equity value through major adverse reputational events. Many have been documented in this blog over the years. Informal estimates suggest that the cost of an adverse reputational event is around 5% of market cap. Steel City Re, the reputation risk insurance specialist, calculate a value closer to 7% but their model arguably ignores "lesser" reputational events. Since 2005 when the Economist Intelligence Unit published its seminal article on reputation risk, reputation management gained a new internal stakeholder - the enterprise risk manager.

These data affirmed management's need to avoid reputational risk, but they provided little in the way of guidance of how to avoid it. Also, while they suggested how much to invest in the avoidance effort, the lumpy nature of reputational events ensured that any classical actuarial model would leave a firm statistically comfortable with its risk management strategy and yet woefully underprepared.

In November 2011, Steel City Re announced that its data on reputational value indicators had been incorporated into an equity strategy and was available through Dow Jones Indexes. The ten-year history, several years of which have been published weekly on this site, indicated a significant outperformance relative to the benchmark S&P500 index. Critics suggested that the outperformance could be attributed to higher beta securities rather than an inherent value proposition associated with exploiting latent reputation value.

We now report an additional analysis of the RepuStars algorithm in which the stock selection was limited to the S&P500 constituent members only. Details on the 3-year old RepuStars Variety algorithm and the underpinning reputational statistics are provided elsewhere. In this study, stocks were selected by the algorithm at the beginning of each of ten years beginning December 2001. In general, the portfolios comprising stocks selected using the RepuStars Variety algorithm outperformed the universe of S&P500 firms (the Index) each of the ten years. The single exception was 2008 (image below). The ten year average was 6.5%, a value surprisingly similar to the 7% losses realized with adverse reputational events.


From an investment perspective, the portfolio based on the above would have produced an annual 9% cumulative return which is within 10% of the RepuStars Variety price index returns that are reported each Monday (image below).


The upshot is the reputation management is not only good risk management. It is a source of value creation. Firms that do it right can expect, on average, an additional 6.5% in equity value growth, and protection against 7% in equity value loss, all other things being equal. Arguably, there are very few managerial strategies a firm can pursue today short of inventing the next i-device or replacement for facebook that can deliver such value.

In this month's issue of IAM magazine, #48, the regular contribution on reputation explains how this epiphenomenon can provide management with freedom to operate. In the words of editor Joff Wild, who also recently penned a much appreciated shout out, "Although it is intangible, reputation allows businesses and executives operational freedoms that lead to very tangible results."

Now for an update from the National Association of Corporate Directors. According to their daily newsletter, NACD Directors Daily (13 July), "In an rare example of how 'say-on-pay' votes can influence companies' relationships with some shareholders," Cincinnati.com (July 12, Boyer) reports that "a lawsuit has accused Cincinnati Bell Inc.'s outside directors of breaching their duty to investors and the company's top executives of 'unjust enrichment' over pay raises granted last year." The raises range from 54 percent to 80 percent for three of the company's top officers despite a 68 percent drop in 2010 net earnings. A non-birding shareholder vote in May opposed the pay raises. "The lawsuit was brought in U.S. District Court in Cincinnati last week by attorneys for the Illinois-based NECA-IBEW Pension Fund, a Bell shareholder," the website reports. "It seeks a court order and unspecified damages on behalf of the corporation, possible return or impoundment of the pay increases, and implementation of internal controls preventing excessive compensation to the company's top executives."

We've discussed "sue-on-pay" before. And we will again. It appears compensation is evolving into a contact sport.

NB: Further to recent queries from attentive followers of this blog, Huygen's will opine on the reputational crisis gripping News Corporation (NASDAQ:NWSA) presently.

Warren Buffet is well known and much respected for his earthy aphorisms. He is admired for his lofty valuation. Berkshire Hathaway (NYSE:BRK), an insurance-based conglomerate has been rewarded historically with outsized intangible asset values owing to the reputation of its founder. Those valuations are approaching the median of the Property and Casualty Insurance sector and the polish continues to come off.

What is the evidence? The man who made reputation management a "household" phrase in the C-suite and boardroom, who famously said, "“If you lose dollars for the firm from bad decisions, I will be very understanding. If you lose reputation for the firm, I will be ruthless,” is named in a shareholder suit alleging -- you guessed it -- loss of reputation for the firm.

The National Association of Corporate Directors NACD Daily (April 20), a compilation of other news sources, shares that "Warren Buffett and the rest of Berkshire Hathaway Inc.'s board of directors were sued by a shareholder Tuesday over presumed heir apparent David Sokol's trading in the stock of a company that was later bought by Berkshire," the Montreal Gazette (April 20, Hals) reports. Sokol, who purchased shares of Lubrizol Corp. before pitching the company as a possible acquisition, was also named in the lawsuit. He resigned from Berkshire Hathaway last month. "The lawsuit filed by Berkshire shareholder Mason Kirby in Delaware's Chancery Court calls for Sokol to give up any improper gains to Berkshire," the Gazette notes. "It also calls for Buffett and other directors, including vice-chairman Charlie Munger, to compensate Berkshire for the damage they caused to the company's reputation and goodwill."

In total, the Omaha World-Herald (April 20) states, Sokol purchased just over 96,000 shares of Lubrizol in early January prior to recommending that Omaha-based Berkshire acquire the company. In the suit, Kirby charges: "Sokol knew that Buffett would closely consider and likely take his recommendation. As a result of Sokol's unethical behavior, Berkshire suffered significant reputational losses and other damages."

The metrics affirm that something is up. The reputational value changes to the Steel City Re Corporate Reputation Index rankings noted two weeks ago persist, and both the reputation volatility and vector trends are on track upwards and downwards respectively.

Most telling, however, is that the loss of intangible asset fraction now makes the Company look like a typical property-casualty insurer. Sure, relative to other conglomerates, the Company's intangible asset fraction of some 10-20% was materially below the peer group's median. But seen as an insurer, the Company had a 20% higher valuation.

That valuation ascribable to intangibles, what we call for lack of a better term "reputation," is disappearing quickly (see asterisk below). Berkshire Hathaway's lofty intangible asset valuation is coming down to earth.
 

The Financial Times is concerned that the nuclear crisis in Japan may adversely impact the reputation of General Electric (NYSE:GE).

According to the FT, GE designed the Mark 1 boiling water reactors (BWR) used at the Japanese plant, and supplied the No 1 and No 2 units that went into service in the early 1970s. It has also had engineers at the site up until last week; a team of 44 had been working on maintenance at the shut-down No 4 reactor when the earthquake hit. GE’s nuclear operations are now part of a joint venture with Hitachi of Japan that has two businesses: Hitachi GE Nuclear Energy, which is owned roughly 80-20 by the Japanese and US groups, and is based in Japan, and GE Hitachi, which has 60-40 US-Japanese ownership and covers the rest of the world.

Although the businesses are formally separate, they are closely linked. As well as the 70 people working on the crisis in North Carolina, they have a centre in Tokyo, near the Japanese government’s main response centre, to provide technical support and advice. You can read the balance of the FT article here.



Looking at the reputation metrics, GE’s ranking has been sliding as of late. The Steel City Re Corporate Reputation Index shows that after a steady rise, GE’s ranking shows a net drop over the trailing twelve months from the 60th percentile to the 50th percentile among its 86 peers of General Diversified companies. Consistent with the FT's concerns, the exponentially weighted moving average of the reputation ranking has been climbing lately and measured this past week at just above 6%.

The ten point slide in the Corporate Reputation Index has been associated with a trailing twelve week reputation velocity of -14% and a trailing twelve week reputation vector of -0.8%. Both, being signs of significant reputation volatility, reflect especially acute changes over the past week and suggest growing concerns about GE's reputation for design quality and safety excellence - key intangible assets in the nuclear reactor construction industry.

Now to bring this all back to finance. While GE has been outperforming its peers recently, as of 17 March, its return on equity over the trailing twelve months is only 2.3% greater than the median of its peer group. And it is trending negative.

There are national accounts, and national intangible assets. Our ability to account for the latter may be no better than what we show on corporate balance sheets. Worst, absent an indicator like market capitalization that reminds us that there is significant value in excess of book (x2-3), we may not even be aware of them.

National Public Radio’s Planet Money, a multimedia team covering the global economy, recently aired a program in which the benefit of the overarching term we use at the Society, reputation, was addressed in a geopolitical setting.

We used to talk about the G-7 — the world's seven biggest economic powerhouses. Every so often, the leaders of the G-7 countries would get together and hash out the important issues facing the global economy. That grew to become the G-20, which included big players in the developing world (China, India, Brazil). In the heat of the financial crisis, the G-20 made a good show of cooperation. But as the crisis has faded, so has the cooperation. What's left is a world where there's no clear economic leadership. That creates a new set of problems, David Gordon says. Gordon, research director at the consulting firm Eurasia Group, calls this new world "G-Zero."

The G-Zero is a concept that acknowledges that there is no longer any center of power and marks the end of the most recent era where the one remaining superpower provided global leadership.

According to Gordon, “the United States reputationally has been weakened by the financial crisis – blamed for it – and our model of capital markets and all of this, combined, are no longer seen as things that countries should aspire to. That reputation hit, combined with our own relatively weak recovery and fiscal challenges, means that we are no longer able to give the kind of leadership to the world economy that we did forever.”

Listen to the NPR Planet Money G-Zero podcast on the NPR website (click here) or to the current Planet Money program (click below).
 

SAP is the dominant solution provider in the $8 billion enterprise management and business intelligence software sector. The company's products provide businesses with an integrated view of their operations for cost and asset value optimization, and predictive analytics to help identify opportunities and risks. But their software doesn't manage intangible assets, and the risk their software didn't help them see was a breach of ethics and intellectual property management best practices by a partner company that they subsequently acquired.

Cutting to the chase, Oracle (NASDAQ:ORCL) last week won a $1.3 billion jury verdict against rival SAP (NYSE:SAP), netting the biggest copyright-infringement award ever. According to Bloomberg News, the jury delivered the verdict Tuesday, after an 11-day trial in federal court in Oakland. The lawsuit started in 2007, with Oracle claiming the German company's TomorrowNow business made hundreds of thousands of illegal downloads and several thousand copies of Oracle's software as part of a plan to steal customers.

SAP acquired the TomorrowNow in 2005 and closed it in 2008. SAP had hoped to use the unit to lure thousands of customers of PeopleSoft and JD Edwards, which Oracle had acquired, to purchase SAP software, according to evidence presented at trial. The unit garnered 358 customers.

The award was more than analysts had estimated - and far beyond the $160 million that SAP had set aside for the litigation.The immediate equity costs -- SAP is underperforming the mean of its 217 peers in the Systems and Subsystems sector by 7.71% -- are therefore understandable. What about the long-term reputation effects?

One week out from the verdict,  the signals are mixed. Over the trailing twelve months, The Steel City Re Corporate Reputation Index has risen from the 92nd to the 96th percentile. The Exponentially Weighted Moving Average of the volatility of the Index, which had been falling for most of the past six months, has been rising over the past few weeks to .4%. This is a negligible amount. On the other hand,  the trailing twelve week Index velocity is negative and the vector is negative, and these are worrying signs. The intangible asset fraction is unchanged at around 93% beating the sector mean of around 80%.

If the stakeholder community looks at SAP and concludes that they are really a good company that had a rogue unit, then they will come through this period with a loss equal to the cash costs of litigation. If the stakeholders view SAP as a behemoth that may harbor other TomorrowNow-like risks, then there will be significant long-term costs.