Catastrophes and Your Investment Risk
Andrew Leckey

Bad news travels fast and can dramatically alter the prospects of your stock.

The BP oil spill is the latest example of a catastrophe bringing the methods of a company and its industry into question, but it is important to consider the potential risks of every investment.

That's not to scare you off altogether as an investor, but to point out that it makes sense to diversify your holdings -- for those times when bad turns to worse.

When oil tanker Exxon Valdez ran aground 21 years ago, spilling 11 million gallons of oil into Prince William Sound and the Gulf of Alaska, massive cleanup operations, litigation and damages resulted, but the company survived.

"Exxon -- and I own ExxonMobil stock -- had a quantifiable amount of oil spilled and the technology wasn't the same as it is now," observed Ted Parrish, co-manager of the Henssler Equity Fund (HEQFX), up 21 percent over the past 12 months. "However, BP has had management turnover and several significant disasters the past few years, so there is a real issue about its risk management."

Following BP's prior explosion in Texas City and oil spill from a corroded portion of its Alaskan North Slope pipeline, the firm said it had improved safety. While it has thus far been able to line up cash to help cover its Gulf cleanup costs, it has also seen its stock price cut in half and bond prices decline. Uncertainty hangs over it and offshore drilling.

Compare that to 1982, when Johnson & Johnson swiftly recalled 31 million bottles of Extra-Strength Tylenol after seven people in the Chicago area died from cyanide-laced capsules. It offered safer replacement tablets free of charge. Bold moves were applauded, and battered stock price recovered.

"Johnson & Johnson has been in my mutual fund since the beginning and I believe investors should always look at how a company reacts in bad situations," noted Parrish. "In the original Tylenol scare, it made the right decisions by recalling its product, owning up to the problem and moving forward to fix what allowed it to happen."

But early this year Johnson & Johnson recalled 200 million bottles of Tylenol, Benedryl and other children's medicine due to a musty odor from low-level chemical contamination the company said offered low risk of serious adverse health effect.

It subsequently expanded the recall for additional packages that it said were inadvertently omitted. The Food and Drug Administration said it is considering possible criminal action due to quality lapses and reporting delays tied to the recall.

"Though it built up a vast reservoir of goodwill over the years after Tylenol, Johnson & Johnson is watching that deteriorate," said Les Funtleyder, health care specialist with Miller Tabak & Co., New York. "In health care, there can be bad outcomes with drugs and biotech and devices because mistakes and bad things do happen."

Parrish is less critical, noting that even Johnson & Johnson (JNJ) "can't be perfect every day." The stock is down 7 percent this year.

In 2004, Merck & Co. Inc. pulled popular arthritis drug Vioxx off the market after its researchers found increased risk of heart attack, stroke and death. It is winding down payments of a $4.85 billion settlement to end 50,000 patient lawsuits, and faces additional lawsuits. Merck (MRK) shares are down slightly this year.

"Merck dealt with everything head-on by taking a public-health approach, then settling the class-action lawsuit and getting things back on track," Funtleyder said. "That contrasts to the BP situation that has had a lot of conflicting information and finger-pointing and not enough 'it's our bad and we will make this right.'"

An investor should do homework on every company he invests in to determine competitive, legal and catastrophic risks, as well as financial strength.

"It is hard to say any one or two stocks or companies are immune from having problems," said Andrew Fitzpatrick, director of investments for Hinsdale Associates in Hinsdale, Ill. "Coca-Cola could have a problem with its formula and any consumer products company can have a bacteria issue impacting a cereal or other product."

You can't directly compare risks of BP versus a consumer products firm such as Procter & Gamble, said Parrish. A different kind of problem is Apple Inc. having to fix its iPhone glitch that inflated readings of cellular signal strength -- embarrassing but not devastating.

Consensus analyst rating of reduced-price BP stock is between "buy" and "hold," according to Thomson Reuters.

"BP was slow getting in front of its problem and didn't seem to be fully open," said Fitzpatrick. "It indicated it had the problem under control when the opposite was true, it didn't have a good disaster recovery set-up and no one knew when the leak would stop."

There's still considerable risk in BP due to the unknown extent of liabilities, he said, so an investor would have to take the "high-risk/high-reward" long-term view. Fitzpatrick said he'd tell clients to stay away from BP stock, but considers many oil stocks attractive because their low prices are unwarranted.

"I couldn't fathom BP not surviving because it has so much in proven and unproven reserves around the globe," concluded Parrish. "However, it made a bad bet by self-insuring one of its higher-risk wells."

Available at Amazon.com:

The Seven Deadly Sins of Investing: How to Conquer Your Worst Impulses and Save Your Financial Future