Practical analysis for investment professionals
24 September 2015

The Volkswagen Disaster: Could Analysts See It Coming?

Volkswagen (VLKAY) share prices fell by more than 20% this week amid an emissions scandal that affects 11 million cars worldwide. It has triggered a critical question: Could analysts have seen it coming?

We posed this question to the readers of CFA Institute Financial NewsBrief. A clear majority, 81% of 826 respondents, said no, financial analysts cannot anticipate the risk of such losses through analysis of a company’s governance and internal controls.


Volkswagen’s share price suffered a large decline amid the US air-pollution tests scandal. Can financial analysts anticipate the risk of such losses by analyzing a company’s governance and internal controls?

Volkswagen's share price suffered a large decline amid US air-pollution tests scandal. Can financial analysts anticipate risk of such losses through analysis of a company's governance and internal controls?


The Argument for No

Analysts rely on publicly available information from companies, regulators, news media, rating agencies, and other sources. But what we are talking about in the Volkswagen case — to use the most polite adjective now employed by the news media — is deception. Deceivers try to avoid making their lies public. When the news comes out about such deception, it will always catch the market by surprise. You can see it with hindsight but not foresight.

James Macintosh argued in the Financial Times that investors need to go beyond box ticking and that analysts’ valuation models “must assess corporate governance.” Not everyone was impressed. “Great reminder after the fact. Any other insights into the past?” commented one reader.

Could the modern sustainability/environmental, social, and governance (ESG) movement have helped provide some foresight?

Foresight with Sustainability Analysis?

Some analysts have been arguing that integrating ESG issues results in more complete investment analysis and leads to better informed investment decisions. Clearly, the idea is not that one can predict specific events like the emissions scandal, but that one can judge the probability of such an event happening and act accordingly. When we recently surveyed CFA Institute members, 63% of respondents said that they analyze governance issues in investment decisions.

So why couldn’t all those analyzing the governance of Volkswagen see it coming, particularly the ESG specialists? They saw Volkswagen proudly touting its sustainability record on its website:

“The Volkswagen Group has again been listed as the most sustainable automaker in the world’s leading sustainability ranking. As in 2013, RobecoSAM AG again classed the company as the Industry Group Leader in the automotive sector in this year’s review of the Dow Jones Sustainability Indices (DJSI). Volkswagen is thus one of only two automakers to be listed in both DJSI World and DJSI Europe. . . . The review analyzed the corporate performance of a total of 33 automotive companies, seven of them from Europe. Volkswagen took pole position with a total of 91 out of 100 possible points.”

So why couldn’t this sustainability/ESG analysis do any better?  It too relies on publicly available information. But why did 12% of our poll respondents choose to answer yes? What are they thinking?

The Argument for Yes

Bad governance produces bad outcomes, and it was public knowledge that Volkswagen has serious governance problems. Back in 2009, the Financial Times published a story, “VW Governance ‘Worst’ of German Blue-Chips.” And this is not an isolated account. For instance, in 2012, the Financial Times ran another less-than-complimentary piece, “VW’s Governance Regime Irks Investors.” There were many such reports in mainstream news.

Bad governance infects a company and makes bad things possible. Here I would quote a comment posted on the New York Times website by one reader in response to a news report on Volkswagen:

“I used to work on emissions control software for one of the Big Three. The engine control and emissions diagnostics software is incredibly complex. We had hundreds of software developers, calibrators, validation experts, etc., working on these efforts. If you worked on oxygen sensors or catalytic converters, or vehicle speed or really anything, the software would interface with dozens of other functional areas . . . there is simply no way that this effort didn’t involve a concerted effort by many individuals [emphasis added].”

It makes sense that deception on such a scale and for so long does not take place without an enabling culture, which in turn is nurtured by poor governance.

Indeed, there were also those who minced no words in forewarning about the grave consequences of poor governance at Volkswagen. Back in March 2013, Olaf Storbeck wrote for Breakingviews:

“Management theory and history of other companies show that this [governance] structure is a recipe for disaster. VW’s own story supports this case. In the early 1990s, it plunged into an existential crisis. A decade later, the company was rocked by a compliance scandal, involving prostitutes and luxury trips for the members of the workers’ council.”

Did he say “a recipe for disaster”? Bingo!

Still Not Convinced?

Some of us may still be skeptical that one could anticipate such disasters ahead of time. After all, you can always find some people forecasting catastrophe for some companies based on one reason or another. The future is bound to make some of them look prescient.

The point is that it was public information that Volkswagen had serious issues with its governance. The analysis that was proven right about Volkswagen has been proven right for the right reason. It was, of course, not possible to predict this particular scandal, but it was possible to judge that over the years, the governance issues at Volkswagen would cost its investors — and would cost them big. Analysts could see that coming.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Usman Hayat, CFA

Usman Hayat writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals," and the literature review, "Islamic Finance: Ethics, Concepts, Practice." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. Previously, he was a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP). He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in Development Economics. His personal interests are reading and hiking.

25 thoughts on “The Volkswagen Disaster: Could Analysts See It Coming?”

  1. Mashood ahmad says:

    More recently the culture issue became prominent when the dispute with Suzuki came out. Nobody was paying attention to suzuki’s complaints. I am for one not suzprised. Maybe the analyst were not paying attention to the clues

  2. Mashood Ahmad

    Thanks for visiting the blog and sharing your comment.
    If I have understood you correctly, you are referring to the Volkswagen-Suzuki dispute in which recently arbitrators upheld Suzuki’s request to terminate a 2009 agreement with Volkswagen.
    If I interpret you correctly, you are on the “Yes” side, that there were enough publicly available clues available, and analysts could see the Volkswagen disaster coming.

    Regards

    Usman

    1. subrahmanya swamy says:

      what is needed for general investor community is a continuous alert system for any company with red flags for the potential risk it carries globally like the one followed by FDA with respect to pharmaceutical product for reporting Adverse event.This is the area where regulator needs to work with million eyes & ears wide open to save public & equity market.

      1. subrahmanya swamy

        If I have understood you correctly, you want regulators to help protect consumers and investors from such risk.

        It is an ongoing debate whether we should rely more on government regulation or ethics or market mechanism. Clearly, regulators will only be able to do so much if there is widespread misconduct. I’m afraid there are no easy answers in this debate.

        Regards

        Usman

  3. In hindsight, it’s easier to now relate and say that “yes” analyst could have predicted it easily etc etc, but the cases may or may not be related to the current situation. Every company has gone through some bad phase where there are questions on governance or some slack ceo or some turf with regulators or shareholders or otherwise promoter trying to benefit etc. We get into debate of Good Co or model/Bad Governance or Bad Company/Good governance.

    Every state owned company in Asia or other wise across the world has some governance issues, disputes with suppliers/creditors are common too.

    Nonetheless, you can always count the hunch/gutt feeling in if you can’t find a reason.

    1. Biharilal Deora,

      Thanks for your continued engagement with Enterprising Investor.

      As pointed out in the news items and analysis I’ve quoted above, the corporate governance issues at VW were serious and longstanding, and some analysts were pointing out that they will have serious consequences. They have been proven right for the right reason.

      My view is that based on what we have learnt from the VW scandal, we should be making a case for more rigorous analysis that better integrates corporate governance issues. But I do understand that everyone will not agree to this view.

      Thanks again for visiting the blog and sharing your views.

      Regards

      Usman

  4. Darshsn says:

    @Usman Hayat

    I’m Level 3 candidate and trying to adjust my foot into the analyst industry.
    I’ve always been hearing about the governance compliance and your post turned out to be eye and mind opener that how i should give proper attention to ESG issues of the cos as well. Can you provide some guidance on how to and where to find these kind of information?

    Thano in Advance

    1. Darshsn

      Thanks for your kind comment.

      To learn more about ESG issues in investing, please visit the following page, it provides a detailed list of CFA Institute educational content in this topic area: http://www.cfainstitute.org/learning/future/knowledge/pages/esg.aspx

      Regards

      Usman

      1. Darshan says:

        Thanks a ton Mr Usman for such a prompt reply. Really appreciated.

        1. My pleasure, Darshan.

          I would suggest checking out our free e-course ESG-100. So far, it has received 4.1 stars out of 5 from 62 ratings and a 96% recommend rate. I hope you will find ESG-100 useful and enjoyable.

          Regards

          Usman

  5. Vipul Arora says:

    Usman, it is possibly correct that standard ESG research cannot see such risks coming since it relies on public corporate information.

    However, ‘primary research’ based ESG can see such risks coming. We have been practicing exactly this over last 8 years. And every time we have been asked by clients to apply this primary ESG research to look at specific stocks, we have been able to see risks in advance.

    Examples – $20 Bill Petrobras scandal in 2012, $45 Bill OGX bankruptcy in 2012, 25% drop in share price in GSK since 2013 etc etc.

    Here is a link, describing how primary ESG research delivered alpha in above stocks, ahead of time:
    https://www.youtube.com/playlist?list=PLbeNaMYwn5kccHD16XPrJ4b_X_BHP3kSR

    One caveat though – we have not been asked to do this on 3000+ index stocks that the market mostly tracks. Clearly it is more time consuming and expensive than off-the-shelf secondary research that is easily available.

    Can everyone do this? Definitely. We have freely shared our approach in the webinar link above. Only research needs to give up its focus on quantity and go deep-dive on individual stocks to stand any chance to see risks in advance.

    1. Vipul Arora

      Thanks for reading the post and sharing your detailed comment.

      I do think there is value in ESG research. I haven’t seen all the ESG research on VW, so I definitely do not wish to generalize about how effectively ESG research in general dealt with VW.

      Regards

      Usman

  6. Datamaran says:

    When Datamaran analyzed Volkswagen’s public disclosure over the past 6 years, we noticed VW went increasingly silent on the topic of air emissions. https://www.linkedin.com/pulse/what-big-data-tells-us-volkswagen-public-filings-marjella-alma?trk=hp-feed-article-title-share

    1. Ramani says:

      “Volkswagen is thus one of only two automakers to be listed in both DJSI World and DJSI Europe. . . . ”

      The other automaker on DJSI is General Motors. This has got me wondering if GM is for real!

      1. Ramani

        Thanks for visiting our blog.

        I think one of the worst aspects of such a scandal is that it erodes trust in general, not just in the culprit organization/individual.

        The less trust we have, the less business we are likely to do, the more time and money we spend on monitoring and worrying. Other auto makers are already under scrutiny because of VW. A scandal creates powerful negative externalities, affects many.

        Regards

        Usman

  7. Murat Ünal says:

    Dear Usman. Your question is “Volkswagen’s share price suffered a large decline amid US air-pollution-tests scandal. Can financial analysts anticipate risk of such losses through analysis of a company’s governance and internal controls? “

    We are actually back to the role of environmental, social and governance factors (ESG) as well as the importance of social network related data which should act complementary to financial analysis.
    From a governance perspective what first comes to our mind is the existence of dedicated/appointed board members whose main role is to ensure that ESG aspects are trickled down into the entire organization, across all functions.
    This holistic structure could also include a whistle blowing function to ensure that such breaches are reported back within the organization, potentially even to the supervisory board (i.e. the non-executive directors). One could check for such solid structures as part of the analytic process. If executive managers and non-independent directors ( see also
    http://www.sonean.com/uploads/media/20744_SONEAN_Whitepaper_Feb_2015_en_final_Web_01.pdf ) are socially independent from their executives it potentially adds more credibility to the control function as well. Such cover ups are typically known within a network of strong ties (similar to a cartel) and the probability of defection is increased if you offer people from the network, who blow the whistle, a fair and just process. An internal process to guarantee this would certainly add value. It should also offer the opportunity to communicate externally to an independent entity if the internal process fails. This makes especially sense among listed companies where shareholders are generally detached form professional management.

    1. Murat Ünal

      Thanks for the detailed comment Murat.

      Yes, one thing is for sure that VW did not have the checks and balances in its supervisory board that it was supposed to have, the kind you are suggesting.

      I found a passage in an article in New York Times today, “Problems at Volkswagen Start in the Boardroom”, which, among other things, talks about lack of independent directors. I am copy-pasting from it below.

      “One measure of Mr. Piëch’s influence: In 2012, shareholders elected his fourth wife, Ursula, a former kindergarten teacher who had been the Piëch family’s governess before her marriage to Ferdinand, to the company’s supervisory board.”

      http://www.nytimes.com/2015/09/25/business/international/problems-at-volkswagen-start-in-the-boardroom.html?smid=tw-share

      This was public information.

      Regards

      Usman

    1. Stuart Woollard

      Thanks for reading the post and sharing your comment via Linked In.

      Because your comment, to a significant extent, is an evaluation of my commentary, I need to clarify a few points. To begin with, this is my opinion, not that of CFA Institute. I did not argue that analysis of governance can predict a specific event (emissions scandal) or that it can quantify the adverse impact of such an event. Also, I think the link of governance and culture is obvious and there is plenty that’s been written on this subject. See for instance recent coverage of banking scandals with culture and governance.

      I provided specific examples of “ex ante” publicly available information regarding VW corporate governance problems as well as “ex ante” publicly available analysis based on such information. This is materially different from claiming what some form of human governance analysis might have achieved, had it been done for VW.

      I wish you good luck in your work.

      Regards

      Usman

  8. ingo reeps says:

    did anybody check the conflict of interests of all analysts that covered VW at the time ?

  9. ingo reeps says:

    just an example for current conflicts of interest.: deutsche bank

    Recommendation: Hold
    Last Price at 15 Jul 2016: EUR 116.15
    Target Price: EUR 140
    Market Cap: EUR 61775 (m)

    Company Disclosures (Last Updated 15 Apr 2016)

    Important Disclosures Required by U.S.Regulators
    Disclosures marked with an asterisk may also be required by at least one jurisdiction in addition to the United States. See “Important Disclosures Required by Non-US Regulators” and Explanatory Notes.
    1*
    Within the past year, Deutsche Bank and/or its affiliate(s) has managed or co-managed a public or private offering for this company, for which it received fees.
    7*
    Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year.
    8
    Deutsche Bank and/or its affiliate(s) expects to receive, or intends to seek, compensation for investment banking services from this company in the next three months.
    14
    Deutsche Bank and/or its affiliate(s) has received non-investment banking related compensation from this company within the past year.
    15
    This company has been a client of Deutsche Bank Securities Inc. within the past year, during which time it received non-investment banking securities-related services.
    Important Disclosures Required by Non-US Regulators
    Please also refer to disclosures in the “Important Required US Regulation Disclosures” and the Explanatory Notes.
    1
    Within the past year, Deutsche Bank and/or its affiliate(s) has managed or co-managed a public or private offering for this company, for which it received fees.
    7
    Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year.

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