As considered here, the allegations of Walmart violating the US Foreign Corrupt Practices Act (FCPA) presents an interesting opportunity to watch the Shleifer Effect in play.
It's about three days since the news broke. The market reaction has remained pretty tame with Walmart down about 6.5 percent (to about $58) from its Friday close. True, that's $15 or so billion in value disappeared, but that's for a company sporting a $200+ billion market cap. And while it puts WMT near its lows for this calendar year, let's remember that Mr. Market was pretty down on the business just several months ago when it traded below $50 per share. A 6.5 percent drop is big for a single day, but it's not beyond the sort of fluctuating price range most fundamental investors might expect from Mr. Market's typical fickleness. Per the Shleifer Effect, it doesn't seem to indicate a wholesale change in the way most investors view the business. In other words, it would be hard to argue that the news has stoked an overreaction bias.
When considering the Shleifer Effect, not all news is created equal. Let's say there are two categories of news. You have first order news, the kind that suggests to owners that their thesis for investing might be wrong and a new (negative) trend might be taking hold. This information might say that sales are slipping or expenses increasing or the market is not as strong as hoped or competition has an edge...basically, anything that gives the investor reason to believe the earnings trend points down instead of up.
First order news is more likely to generate a change in "conservativeness bias", creating a belief in a new trend taking hold, and instigating an overreaction.
I would suggest that first order news is either a.) a story or piece of information that gives the market sufficient reason to believe that earnings will be affected or, b.) earnings themselves coming in below expectations.
Then there is second order news. While this might be salacious or disturbing, it's ambiguous about how or whether it affects the actual prospects of the business. Investors take notice of it, but they don't necessarily change their views on the prospects of the business itself.
The NY Times story seems to be second order news when it comes to the Shleifer Effect. It has certainly grabbed people's attention, but the market response (so far) suggests investors are willing to wait to see whether the alleged FCPA violations actually affect Walmart's business fundamentals in a meaningful way.
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As a current investor, my initial thoughts on the potential impact of the news are as follows (in order of magnitude):
1. Walmart's International Growth Suffers
Not only will corporate management become entangled in the legal and PR aspects of managing this crisis, but the in-the-trenches guys will be considering their own practices in a different light.
As suggested in this Business Week article (here), Walmart has relied heavily on its international division to produce earnings growth while US performance has been sluggish for a few years. I can easily see a scenario in which international managers go into CYA mode, becoming so conservative in their business practices that they sacrifice growth opportunities.
Let's hope that the Mexico thing represents the extreme version of international managers pushing the envelope in the name of growth. But I have no doubt that plenty of other managers are aggressive, stepping deep into the gray zone of ethics as they attempt to hit ambitious expansion targets.
I think it's reasonable to expect that executives throughout the corporation perform a quick review and start slashing practices that might attract any attention from investigators that start poking around, no matter if they're illegal...if it's in the gray zone, it's out. This could affect the number of new store openings, a critical driver of growth.
I don't think we would know anything more about this until we read Walmart's announcements on the performance of its various divisions. So, we wait and see...
2. Walmart's Senior Management Goes Through Widespread Shake-Up
The NY Times article claims that many of Walmart's senior executives were made aware of the activities in Mexico and elected to cover up the problem rather than self-report to the Department of Justice. It implies CEO Mike Duke, who had management responsibilities over Mexico operations in his role at the time, was briefed on the violations.
(Somehow Doug MacMillon, current CEO of Walmart International, escaped mention in the article. That's a little baffling especially given his rising star within the company.)
If true, it's hard to see the current regime of executives surviving the investigation. Walmart is under the firm control of the Walton children (who have nearly 50 percent ownership and much more say than all other investors), and I don't see them allowing a wide assault on the reputation of their business without going to the bench to promote a new group of managers.
Expect a shake-up with ensuing disruption. While I'm inclined to want continuity in operations and management (give their strategies a chance to develop), I suspect the Waltons and other investors would not be heart-broken to see the current regime leave. Their performance has not exactly been stellar, most notably when it comes to U.S. same store sales growth, a division that Eduardo Castro-Wright attempted to overhaul after he was promoted from Mexico to run the U.S. (Castro-Wright failed in this attempt and was demoted in 2010 in favor of Bill Simon.)
The shake-up would likely create optimism for the stock provided Walmart has the right managers in waiting that are both immunized from the scandal and capable up stepping-up.
3. Walmart Is Punished and Subjected to Historic FCPA Violation Fines
Here is the area where we can expect the greatest speculation. Business Insider has already put together a scenario (here) in which Walmart would have to pay out a fine in excess of $13 billion.
I have no relevant experience here to make even an educated guess at how this plays out with the DOJ. But I'll try anyway.
I think it's fair to assume that politics will get nasty and regulators will look for their pound of flesh, hoping to make an example out of Walmart. That being said, it's worth noting that the biggest penalty to date under FCPA has come from Siemen's AG at $1.6 billion. Perhaps Walmart would end up paying higher fines, but I would suspect the DOJ would get what it could and not risk trying to extract such a high penalty that it risks Walmart goes nuclear in fighting back. Would DOJ risk going for something too high and watching Walmart choose litigation over settlement? I would assume they are reasonable and get the guaranteed money for the US Treasury.
Still, what's the effect? First, the process is likely to take a long time (as noted below by Mike Koehler of FCPA Professor in his thoughts here on what we might expect for Walmart's near future as a result of these allegations):
...the information revealed in the Times article is likely to be a long and costly exercise for Wal-Mart and certain of its executives. Wal-Mart’s statement over the weekend indicated that it already is conducting a world-wide review of its operations and such “where else” investigations frequently uncover additional problematic conduct...This world-wide review will take time and for this reason FCPA scrutiny of the type that Wal-Mart is currently under is likely to last 2-4 years.
Second, the fine will be a one-time thing. With Walmart losing $15 billion in market value, one could easily argue that investors have already accounted for its penalty (and then some). That's wishful thinking, of course. But with $24 billion in net cash provided by operations last year, we can feel safe that even a large penalty doesn't threaten the ongoing health of Walmart.
It's hard to imagine that a one-time event that might happen two or more years in the future can be properly discounted now. However, when expectations about its price tag get more settled, it is the sort of thing that could create a short-term hit to Walmart's price. We'll watch it then.
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And so we call the NY Times story second order news. It puts everyone on alert, and it probably means most investors will be paying a lot more attention to Walmart's earnings announcement over the next several months to see how/if the Mexico scandal is bleeding into operations in a broader way.
We will continue thinking about our own investment in WMT, watching those earnings carefully to see if they produce a Shleifer Effect overreaction and create another buying opportunity for long-term investors.
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