Operating costs such as internal frictional costs are the bane of any executive accountable for the bottom line. True, they can be cut – usually through workforce reductions – but the long-term effects on surviving employees may include net losses in productivity and even greater internal frictional costs.

Here is good news, executives. There is a proven strategy for lowering internal frictional costs. This is it. Be ethical. Be sustainable. Be safe. And be known for it.

In other words, all you need to do is apply the best practices found in other companies that are superior stewards of their intangible assets – the business processes that lead to reputations for ethics, safety, quality, innovation, security, and sustainability. Companies that follow these practices tend to out perform their peers and better reward their shareholders.

The relationship between these business processes, reputation, internal frictional costs, and value creation are illustrated on a webpage of one of our members, Steel City Re, a leader in risk and reputation management. The latest data affirming these principles comes from Kelly Services, Inc. (NASDAQ: KELYA, KELYB), a world leader in workforce management services and human resources solutions.

According to the Kelly study announced late last month,

Major public issues such as a company’s reputation for strong ethical practices have become critical factors in choosing where to work, even to the point where many employees are prepared to sacrifice pay or promotion in order to work for organizations that are actively engaged in good social responsibility practices. More specifically, concerns about ethical behavior outweigh concerns about the environment by all generations, when making employment choices.

Here are some other key findings:

• Almost 90 percent of respondents say they are more likely to work for an organization that is considered ethically and socially responsible, something that is consistent across all age generations.
• 80 percent are more likely to work for an organization that is considered environmentally responsible, a figure that is considerably higher among older age groups.
• In deciding where to work, an organization’s reputation for ethical conduct is considered ‘very important’ by 65 percent of Gen Y, 72 percent of Gen X, and 77 percent of baby boomers.
• 46 percent of Gen Y would be prepared to forego pay or promotion to work for an organization with a good reputation, rising to 48 percent for Gen X and 53 percent for baby boomers.
• In deciding where to work, policies to address global warming are considered ‘very important’ by 31 percent of Gen Y, rising to 35 percent among Gen X and 36 percent for baby boomers.

Here's the action part. Want to cut operating costs? Ramp up your company’s reputation for ethics, sustainability, safety, etc. Become a superior risk and reputation manager.

Want to know how to do it? Join the Intangible Asset Finance Society. We provide a forum for executives to discover better ways to increase the visibility, transparency, and value of intangible assets. These assets comprise 50% of the average company's value. Click here for information on membership and affiliate with us on LinkedIn.

Thirteen days have now 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. The fund has liquidated about 90 percent of its nearly $3.7 billion portfolio of technology stocks and other securities and will be consigned to history, shortly. 

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.

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.

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 10/1/2009-10/29/2009. The first search was for the pairing of “Galleon and Rajaratnam.” Jim then searched the resulting 112 articles for the additional terms of McKinsey, IBM, or Intel.



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. It is consistent with our general contention 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 yields a p<.03 (statistically significant).

Of the various companies caught up in the Galleon Hedge Fund matter, the headline that caught our attention was from Reuters and exclaimed, “McKinsey shocked by insider-trading allegations.” It has a whiff of Claude Rains, in the role of Captain Renault, expressing shock at the gambling in Casablanca. This is why.

One one hand, McKinsey has strict standards barring its consultants from trading stocks or funds that relate to the companies they are advising, a source close to the company said. The company's partners sign off each year on the policies. On the other hand, according to the Reuter’s story, McKinsey was aggressively recruiting college graduates by offering them new investment options, including getting a stake in a pool of McKinsey clients that gave the firm equity instead of cash for their consulting services. “A slippery slope,” says Lawrence White, a professor at the New York University's Stern School of Business.

McKinsey is looking at headline risk. The Financial Times' Newssift sentiment index reports that for the past week, the 9 article in the business press on McKinsey that included the word reputation were evenly divided at 33% each positive, negative, and neutral giving a positive/negative ratio of 1.0. For the month before the scandal broke, of the 11 articles, four were positive and two were negative for a p/n ratio of 2.0. (For comparison, Johnson & Johnson (NYSE:JNJ), the reputation leader for early 2009, had a one-year p/n ratio of 8.3)

Ironically, earlier this year, consultants from McKinsey authored an article on the importance of reputation management. The article called for substantive business process controls, and highlighted the limitations of public relations. Perhaps this is why McKinsey, so far, has been tight lipped?

Procter & Gamble (NYSE:PG) serves four billion of the world's seven billion consumers with products comprising one of the strongest portfolios of trusted, quality, leadership brands. The have consistently scored in the top tenth percentile of the Steel City Re Corporate Reputation Index. The Financial Times’ Newssift sentiment metric reports that of the 218 news stories mentioning P&G’s reputation this past year, favorable stories outweigh unfavorable by a ratio of 8:1.

Brands are material to the Company. According to the 2009 annual report,

P&G is the brand-building leader of our industry. We’ve built the strongest portfolio of brands in the industry with 23 billion-dollar brands and 20 half-billion-dollar brands. These 43 brands account for 85% of sales and more than 90% of profit. Twelve of the billion-dollar brands are the #1 global market share leaders of their categories. The majority of the balance are #2. As a group, P&G’s billion-dollar brands have grown sales at an average rate of 11% per year for the entire decade.

In view of the above, and with a price to book ratio of 2.7, the lion’s share of the Company’s value comprises superiorly managed intangible assets. We felt therefore it would be instructive to see how this Company discloses its financial risks. In this basic analysis, we looked at the boilerplate blue sky Forward Looking Statement that trails any financial announcement in compliance with the Private Securities Litigation Reform Act of 1995. In our analysis, we looked at the 15 enumerated items that represent “certain factors that could cause actual results to differ materially from those anticipated” by the financial announcement, and we analyzed each to determine if the risk involved a physical asset or an intangible asset (business process).

This is what we found. Of the 15 enumerated risks, 14 centered on intangible asset management. The lone physical asset risk was the Company’s IT system. Among the 14 business process risks, we found three references each to the business processes of sales, marketing and supply chain management. We found two references each to innovation, intellectual property, finance processes, and business processes in general. Last, we found one reference each to brand management, human resource management, and geopolitical risk management. Reputation risk is specifically noted. Interestingly, and consistent with our observation that only risk managers look at the world from a risk perspective, is that the descriptive language of the risks comprised neutral-to-positive managerial verbs rather than disastrous end-state nouns.

From the above, it appears that even in risk management, a superior intangible asset manager such as P&G focuses on executing the business processes that are central to its enterprise value. And given their a 170 year history, perhaps this is their intangible secret to longevity?

Ninety days ago today, on 10 July, General Motors (fomerly NYSE:GM) emerged from bankruptcy. At an auto show this past weekend, Robert Lutz, the ‘new”  General Motors vice chairman of marketing and communications, said, “The world does not realize how great today’s GM products are." Lutz said GM is not afraid to back up those comments. He is heading the team that has started a new “may the best car win” ad campaign, “Our products are equal or superior to the competitors.”

While some members of our Society may know much about cars, as a group we share common interest in the concepts of quality and reputation, and we recognize that communications are an integral step in the process by which stakeholders form impressions that culminate in a company's reputation. In view of Bob Lutz's challenge, we thought it would be interesting to baseline business sentiment in the media covering the Automotive sector. As before, we use use the Financial Times' Newssift engine for the sentiment analysis.

We searched for articles in the business press covering both reputation and one of these five automobile companies: General Motors (GM), Ford (NYSE:F), Toyota (NYSE:TM), Honda (NYSE:HMC), and Daimler (NYSE:DAI). We broke down the data into the 90 days prior to GM's emergence from bankruptcy, and the 90 days following, and using the Newssift engine, sorted articles by sentiment: positive, neutral, or negative. Here are the results.

With respect to business press articles that had a positive angle, GM and Daimler showed little change. Positive articles comprised about 1/3 and 1/2 of the news stories, respectively. Positive articles about Ford and Toyota increased from about 1/3 to nearly 1/2. Positive articles about Honda dropped from nearly 1/2 to less than 1/4, although the total number of articles about Honda in each case, 25, is small compared to the total of 1139 articles analyzed.



With respect to business press articles that had a negative angle, GM and Daimler again showed little change at around 20% and 11% respectively. Negative articles about Ford dropped from 25% to 13%; they rose for Toyota from 13% to 20%. At Honda, they remained the same at 4% which represented only one article for each period. For those of you keeping score in the reputation sweepstakes, the current winner following GM's emergence from bankruptcy is Ford.

 

Turning now to the economic returns over the 180-day period, looking at the chart adapted from BigCharts.com, so far Ford is leading with an ROE of about 70% followed by Daimler at 40%. The S&P500 is up about 20%. As they say in the business, the race is on. And as Bob Lutz says, may the best car company win. Stay tuned.

In the world of intangible asset management and value, there are those who argue that the CEO's reputation is the main driver of corporate intangible asset value. We touched on this a few weeks back in the context of Whole Foods and their outspoken CEO, John Mackey. While we agree that the CEO alone can impact reputation-linked value, the magnitude is often far less than might be expected.

The Chicago Tribune posted a recent story titled: More CEOs cast themselves in company commercials: Corporate commercials: GM, Walgreens, Sprint put executives on the air, but effect is debatable. The short article includes a quote from Jon Baskin who spoke at our 2008 Fall Conference and is worth a read. We thought we would cut to the chase on motivation. The Tribune reports that "GM is trying to resurrect its image after a trip through bankruptcy court and a government bailout. Walgreens is undergoing a marketing makeover as it aims to return to steady profit growth. And Sprint is attempting to stem the loss of subscribers." The two year equity returns, shown below, speak volumes.



In the chart above, General Motors (NYSE:GM) is blue, Sprint-Nextel (NYSE:S) is in red, Walgreens (NYSE:WAG) is in black, and the S&P 500 index is golden yellow. We have looked at both General Motors  and Sprint  in the past and noted significant reputation losses. We have also shown in our forthcoming book, Mission:Intangible, that the business processes driving quality, integrity etc. are the primary sources of reputation value. The role for the CEO is to champion value-creating best intangible asset management practices.

But, fundamentally, we are empiricists, so we'll return in a few months to gauge effectiveness of the "CEO as brand" strategy.

During the 6 February 2009 MISSION:INTANGIBLE Monthly Briefing, Fish & Richardson’s Cathy Reese, who chairs the Society’s IA Corporate Governance Committee, indicated that under Delaware Law, Directors and Officers had a Duty of Care to oversee the management of the business processes that help establish reputation. She noted that absent oversight systems, Members of the Board could be personally liable to shareholders for adverse events that impaired a company’s reputation.

Cathy’s warning of shareholder-driven exposure is just the beginning. Now companies are seeking restitution, too. According to the newspaper Deutsche Welle, after spending nearly 2.5 billion euros to cover legal bills and fines stemming from an international bribery scandal, Munich-based Siemens AG (NYSE:SI) is seeking payments from its former leadership team. Siemens was investigated for paying 1.3 billion euros in kickbacks between 2003 and 2006 to potential buyers in 12 countries, including Italy, Greece, Russia and Nigeria. In Germany and in the United States, the company was found guilty of corruption and ordered to pay combined fines of just over a billion euros. After the 2006 investigation, Siemens then accused some of its former managers of having failed to stop illegal practices and wide-ranging bribery.

It gets more interesting. The Financial Times reports that some of Siemens’ investors have threatened to sue the company if it did not claim damages from its former managers.

The value of risk and reputation management at the board level should be painfully obvious. The consequences of failing to manage a firm’s business processes for ethics, sustainability, innovation, quality, safety, security, etc. – the drivers of reputation – can place officers and directors at great personal peril. Yes, it’s personal.

Financial players are salivating over opportunities in the Food Products sector following Kraft Foods’ (NYSE:KFT) unsolicited $16 billion for Cadbury PLC (NYSE:CBY). According to Kraft’s CEO, Irene Rosenfeld, "We are eager to build upon Cadbury's iconic brands and strong British heritage through increased investment and innovation." Sounds to us like a reputation (brand) and intangible asset (innovation) opportunity.

So now that the sector is in play, we thought we’d look back over the past year and see how our predictions for value creation panned out. After all, when mergers and acquisitions are all the rage, if you are not at the table, you are on the menu.

Our last look at the Food Products sector was April 14 and was motivated by the sudden decline in the reputation standing of the HJ Heinz Company (NYSE:HNZ) as measured by the Steel City Re IA (Corporate Reputation) Index. The Index, which correlates with reputation surveys such as those published by Forbes, Fortune, and Harris Interactive, captures the financial implications of stakeholder behaviors and expectations of stakeholder behaviors as determined by corporate reputation. The Index is a good leading indicator of financial performance and returns on equity.

Six months ago, the top dozen ranked companies in the Food Products sector, according to the Index, included Heinz and Cadbury. Kraft was number 17. Here is our recap of the baker’s dozen with market value as of the close of the markets Friday 4 September before Kraft's announcement.



Heinz, a company that was highly ranked in March 2009 but caught our attention because of a sudden drop in its reputation standing, underperformed the balance of the baker's dozen over the full year with a disappointing -24.5% ROE. Kraft, which lost only 11% over the year, outperformed Cadbury which lost 16.5%.  Firms that had a higher reputation ranking in March 09 slightly outperformed their peers. The correlation between rank and six month return was 16%. The top 12 firms, in a demonstration of reputation resilience, outperformed both the S&P Index and the Food Sector index with a loss, as a group, of less than 1%.

One other reputation note. Kellogg and Cadbury, both firms with strong reputation rankings and exceedingly strong brands, reported quality issues related to melamine and salmonella. We know that the impairment of reputation-linked assets such as quality have brought down companies from all sectors. We wonder, for the record, if business process challenges were responsible for making Cadbury an appealing target?

Note added after original posting:

Comments received after posting from readers of MISSION:INTANGIBLE focused on the relatively short window in which we reported economic results. The readers rightly pointed out that the Food Products sector is a long-term business. Tastes may evolve over time, but the business processes associated with delivering tens of millions of safe, quality meals reliably and repeatedly demand eternal vigilance. Consistency is the watchword, and therefore long-term financial results should be included in any discussion of reputation.

We agree. Below, the ten-year returns of the Baker’s Dozen listed above less Campbell’s soup (CPB) due to space limitations. Highest returns: JJSF; lowest returns shown KFT. The only major Food Products sector firm from our top 12 (sector rankings for reputation as of April, ’09) to underperform the S&P500 (10 yr equity return -20%) was CPB (not shown). Prices not adjusted for dividends.

Copious amounts of ink and countless electrons have been deployed in the debate over the commercial impact of social media. The debate? Yes, there are contrarians such as Jon Baskin, a speaker at our 2008 fall conference, who discount much of the power attributed to social media venues like Facebook and Twitter. While wary, we are slowly being persuaded.

Consider the case of Dominos Pizza (NYSE:DPZ). In late May, we analyzed the affair where employees of a franchisee disparaged Domino’s reputation through YouTube. In short, they challenged the quality of the product. In as much as quality is a life-supporting intangible asset, we saw this as a reputation body blow; and so did a good part of the mainstream business media.

We were wrong. We succumbed to conventional wisdom, when we should have equivocated. After all, the Steel City Re Corporate Reputation Index reported a steady climb in Domino’s reputation ranking for the preceding 8 months indicating the potential for outperformance going-forward, or at the very least, some degree of resilience. The index beat our gut instincts.

In our May 27 note, we compared Dominos to the three highest ranking firms among 47 in the Restaurant sector, Panera Bread Co. (NASDAQ:PNRA), McDonald’s Corp. (NYSE:MCD), and Chipotle Mexican Grill Inc. (NYSE:CMG). To appreciate our error with respect to Dominos, we revisit their economic performance of all four since 11 May, a few days before the YouTube affair.

As shown in the chart pasted from BigCharts.com below, Dominos suffered a 10% market cap drop in the period immediately following the affair (red arrow). Trading volume surged. Then there was a rebound as the Company rolled out an aggressive and effective campaign to restore its reputation. And the metric for success? Its returns beat those of two of the three most highly ranked firms in the restaurant sector from that period.

While many might attribute the rebound to excellent marketing, the Society would posit that Dominos' reputation resilience was evidence of substantive business processes that drive quality, and a communications effort that allowed stakeholders to appreciate its value.

What are those quality processes? They are systems that improve managerial motivation, provide time for managerial oversight, and technology that enhances quality while reducing opportunities for adverse human intervention - malicious or otherwise.

Dominos' greatest reputation risk lurks in an among the employees of the franchisees. Its strategy to mitigate that risk comprises two creative HR-focused processes. First, it requires that every franchise owner be 100% committed to the business -- no outside (distracting) revenue opportunities. Dominos wants the fortune of its franchise owners to depend on the success of the franchise. Second, it provides vertically integrated dough manufacturing and supply chain systems that allow the franchise owner to dedicate more time to human resource management rather than engage in “back-of-store” activity typical of the industry. Then there is innovation and technology. Dominos is constantly innovating process and system improvements to increase quality: the efficient, vertically-integrated supply chain system described above, a sturdier corrugated pizza box and a mesh screen that helps cook pizza crust more evenly; and the Domino’s HeatWave® hot bag, which was introduced in 1998, that keeps pizzas hot during delivery.

In summary, Dominos showed reputation resilience because it understands that its value is tied to the quality of its product. Dominos also showed that it understands well that its reputation for delivering a quality product can be protected through business processes and systems.

Several months ago, we took a look at ethical pharmaceutical companies on the occasion of a publication by Ethisphere magazine that ranked the "most ethical companies." We now revisit those companies on the occasion of the formal announcement that Pfizer and a subsidiary have agreed to pay $2.3 billion to resolve criminal and civil claims stemming from the illegal promotion of certain pharmaceutical products (read, unethical behavior).

The Society is interested in the economic value of business processes that support intangible assets such as ethics, innovation, sustainability, etc that stakeholders percieve as reputation. Companies reputed to be more ethical, the Society suggests, will reward shareholders with above average returns.

In our 1 May MISSION:INTANGIBLE posting, we noted that the reputation ranking of Novartis (NYSE:NVS), as measured by the Steel City Re Corporate Reputation Index, was superior to Eli Lilly (NYSE:LLY), whose index ranking, in turn, was superior to Pfizer (NYSE:PFE). We noted, however, that Pfizer’s ranking appeared relatively stable while Lilly’s ranking was drifting down rather quickly.

In our experience, firms with superior reputation rankings as measured by the Steel City Re Reputation Index outperform their peers. Those with declining reputation indices tend to underperform their peers. We therefore expected that going forward, Novartis would outperform Pfizer, and that Pfizer would outperform Lilly. The stability of the reputation index data for Pfizer suggested that stakeholders had already factored the alleged ethical breaches into their respective assessments.

Yesterday’s announcement provided an excellent test of our expectations for economic behavior going forward from 17 April (4/17).

The data, summarized above from a Big Charts graph (pasted below), confirm the forecast we made based on the Reputation Index. From the period beginning 17 April (when we ran the index data for the 1 May blog note on these companies) through yesterday, Novartis rewarded its shareholders with a 29% return on equity. Pfizer rewarded its shareholders with an 18% ROE, and Lilly disappointed its shareholders with a ~0.5% gain.