Could investors have foreseen VW’s failure?

volkswagenThe CFA this week mulled over whether analysts could, or perhaps should, have spotted that VW had an underlying material business risk. The CFA piece argues that VW’s poor corporate governance record should have been a warning indicator on the basis that “Bad governance produces bad outcomes” and that poor governance can help to “nurture” an “enabling” corporate culture.

Is the CFA right? Of course, governance is important in considering long-term value and risk of a business. However, it is only one part of a much bigger organizational ‘whole-system’ that must be understood to really get to grips with why VW ended up with its present failure. Or indeed, whether such an outcome could have been predicted. Poor governance at VW was a warning sign but its link to the risk of employees designing software that masked the true level of diesel emissions is in no way clear. It does not help us to identify the nature of likely risk outcomes, nor does governance analysis allow investors or analysts to quantify it.

At an event in the City of London this week, which discussed how to measure “good” companies, I explained how we rate firms on their ability to manage human capital with respect to material value and risk. It is, of course, increasingly recognized that corporate failures of recent years typically have a human capital management problem as a root cause. So, of course, I was asked how we would rate VW and whether we could have spotted this risk.

Our ratings analysis considers a company as whole system human capital framework (for example, this includes suppliers) and how this plays out in terms of human capital driving value and risk. Our starting point is to measure the corporate value motive (or purpose) and from here we can quickly start to build a picture of why VW employees were driven to behave in the way they did.

For example, as the FT recently pointed out, VW were focused on building scale and overhauling Toyota as the world’s number volume car company. Growth of output and profit can become addictive and obsessive targets, and there are plenty of examples where a skewed purpose towards narrow value outcomes has caused corporate problems and disasters – from Enron to VW today, the world is littered with them. And ironically, while VW chose to chase Toyota, it failed to heed a prescient warning from its competitor’s CEO – that chasing growth in isolation compromises quality and long-term value.

But of course, while understanding an organization’s value motive is critical, we need to analyze much more – whether a company is a true learning organization (e.g. how does it acquire and use knowledge for value? How does it deal with mistakes or operational problems?). Does it operate as a true, whole system enterprise, or on a more fragmented and dysfunctional basis? What are the nature of performance and rewards systems? Is human capital risk assessed, managed and mitigated? How does a company communicate and make decisions?

Our OMI ratings are a benchmark index with which companies can be viewed in terms of underlying value and risk in human capital management terms. Or what we now call Human Governance. And from these ratings we analyze specific companies and sectors to identify key risk and value areas. In short, would we have spotted this specific VW risk? While I would like to think so, this is unlikely. But, could we have identified that VW carried unnecessarily high, material human capital risk that could significantly affect its value? And could we have helped investors and analysts to price this in or to engage with VW leadership to ascertain how this risk may manifest and perhaps be mitigated? Absolutely.