How To Ruin a Company in One Day

Last Updated Jun 23, 2010 6:23 PM EDT

The BP disaster has caused me to think about other ways that big companies could be ruined by one bad day. At first, I thought it would be a difficult exercise. But I pretty quickly came up with all sorts of disaster scenarios for the 10 major industry sectors in the S&P 500. As a good lesson in why you should diversify, I'll run you through a few of them.

Energy. While the risks look so obvious now, prior to the BP disaster, most invesors thought the biggest risk for energy firms was another Exxon Valdez type spill, which would be quantifiable. No one really anticipated a perpetual gusher that floods an entire ocean. But now we can add that to the list.

Utilities. Seems like a pretty stable industry, until you add the word nuclear. One bad afternoon at a nuclear power plant could take down any company. And it doesn't actually have to be nuclear. Think about the east coast black-out that started in Ohio several years ago. Well, just imagine a utility company that someone fries a major power grid for a month or more. If BP is liable for all sorts of consequential damages, a power company could be as well.

Consumer Staples. These companies make things like cereal, soup and syrup. It's a relatively low risk business, until you have some sort of contamination that spreads quickly. I thought I was reaching on this one, until on Friday I read a story about millions of pounds of Spaghettios that may have been contaminated when a meatball machine malfunctioned. Because products are produced in vast quantities and distributed so quickly, one bad afternoon at the processing plant could create massive liabilities for any company if people get sick or die from the product.

Finance. Lehman, AIG, Bear Stearns, Washington Mutual ... Enough said.

Materials. Materials companies are engaged in all sorts of potentially dangerous activities, from high risk processing of chemicals to mining and mineral extraction. It wouldn't take much to create a big disaster. And by the way, we've already seen this. I'm sure you remember the Union Carbide accident in Bhopal, India. That terrible one day event event reportedly killed thousands of people.

Technology. How much risk do technology companies take? Again, at first it doesn't seem like much. But consider any sort of software glitch that leads to a critical systems failure in any company, industry or the economy in general. While technology and software companies claim they're not liable for incidental and consequential damages, let's be reminded that BP's liability was limited by certain maritime laws to about $75 million, and somehow that turned into $20 billion. The lesson from BP is that if the damage is big enough and broad enough, a company can be exposed beyond the disclaimers their lawyers drafted.

Health Care. Most pharmaceutical companies have incurred some form of liability for the drugs they've developed. The real question is could you have a blockbuster liability. Well, Merck ran into this challenge with Vioxx, and I'm sure it won't be the last drug company to be confronted with large liabilities.

You might think that this was a bit of a morbid exercise. But your main job as an investor is to understand how to manage risk and uncertainty. Once you consider these types of scenarios, it leads you to the conclusion that you must diversity.

There's no way to anticipate or predict which company might find itself on the hot seat next week. If you ask them, they all think they're doing a terrific job of managing risks and don't see these types of events as plausible. And I'm sure most of them truly believe they're doing the best they can. But sometimes, bad things happen.

  • If you want to read an interesting book on why accidents happen despite the best of intentions, read Charles Perrow's book, Normal Accidents: Living With High Risk Technologies. Basically, Mr. Perrow helps illustrate how seemingly unrelated and minor malfunctions can combine to create spectacular disasters in complex systems.
Bottom line. All companies are subject to large, sudden and unforeseen liabilities. Protect yourself by diversifying your holdings.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.