The Effect of Product Recalls on Stock Performance (Full Post)

A 2005 statistical study published in the Quarterly Journal of Business and Economics analyzed the security prices of non-automotive recalls following the announcement of the product recall in the Wall Street Journal (WSJ).[1] [2]  The study looked at a sample of 269 product recalls from 1984 through 2003 and reported the mean abnormal returns (MAR) for days surrounding the WSJ announcement date, or the event date.  Because markets often know about the recalls the day prior to WSJ publishing (event -1), it was expected to see a reaction on this day as well, so long as the market had had time to react.

 

The results provide impressive evidence that product recall announcements have a meaningful negative effect on the common stock price of the responsible companies. Our MAR on the day prior to the announcement date (t = -1) is -1.11 percent, which is significantly different from zero at the 0.1 percent level. The MAR is -0.64 percent on the event date (t = 0), which is statistically significant at the 10 percent level.  Approximately, 60 percent of the abnormal returns are negative on day -1 and 55 percent of the abnormal returns are negative on day 0. Pruitt and Petersons results closely parallel our own as they too report a large negative reaction to the recalls on both event day -1 and event day 0.

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Daily mean cumulative abnormal returns (MCAR) for selected event days [show that], except for a slight downward drift on day   -12, the MCARs are comparatively stable during the pre-event period. The negative MCARs begin increasing over the post-event period, hover around 3 percent from day 13 to 36, and decline toward the end of the post-event period. The largest MCAR is -3.55 percent and appeared on event days 19 and 20.[3]

The study found that the impact on stock prices due to a product recall were negative and statistically significant.  However, it also found that, on average, the impact did not last longer than 60 days.  It is possible that this finding is skewed by the fact that 74.3% of sample recalls were from companies with a market capitalization greater than $1 billion, somewhat insulating the effects of a single-product recall.  Smaller companies may see both larger and longer lasting impacts.

The study further analyzed the sample recalls by breaking them into six industry categories:  1) Food/Consumables, 2) Drugs/Cosmetics, 3) Electrical/Electronic, 4) Rubber/Auto Parts, 5) Toys/Appliances, and 6) Miscellaneous.  The study showed that, “The two industries most severely impacted by recalls are the Drugs/Cosmetics industry and the Toys/Appliances industry.” but went on to conclude that, “Overall, the product recall announcements have strong negative effects on all industries and appear to be a wide spread phenomenon in the Untied States.” [4]  

 Although this study is quite helpful in proving that recalls do, in fact, generate negative reactions from the market most of the time, it does not attempt to explain why this reaction occurs, nor does it explain why the market does not always react negatively in statistically significantly meaningful ways.

In an attempt to better explain the relationship between recalls and Corporate Financial Performance (CFP), I reviewed news articles and discussions related to several product recalls, including Mattel’s recent toy recalls.  What I found is that, while the recall itself may be viewed positively by some, the net impact on a company’s reputation tends to be negative.[5]   Interestingly, how a product recall is handled appears to have at least as great an impact on a company’s reputation as does having to issue a recall in the first place.  The negative affects are greatly increased if the company is perceived to have handled the recall poorly or in an irresponsible manner.  According to the 2007 KLD report on Mattel, Inc.:

While some observers praised Mattel for voluntarily informing the CPSC of the product safety problems found in its supply chain in 2007, others criticized the company for not having done so quickly enough. As of September 2007, the CPSC was investigating whether Mattel had issued its recall of Fisher-Price toys the previous month in a sufficiently timely manner. The Associated Press reported that month that Fisher-Price had been fined $975,000 in March for being too slow to inform government officials that one of its Little People toys posed a choking hazard. Fisher-Price had been fined in 2001 for similar reasons.

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The CPSC requires companies to report, within 24 hours, any products that could be harmful. According to the Journal, in a number of earlier recall cases, Mattel had gathered information on potentially hazardous toys for several months before reporting to the CPSC.[6]

While Mattel says that it handled its recalls responsibly, it is not inconceivable that a company, not necessarily Mattel, would delay notification of potential dangers in attempt to avoid or postpone negative financial impact. 

In a 2001 discussion with AIG regarding recall insurance, John Pinner, Assistant Treasure at Mattel, confirmed that product recalls have a negative influence on the reputation of Mattel’s products and alluded to the impact we expect to see on CFP.

Mr. Pinner says Mattel doesn't buy product recall insurance because the coverage doesn't pay for the biggest expense associated with a recall - loss of market share. When there's a recall, ``you lose three things,'' he explained. ``You lose the cost of the recall, which most large companies can afford; the loss of the product; and you lose market share, because people now have some concerns about your products.[7]

Whether or not you believe Mattel acted promptly, studies show that not doing so would only exacerbate market-share losses.  BNet Research showed that, “Even the appearance of a sluggish response can turn consumers against a company.”  The study sites as one example the Firestone tire recall.  “60 percent of consumers believe that Firestone did not act quickly enough. …55 percent will never or likely never buy the brand again.”[8]  

On the other hand, a company that makes the decision to recall a product is not resigned to either bad or very-bad financial results.  A Harvard Business Review article discusses in great detail how companies that handle recalls well can actually protect and even increase their market share:

“If product recalls are handled properly, a company not only can keep damage to a minimum but also may find opportunities to reap unexpected benefits.” … Consider Saturn Corporation and Intel, “in both cases, senior managers quickly confessed their mistakes and sought to make amends with appropriate corrections. Both companies reacted strategically, focusing on long-term marketing implications, and both emerged stronger for the experience.”[9]

In addition to speedy recalls and complete information, other studies have shown that recovery efforts, such as quickly responding directly to a customer regarding his or her concerns increases customer retention rates by 60 percent.[10]

While in general the market responds negatively to product recalls, the effects are due to how the market perceives a company’s ability to retain customers and maintain sales.   The company’s reputation – both as a safe brand and as a responsible company – help drive this perception, and therefore stock performance, surrounding product recalls. 

 

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[1] “An Extension of Security Price Reactions Around Product Recall Announcements,”  Quarterly Journal of Business and Economics, Summer-Autumn, 2005

[2] Automotive recalls are not included because the consistently high frequency of recalls in that industry suggested that their inclusion “would result in significant sample bias.”

[3] “An Extension of Security Price Reactions Around Product Recall Announcements,”  Quarterly Journal of Business and Economics, Summer-Autumn, 2005

[4] Ibid

[5]I will not attempt to prove that reputation impacts CFP in this paper, other than to say that, according to Orlitzky, Schmidt, and Rynes’ meta analysis, “the findings with respect to [Corporate Social Performance] CSP operationalizations suggest that studies that used reputation indices as proxies for CSP showed the highest average correlation with [Corporate Financial Performance] CFP’.” [Corporate Social and Financial Performance, 2003] Therefore, since a product recall affects a company’s reputation, we would expect it to also be associated with changes in financial performance. 

[6] KLD Mattel, 2007, p.22

[7] “Managing product recall risks no child's play for toymakers”, Business Insurance, 2001

[8] Widmer, Lori, “When Your Name Is at Risk”, November 2000, BNet Research Center

[9] N. Craig Smith, Robert J. Thomas, and John A. Quelch, “A Strategic Approach to Managing Product Recalls,” 1996, Harvard Business Review

[10] Amy K. Smith and Ruth N. Bolton, “An Experimental Investigation of Customer Reactions to Service Failure and Recovery Encounters: Paradox or Peril?,” 1998  Journal of Service Research