Inefficient Market Theory: The Tylenol Poisoning Case
Shock and fear gripped America in 1982, with news that someone had injected poison into Tylenol capsules. And, they were right to be concerned--seven deaths were attributed to the poison. Investors in Tylenol's maker and distributor, Johnson & Johnson (NYSE:JNJ), were also worried, for a different reason.
How the Johnson & Johnson episode played out is the subject of a second case study in the 2014 book, "Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd." Author Jeffrey C. Hood used the case, along with others, to illustrate how his inefficient market theory worked in practice.
At the time, Johnson & Johnson already had a long history of producing consumer goods, medical devices and pharmaceuticals. Among them was Tylenol, a pain reliever that held a 37% market share in its category. Very quickly, that market share dropped to 7% (in a $1.2 billion market).
The author also reported there was widespread speculation that the company might not survive the event, and its share price swiftly declined by 30%. Hood wrote, "Marketers and news pundits confidently predicted at the time that the Tylenol brand would never recover from the sabotage. There was no precedent to a situation such as this, where a product sold on store shelves had been modified to kill its purchasers."
But contrarian and value investors had a different view.
The variant perception
The first element in Hood's inefficient market theory is "variant perception," which refers to awareness of a gap between market value and intrinsic value. In other words, the market price has declined beyond the point where it matched the intrinsic value.
In this case, wise investors noted that the Johnson & Johnson share price had dropped by 30%, yet Tylenol accounted for only about 15% of its income, indicating that the herd had overreacted to the bad news.
In addition, these investors saw the company take quick and decisive action to address the tragedy and its business. Those actions began with a recall of all 31 million bottles of Tylenol capsules from stores and free replacements to customers who had previously bought the product. When management restocked the product in stores, it distributed only the safer tablets in tamper-proof packaging. It also embarked on an extensive media campaign.
The inefficient rationale
This is the second element in Hood's framework for the inefficient market theory, and it refers to an analysis of the reasons why the crowd is out of touch with reality. It is an investor's explanation of why the market price is wrong, based on a psychological analysis of the "foolishness of the crowd."
In the Tylenol case, Hood began with the overreaction to bad news:
"More particularly, the inefficient rationale would have included a combination of problems with uncertainty, fear and loss aversion. As noted above, an incident such as this had never occurred, and up to that time there had never been a product recall even close to the magnitude proposed by J&J. During a time of such uncertainty and fear, most participants would not have been able to envision the Tylenol brand returning to normalcy."
What's more, the author saw a "mishandling" of the irrational factors pile up and create a "lollapalooza effect," which magnifies existing negative effects. It was enough to trigger panic selling of J&J stock.
A summary
Consensus view: Johnson & Johnson has a serious problem with its Tylenol brand that would shake consumer confidence in the brand and the company. Enough of a problem that the Tylenol brand probably will not recover. Because Tylenol is an important revenue and profit source for J&J, the stock should be severely discounted.
Variant perception: This is a big and diverse company that will face some short-term hardships, but management has dealt with the matter honestly and forthrightly. Consumers will soon resume their old purchasing routines and the brand will recover to at least some degree, as will the J&J share price.
Inefficient rationale: There was fear and uncertainty among both consumers and investors, producing strong feelings of loss aversion. Hall wrote, "Also, market participants are focused on the crisis of the moment, and they are extrapolating the current conditions well out into the future. In other words, many in the market are engaged in short-term thinking, thus preventing them from envisioning Johnson & Johnson operating in a more normal environment once the current crisis has passed."
The contrarians and value investors proved to be right in this case. Thanks to the way the crisis was handled, Tylenol's market share recovered to 30% in the following year. The stock recovered even more quickly, hitting its previous high just two months later. And according to Hood, "If an investor had purchased $1,000 in Johnson & Johnson stock on September 28, 1982, just before the first Tylenol episode, 20 years later, in 2002, he would have had $22,062."
Reporting beyond Hood's book tells us no one was ever charged with the poisonings, but one man was sent to prison for trying to extort a million dollars from Johnson & Johnson. There was no evidence he was the actual poisoner.
All American packaging of over-the-counter medications changed, and the federal government passed anti-tampering laws as a result of the incident.
And, Johnson & Johnson is often used as an example of what companies should do and say in crisis situations.
Conclusion
In this case study, Hood has put meat on the bones of his inefficient market theory. It showed how a wise investor could have ignored the crowd and made a successful investment.
The theory posits that an investor can outperform the crowd by adhering to value investing principles and articulating why the crowd's collective judgment is wrong.
What's new is the author's emphasis on understanding the reasons--mostly psychological, but sometimes also systemic--why the foolish crowd is behaving as it does. Such understanding is like another layer of safety for investors.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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This article first appeared on GuruFocus.
