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Volkswagen Hits a Wall

I’ve always had a soft spot in my heart for Volkswagen, ever since my father drove a VW “bug” when I was a kid. So it was with sadness that I heard the news this week that Volkswagen has been engaging in fraud by engineering diesel vehicles to inaccurately report fuel emissions. 

In all honesty, my dad’s “bug” wasn’t that great of a car; it had no trunk, a lawn mower strength engine, and you had to crawl over the front seats to make it into the claustrophobic back seats with windows that only opened a crack. But it rolled, and it was the first car I ever used to take a girl out on a date in high school (after she insisted I first clean it out since my father wasn’t exactly a neat freak).

It’s one thing for an automobile manufacturer to fudge on its fuel efficiency – that happens periodically, most recently to Hyundai – but lying about the amount of pollutants a car is emitting crosses an entirely different ethical line.

While it is relatively easy to calculate the cost of recalling millions of affected vehicles and making the necessary technical correction, there is no way to accurately estimate the punitive damages that will be assessed by regulators. Also impossible to measure is the damage done to the company’s credibility, and how that will impact future sales.

Consumers may ask themselves: If they lied to me about that, then how do I know what else they may be lying to me about? They may also wonder who will be around to service their cars if Volkswagen eventually goes out of existence as a result of this crisis.

The reaction in the stock market was swift and severe. In the two days following the announcement, Volkswagen’s share price dropped by more than a third. That is similar in magnitude to the damage done to Lumber Liquidator’s share price in the days following its revelation last February that some of its flooring products manufactured in China contained excessive levels of carcinogens. In an article I wrote in the aftermath of that episode (“Lessons Learned from Lumber Liquidators”) I warned that the future legal ramifications of that degree of corporate malfeasance is impossible to accurately quantify, and I think the same applies to Volkswagen.

For that reason, I caution against buying Volkswagen stock until the full extent of its potential legal liability becomes known. The good news is that unlike faulty airbags or malfunctioning brakes, this sort of issue does not endanger the lives of drivers or passengers. The bad news is most countries will view this as a more serious transgression given concerns over global climate change and the long term economic impact associated with excess carbon emissions.

A lot of investors piled into Lumber Liquidators stock in the weeks following its initial plunge, only to see its share price shed another 50% of its value over the next five months. I have a feeling the same may happen in this situation as the seamy details of exactly how a fraud of this magnitude managed to remain hidden for so long. Although the company’s CEO indicated during his resignation speech that he was unaware of the fraud, it is difficult to imagine that it could have been propagated to that extent without the knowledge of the senior management team.

From an investment perspective, this scandal will result in a number of stock market winners and losers. Some of the obvious victims – namely, suppliers of parts and materials to VW – have already seen their share prices adversely impacted. But the winners are not so obvious, as it is less apparent exactly which of VW’s competitors will gain the market share it loses.

Some investors may feel uncomfortable trying to profit off of this type of event, but that is the beauty of capitalism. Companies that can beat its competitors by being smarter and more innovative (without cheating) are rewarded, while those that can’t are penalized. Yes, it’s a brutally Darwinian approach to allocating capital, but it is also the most effective form of ensuring continued economic growth.

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I am amazed that VW did so well prior to this incident. People loved the Beetle in spite of its shortcomings and VW also sold successfully the larger fastback, squareback, and microbus. All of these used air cooled engines. When in the 1970s, they began to make liquid cooled engines, they experiencd a great deal of trouble. The early water cooled engines in the Rabbit, Dasher and Scirocco had numerous problems, not the least of which was the tendency to pop out a freeze plug unexpectedly, resulting in total loss of lubricating oil and catastrophic engine failure. Warranty repairs consisted of installing a rebuilt engine that could have the same problem. It did for a car my employer owned. Once the warranty ran out, the cost of repair was about half the original purchase price of the vehicle.

In addition, quality control on the rest of the vehicle was terrible. A group of Rabbit (later called Golf) owners filed a class action lawsuit. An acquaintance allowed his Rabbit to be repossessed, in spite of a hit to his credit rating, because it cost so much to keep the car running. My Dasher (the forerunner of the Passat and at the time, the top of the line) had over 40 defects in the first 45,000 miles including a broken timing belt, improperly built rear brakes that physically broke from metal fatigue, need for a carburetor rebuild, every dashboard air vent falling apart (including a replacement), the window crank handle braking in two, the carpet wearing out, the upholstery turning into what looked like black corn flakes, every piece of chrome trim on the exterior falling off, and a fire in the dashboard as a result of the heater control circuit board burning up. By 70,000 miles, when I sold it for $200 (it had cost $4400) to a repair shop for parts, it had racked up an additional dozen or more problems including needing a second carb rebuild and having the fitting on the carb that the fuel line attached to come loose (it was apparently never welded when the car was built), spraying gasoline all over the engine compartment. Fortunately, the engine was cold so it did not catch on fire as some other VWs did.

More recently, their quality control improved, but it was nowhere near the standard of Japanese or some American cars. So there really was not much of a reputation to damage except for the luxury image of Audi and performance image of Porsche which many people will likely not even relate to VW as a company.

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