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Beware the (Business) Butterfly Effect: Navigating Surprising Supply Chain Disruption

Steve Marshall | State Street Corporation

April 18,2019

A half-century ago, MIT meteorologist and mathematician Edward N. Lorenz suggested an intriguing concept:

that a tiny atmospheric disturbance — a butterfly flapping its wings in Brazil, for instance — could eventually help set off a tornado in Texas. Some fans of his idea, dubbed "the butterfly effect," often use it to describe a broader notion: that causal links often exist between two ostensibly unrelated events.

The butterfly effect has become particularly prevalent in the global economy via supply chains. Because it's common for companies to work with suppliers and vendors in different countries, everything ranging from labor strikes to natural disasters in one part of the world can affect whether a service or product is successfully brought to market on the other side of the globe. In addition, supply chain lines are now longer than ever, meaning there may be multiple points of vulnerability in the production process.

"Just picture this big spider web that has these bottlenecks that are everywhere and they're just waiting to be tripped," explained Thomas Kull, a research professor of supply chain management at Arizona State University's W.P. Carey School of Business. "Without something going wrong, it's really challenging to predict where the problems lie."

Surprising supply chain disruptions aren't just a headache for companies — they're also worrisome to investors. Supply chain experts like to cite a 2003 study by researchers from the University of Western Ontario and the Georgia Institute of Technology that reviewed 519 supply chain "glitches" — sudden problems that resulted in production or shipment delays — and found that when those glitches were reported to the public, shareholder value in US equities decreased an average of 10.28 percent.[1]

"[I]rrespective of who is responsible for the glitch or what caused the glitch, shareholders of firms that experience glitches pay dearly," the study's authors concluded.

More recently, researchers from Valparaiso University in Indiana and Pennsylvania State University conducted a similar study, this time encompassing both US and Japanese markets, finding once again that supply chain disruptions "result in statistically significant stock decline."[2] There is also evidence that share price declines can have their own "contagion effects" along a supply chain: In 2017, Australian and British researchers determined that a supplier can experience a crash in stock prices up to two weeks after a major customer experiences its own precipitous price decline. Such crashes can even predict a supplier being delisted from a stock market.[3]

How can investors protect their portfolios from the detrimental effects of supply chain disruptions? As with anything else, knowledge is power. It helps to understand the types of surprise disruptions that might befall one of your portfolio companies. Kull organizes them into several overlapping categories. Disruptions can be manmade — think labor strikes — or nature-made, specifically natural disasters. They can also be a combination, such as IV bag shortages affecting hospitals around the country in 2017, following the devastation wrought by Hurricane Maria in Puerto Rico. While the hurricane could be blamed for IV bag factories temporarily shutting down in Puerto Rico, Kull noted that an IV bag maker's decision to concentrate production on the island exacerbated the situation.

Surprising disruptions can also be distinguished as quality-based or delivery-based. In the case of the former, a small part being produced at substandard quality can have major consequences for the companies that purchase those parts. In 2016, for instance, automakers around the world found themselves in the unenviable position of announcing recalls after learning that airbags sold to them by a Japanese supplier were defective. In the case of delivery-based disruptions, the question is not whether a product is of sufficient quality, but whether it arrives at its destination in a timely fashion, if at all. In 2016, when a major South Korean-based shipping company filed for bankruptcy, billions of dollars in cargo were left stranded at sea as port operators questioned whether they'd get paid for receiving the freighters. Companies that saw their products stuck on the ships included an American information technology firm and a South Korean smartphone maker.

Of course, understanding the nature of supply chain disruptions is only part of the battle; it's key to know when they're occurring in the first place. Yet, for investors, it can be challenging and time-consuming to keep tabs on the news and determine whether any particular event will have a butterfly effect on their portfolios. Investment professionals need to shorten the amount of time between when a relevant story breaks and when they confidently answer the question, ”What's our exposure?” Fortunately, tools (including those that combine machine learning algorithms, natural language processing and human expertise), are available to help them address such concerns.

But perhaps the most valuable thing investors can do is take action before a disruption occurs. It's important to research whether companies are undertaking contingency planning and implementing risk mitigation systems to temper the effects of potential disruptions. Learning which companies have backup plans and which are taking a less proactive approach may factor into investor decisions. At the end of the day, perhaps no company can prevent a butterfly's wings from flapping, but with the right planning, both a business and its investors can weather the resulting storm.

1. Hendricks, K. B., & Singhal, V. R. (2003, October 14). The effect of supply chain glitches on shareholder wealth. Retrieved from https://onlinelibrary.wiley.com/doi/10.1016/j.jom.2003.02.003 © Wiley Periodicals, Inc.

2. Jiangxia Liu, Sourish Sarkar, Sanjay Kumar, Zhenhu Jin, (2018) "An analysis of stock market impact from supply chain disruptions in Japan", International Journal of Productivity and Performance Management, Vol. 67 Issue: 1, pp.192-206, https://doi.org/10.1108/IJPPM-06-2016-0104

3. Qiu, B., Xu, F., & Zeng, C. (2017, November 15). Contagious Stock Price Crashes. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3069993

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Steve Marshall | State Street Corporation

Steve Marshall leads Verus, State Street Global Exchange’s new mobile initiative that utilizes a combination of machine learning, natural language processing, and human expertise to explore connections between world events and user portfolios. As an undergrad, Steve went to film school, and despite now having an MBA with a concentration in finance and the CFA designation, he managed to make it through all four years of college without ever having taken a math class.