Contrarian investors should stay tuned to developments at Wesfarmers Ltd

The announcement by the Australian Competition and Consumer Commission (ACCC) that it has instituted proceedings in the Federal Court of Australia against Coles Supermarkets, owned by Wesfarmers Ltd (ASX: WES), didn’t affect the share price on the day it was announced. However, the seriousness of the allegations shouldn’t be dismissed.

The ACCC is alleging that Coles utilised a strategy to boosts its earnings at the expense of its suppliers. Amongst the ways that the ACCC alleges this occurred was via introducing ongoing rebates to be paid by suppliers to Coles. The ACCC believes that if this did occur then it would be in contravention of the Australian Consumer Law.

The ACCC used its compulsory statutory information gathering powers to collect evidence against Coles. This means that suppliers have given evidence on a confidential basis so there is no way of knowing if any ASX-listed suppliers have given evidence or been affected by the alleged activity. However it’s hard to imagine that at the very least mid-tier suppliers to Coles such as dairy manufacturer Bega Cheese Ltd (ASX: BGA) and frozen goods supplier Patties Foods Limited (ASX: PFL) have not been questioned during the process which has been ongoing for two-and-a-half years.

The “headline risk” which greets investors reading about Coles could at the first instance lead some shareholders to consider selling their shares, concerned by the potential risk of a large damages payment and perhaps switch into the perceived safety of peer Woolworths Limited (ASX: WOW). While a monetary penalty is indeed a real danger, it is important to keep the possibility of a one-off fine and other measures in perspective should Coles be found guilty of the allegations.

A more robust decision on whether you should buy Woolworths and sell Wesfarmers would be based upon the appraisal of each company’s fundamental valuation incorporating the new information regarding the ACCC’s actions.

Foolish takeaway

Interestingly, when legal claims against a company occur, a shareholder’s first reaction may be to sell. This can appear an appropriate action to take given the potential for an adverse outcome. In reality it is common for the market to overreact and assume a ‘worst case’ scenario, while ultimately something much less extreme than initially thought eventuates. Under these conditions a sell-off in a stock due to a hazy near-term outlook can in fact create a long-term buying opportunity for contrarian investors.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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