I’ve always had a soft spot in my heart for Volkswagen (OTC: VWAGY). 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. The company rigged its diesel vehicles to inaccurately report fuel emissions during tests.

In all honesty, my dad’s “bug” wasn’t that great of a car. It had no trunk and a lawnmower strength engine. 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 number of pollutants a car is emitting crosses an entirely different ethical line.

It is relatively easy to calculate the cost of recalling millions of affected vehicles and making the necessary technical correction. However, 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.

What Else Don’t We Know?

Consumers are rightly outraged. If they lied to me about that, then what else might they be lying about? They may also wonder who will be around to service their cars if Volkswagen eventually forced into bankruptcy.

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 are impossible to accurately quantify. I think the same concern 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 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. The long-term economic impact associated with excess carbon emissions is a threat to everyone, not just Volkswagen owners.

Catch a Falling Knife

A lot of investors piled into Lumber Liquidators stock in the weeks following its initial plunge. They were too early. 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 this fraud become known. The company’s CEO indicated during his resignation speech that he was unaware of the fraud. However, 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 Volkswagen – have already seen their share prices adversely impacted. But the winners are not so obvious, as it is less apparent exactly which of Volkswagen’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 their 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.