Jewish World Review Dec. 12, 2001 / 27 Kislev, 5762
James K. Glassman
Enron's lessons: Be skeptical of experts
LEAFING through a recent
edition of the Value Line
Investor Survey, an excellent
research service with a track
record for prudence and
accuracy, I ran across what
looked like the perfect
Its profits were rising strongly and consistently. It had a solid
balance sheet. Its shares were owned by some of the
smartest money managers in the business. And its stock had
fallen by two-thirds from its high, so it looked like a bargain,
to boot. But that description hardly does the stock justice.
Earnings per share had grown from 9 cents in 1989 to $1.47 in
2000, increasing in every year but one. Average annual profit
growth for the decade was an incredible 29 percent (and
analysts estimated growth of more than 20 percent for the
next five years). Revenue had soared from $14 billion in 1991
to more than $100 billion last year, and Value Line was
predicting that this year -- which would soon be over --
earnings would jump by nearly one-third and sales would
double. The research service gave the company an "A" rating
for financial strength.
As for stock-price decline, analyst Sigourney Romaine brushed
it off: "We think fears are overdone . . . and . . . markets for
both wholesale and retail services are still growing strongly."
She concluded that the shares had "above-average
She wasn't the only professional who liked the stock. Janus,
one of the biggest and best of the mutual fund houses,
owned 5.6 percent of the company's shares by itself, and the
Fidelity sector fund that specialized in the company's industry
made the stock its biggest holding. No wonder. The company
was a powerhouse in an essential segment of the economy,
and its divisions were varied, some traditional, some on the
cutting edge of high technology.
What a stock! You should just be happy you don't own it --
since (as you might have guessed by now) it's Enron Corp.,
the giant natural gas and electricity company that filed for
protection from creditors last week under Chapter 11 of the
bankruptcy law -- the biggest such filing in U.S. history.
Enron once had a market capitalization of $80 billion and
ranked seventh on the Fortune 500 list. Its stock, which
peaked at $90 a share, was trading at $32.76 on Sept. 21,
the date of the release of the Value Line publication. It closed
Friday at 75 cents.
What happened? Enron disclosed that it wasn't making as
much money as it had been saying. While its balance sheet on
June 30 showed $14 billion in debt, the firm owed nearly three
times that figure. Huge liabilities had been shifted to a series
of private partnerships, away from the prying eyes of the
typical investor. On Oct. 16, Enron shocked Wall Street with
a $638 million loss for the third quarter. Next, three weeks
later, the firm announced it had to reduce earnings by an
additional $586 million for the three previous years. Then, in
another surprise, Enron said it faced an immediate payment of
$690 million in debt. The confidence of investors was
destroyed, and, naturally, they dumped the stock. Enron's
chairman, Kenneth Lay, a high-profile friend of President Bush,
tried to engineer a last-minute sale of the company to
Dynegy Inc., a rival, but the deal fell through. Bankruptcy
Enron had a great story: an energy company that, first, was
profiting from the deregulation of electric-power generation
and distribution and, second, had built a huge trading
business, not just in energy (it was responsible for one-fourth
of the gas and electricity traded in the United States) but in
such new-economy commodities as bandwidth. As a result,
while Dynegy, an admirable but conventional natural gas
company, traded at an average price-to-earnings ratio of 15
during 1999 and 2000, Enron traded at an average P/E of 41.
In other words, investors were saying that every dollar of
Enron's profits was worth nearly three times as much as a
dollar of Dynegy's.
But could the average investor have seen through this story
and determined that the company was in trouble? Absolutely
not. Investing decisions, even those made by professionals,
are built on trust. Joe Berardino, the chief executive of Arthur
Andersen, Enron's auditor, wrote last week that the company
had used "sophisticated financing vehicles known as Special
Purpose Entities (SPEs) and other off-balance sheet
structures" that permitted it to "increase leverage without
having to report debt on the balance sheet." In other words,
what Enron did was probably legal. But it was scarcely
aboveboard, and small investors can't be expected to
understand the intricacies of SPEs or complex trading
contracts such as credit-default swaps or the use of
"mark-to-market" accounting. They have to trust Enron to
give them a clear picture of the company's health. This Enron
did not do.
The bad news is that it is easy for corporations to hide
financial shenanigans -- at least until a day of reckoning. The
good news is that, when the day of reckoning comes, the
punishment from the market is swift, sure and delightfully
brutal. Once a company is found to be untrustworthy -- or
even reliably accused of hiding the truth -- I believe investors
should sell its stock immediately. Companies like this are guilty
until proven innocent. Hang 'em, I say. There are 8,000 U.S.
stocks alone to choose from; there's no need to own a
But are there ways for investors to avoid the brunt of a
collapsing stock like Enron? Here's some advice:
Diversify. If a stock like Enron is among only five or 10
stocks you own, then you're in big trouble, but if Enron
is part of a widely diversified portfolio -- as it should be
-- then you can pick yourself up, take your tax loss and
move on. Many Enron employees owned huge chunks of
Enron stock in their retirement accounts. That's a
shame. If your employer falls on hard times, not only will
you lose your job, but your investment account will
suffer as well. Keep your exposure to company stock
down to no more than 10 percent of your portfolio, if
- Understand the business. "Never invest in a company if
you can't figure out how it really makes money,"
venture capitalist Andy Kessler wrote in the Wall Street
Journal. With Enron, it was practically impossible to
know. You might be able to understand the pipeline
business or the sale of energy at retail, but certainly
not the complexity of the trading the company was
doing in such areas as satellite capacity and
video-delivery networks. Warren Buffett, the
super-investor who chairs Berkshire Hathaway Inc.,
makes it a policy not to own stock in firms whose
business he doesn't know well -- and, as a result, he
has stayed away from high technology. I don't think
you need to understand the ins and outs of
programming to own a software company, but you need
to be able to explain where a firm's profits come from.
- Be skeptical of the experts. Wall Street has a herd
mentality. Not only do analysts have a bullish bias, but,
worse, they have a sheepish bias. They don't want to
stand out from the flock. So if a few top analysts start
buying a story, then practically every analyst buys the
story. In the case of Enron, it was a famous
short-seller, James Chanos, who started asking
questions about the company's financial statements.
Chanos, of course, had an ax to grind himself because,
by selling short, he made money if the stock fell. But he
proved an important point for small investors: Often, in
the market, as in life in general, it is better to listen to
non-conforming argument than to the conventional
- Buy people. The personal integrity of top executives is
at least as important as their corporate management
skills. Beware of managers who strut like peacocks or
companies whose corporate culture is braggadocio.
Remember "Chainsaw" Al Dunlap of Sunbeam, the man
who told everyone he could whack any company into
shape? His hubris was his downfall. Conceit often leads
to deceit. Jeffrey Skilling, Enron's CEO until he resigned
in August, "loved nothing more than to mock executives
from old-line gas and electric utilities," wrote Steven
Pearlstein and Peter Behr of The Washington Post, who
also noted that a sign in the lobby of headquarters
proclaimed that Enron intended to become "the World's
Greatest Company." Ken Lay, whom I know personally,
is a more difficult call. He's no showoff, but he either
knew what was happening and should have put a stop
to it -- or didn't know, which is probably worse.
- Beware of financials that look too good. In a business
as volatile as energy, Enron's amazingly consistent
earnings growth should have been a red flag that
someone might be monkeying around with the numbers.
Imperfection is fine in business. Perfection is suspicious.
Finally, however, you have to recognize that events such as
the Enron debacle are part of the risk inherent in investing.
They'll always occur. If you had Enron in your portfolio and
didn't sell it at $90 or even at $10, don't feel embarrassed. As
Alfred Harrison, a money manager at Alliance Capital
Management Holding LP, which owned a ton of Enron, put it,
"On the surface it had always seemed to be a fairly good
growth stock. We bought it all the way down."
Yes, bad things happen to good investors. The trick is to
learn from the
JWR contributor James K. Glassman is the host of Tech Central Station. Comment by clicking here.
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