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 company.
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 appreciation potential.”
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 ensued.
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 questionable one.
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 you can.
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 wisdom.
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 experience.
