Enron Debacle Says It's Time to Reassess

Sure, this was an unusual situation. But being more careful can keep you out of these pickles.
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Can we learn anything from the

Enron

(ENE)

debacle? Yes. An event of this size always makes me say, boy, I've got to be more careful next time. But there are some other things to consider:

  • No one's invincible. When Enron was trading at $84 back in the first quarter, the company appeared unstoppable. But in reality, folks, no company is indestructible. The fact is, no one knew just what risks were involved in Enron's stock, because no one could really decipher their books and say exactly how their business was doing. So even when a company appears to be hugely successful, don't buy it until you understand exactly how they're succeeding.
  • Big names won't save you. Arthur Andersen is undoubtably a fine firm, and an overwhelming majority of its many partners and employees do all they can to keep their clients' books in order. But mistakes were made in the Enron case, and Andersen and its partners will have to take their lumps before regulators. Last month, for instance, Enron was forced to restate its earnings going back several years; apparently the company failed to properly book profits and losses from relevant third-party transactions. Andersen apparently signed off on quarterly reports in which many of its suggestions, which would have cut profits substantially, weren't adopted by the company. Having the name of a Big Five firm on the audit report makes shareholders feel better, but this case makes you wonder why.
  • Ignore the sell side. Sure, many analysts are good at what they do. But a few are driven primarily by the prospect of attracting future banking relationships, while others simply neglect to do their due diligence. And the overwhelming majority probably never knew substantially more about Enron's finances than you did, which is a scary thing if you're looking at these guys' work for recommendations. To wit, up until a month ago the average sell-side analyst figured that Enron would earn $1.81 a share in 2001 and $2.10 a share in 2002. Those numbers look a tad high now.
  • Never assume. Enron investors assumed that a combination with Dynegy would provide the company with the liquidity it needed to survive, and that such a deal would contribute markedly to Dynegy's bottom line. But Dynegy backed out after deciding it couldn't rely on Enron's books. The upshot: Even if a deal looks like a no-brainer, something could easily come along and thwart the transaction.
  • Too much of a good thing is bad. Beware of companies that grow too rapidly. You know how your mother used to tell you, If something looks too good to be true, it probably is? Well, that advice can be applied to investing as well. The lesson: When times are good, look for what can go wrong. Remember, every company has a weakness. And the smart investor will identify a problem before it surfaces.

In short, always assume that there's something you don't know. Most companies don't have the kinds of problems Enron had. But you should plan ahead and be ready to cut your losses when the situation starts looking bleak. How bleak? Well, you have to judge your own risk tolerance to know for sure. But one thing is certain: It's much better to ask the tough questions before you are really uncertain of the answers.

In keeping with TSC's editorial policy, Glenn Curtis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Curtis welcomes your feedback.