Enron and On and On

January 1, 2002

Dear Investor:

The collapse of Enron is no doubt a cautionary tale. But of which caution? To read Gretchen Morgenson’s recent piece in the New York Times would strand readers with the conclusion that no amount of caution could protect against buying Enron. The reality is that Enron-like mistakes will go on and on. But not because the red flags aren’t there; only because most investors are too lazy to look for them.

There were early suspicious moles on Enron’s milky skin: it’s important to recall that Morningstar, even before the crisis, had graded Enron’s financial health a gentleman’s C, far below the threshold for true safety; the balance sheet was already swollen with $13 billion in disclosed long-term debt; and no one really understood how the company made money, including apparently the former CEO (who now appears to be claiming some vague type of mental insufficiency).

One of Warren Buffett’s rules is to follow one hypothetical dollar in and out of a company. If you can’t account for that dollar every step of the way, don’t buy the business. Buffett’s rule would have worked well here. In The Warren Buffett Way, money manager Robert Hagstrom explains how easy it is to trace a dollar through a simple, well-run company. To paraphrase his analysis, we’ll take PepsiCo: you buy a Pepsi at the deli and hand over a dollar. Half the dollar drops in the cash register, the other half gets paid out to Pepsi. A few cents of that fifty goes to investors via dividend, a few get reinvested in the business, and the rest goes for overhead, taxes and to pay for ingredients. This is an oversimplification, but not much of one. Pepsi’s business is pretty straightforward. Enron’s was not. And businesses too difficult to understand are investment accidents waiting to happen.

The other warning was the debt load. Buffett’s favorite quip is that you never know who’s swimming naked ‘til the tide goes out. In this spectacular case, the recession struck, the tide rushed out like a bandit, and Enron was left grasping for a fig leaf. Overleveraged companies have less margin for error. Some will argue that since Enron left its liabilities undisclosed, no one could have ever known the true dark side of the ledger. Perhaps. But if Enron were not already saddled with a large disclosed debt on the balance sheet, it might have weathered its dirty little secret. Without the margin for error that a strong balance sheet provides, what’s undisclosed takes on new meaning. Enron’s thirteen billion, though nothing unusual in the realm of binge borrowing, was enough to sink Titanic, not just a shoddy skiff.

Other clues were the conflicts disclosed in the filings. The Enron 10-K, proxy and footnotes showed a complicated set of partnerships managed by an Enron executive. This alone was not entirely suspicious since many companies are rife with double-dealing, some of which is immaterial. But the reluctance of Enron to fully disclose the liability of these partnerships should have raised a red flag. Other companies have potential conflicts off the books. The First Data Corporation (FDC) proxy (which yours truly was recently reviewing in screening companies for fund investments) reflects that James Robinson III, FDC Director and former Amex honcho, runs a venture capital fund to which FDC has committed approximately $8 million. Is this a conflict? I believe so. Is it material? Probably not, because the extent of the investment is clearly laid out, and the structure restricts liability of FDC to its $8 million. For a company with over $6 billion in annual revenues, $8 million is not material. Investors should always scrutinize the “Related Party Transactions” or the more coyly worded “Certain Transactions” headings on the proxy. In many cases, these sections may as well be retitled “How We Are Screwing You, The Shareholder.”

Very few investors actually scour the filings. Even analysts who read these laborious tomes tend to check their common sense at the door. People bought Enron because it kept going up. But analysts saw bizarre signposts along the way. Some even commented on the “opaque accounting.” But they all exulted “buy” for the same reason they now cry “sell”: because everyone else did. The casual investor in Enron probably never glanced at the 10-K or proxy, let alone the annual report. This all goes to the essential reality that people spend more time researching a washing machine purchase than a stock purchase. Talk about a false economy: they get a tough-as-nails $499 washer and a sorry stock that spin-cycles their thousand dollars into $4.99.

Investors in Enron may as well have led with the infamous pilot’s announcement: “The bad news is we’re lost. The good news is we’re making great time.” Hagstrom tells us that Jack Byrne, the legendary Geico CEO, once quoted this joke in a report to shareholders. Will caution against laziness prevent buying future Enrons? Probably not. There will always be companies that defy the most careful investor. But could anyone have seen this particular one coming? You bet. Any other answer is politely called passing the buck.