Are You the Next Enron? (March 2002)

Wynn Quon

That was the tongue-in-cheek headline in the humor magazine, The Ironic Times. It was making fun of "Enronitis" after the disastrous scandal and collapse at what used to be the seventh biggest corporation in the U.S. While we recover from the shock, some historical perspective comes in handy.

The fact is that every bull market fosters devil-may-care accounting, double dealing and larceny. How about that innovative energy firm that grew like gangbusters but turned out to be using massive leverage and off-balance sheet accounting? Enron? Them, too, but there was also MidWest Utilities. This massive conglomerate founded by Samuel Insull created the American power grid in the 1920s. After the 1929 Crash, it faced the equivalent of a giant margin call. It turned out Insull’s empire was built on massive debt. The company collapsed overnight. Insull took the easy way out and fled to Europe, while thousands of his investors were wiped out.

Whether it was the Japanese bull market of the 1980s (which produced dozens of corporate scandals including the Nomura Securities fiasco), the North American bull market of the early 80s (which gave us Michael Milken and Drexel Burnham Lambert), financial mischief is part of the stock market cycle. John Kenneth Galbraith had a word for the large amount of undiscovered wrongdoing that accumulates during a bull market. He called it the "bezzle". So, if you want to become a battle-hardened investor, don’t forget the bezzle!

While the politicians stepped in and pilloried the culprits, the talk is about tightening regulations. Will this mean a future repeat is impossible? Not a chance. As long as there’s smart people of high ambition and low moral fiber, the danger remains. We can tighten auditing rules but in the end do you know what the best auditor is? A recession. When stock prices plunge, loans get called. People who are owed money suddenly want to get paid. Anyone who’s built a house of cards gets to speak into a microphone before Congress.

Is it possible to avoid the Enrons, the Nomuras and the Drexels? Not always (diversification says hi!). But sometimes, you’ll see smoke before everything goes up in flames. With Enron, Fortune magazine blew the whistle in March of last year. (This took a lot of guts because they had previously anointed it as a no-brainer stock to hold for the next decade.) There were others who were also on the ball like shortseller Jim Chanos. On the other hand, retail stock analysts were mostly clueless. Some brokerage companies maintained their buy ratings on the stock even after the collapse was underway. The lesson: when you’re investing in a stock, seek out contrary opinion. This is difficult. One of the psychological pitfalls we’ve talked about in previous columns is confirmation bias. We often become so dazzled with an investment, we stop hearing bad news. This is doubly true if it’s been doing well: there’s no stronger opiate than a rising stock price.

Perhaps the biggest sign of trouble at Enron was the sudden resignation of CEO Jeff Skilling last August. There are times when you want to get out of a stock, and there are times when you want to get the heck out of a stock. If a CEO resigns after only six months on the job for "undisclosed personal reasons", it’s time to get the heck out.

Market Outlook

In our January column we spoke of the danger of a false rally. This appears to be coming true as markets have retreated in February. I’m still pessimistic. My operating scenario is "50% of 50%". In the next 12-18 months, I see a 50% chance of a 50% fall in the markets. That means a drop in the Dow and the TSE to 5000. The main reasons are the unsustainably high market P/E ratios and the historically high levels of consumer and corporate debt.

The S&P P/E ratio according to First Call is 24.7. In the past, such a level means that stock market returns suffer badly. What makes the situation worse is this: First Call uses pro-forma numbers in calculating the P/E. Pro-forma is an accounting finagle that tries to ignore "one-time" events. Unfortunately, it’s also being widely abused to gussy up corporate results. If you use standard accepted accounting practices the actual market P/E is almost 40. (I wish I could run my life on a pro-forma basis. I could punch my noisy neighbour in the nose and get away with it, because hey, it’s a one-time event.)

Corporate debt in relation to GNP or profits is now at a record high in both America and Europe. Same for consumer debt. So far the debt burden hasn’t felt heavy because of the huge increase in stock market and real estate assets over the past decade. But here’s the catch: Stock market and real estate assets can fall in value while debt doesn’t. (This is exactly the hole that Enron fell into.) At some point, high debt levels will put the economy into reverse and it can happen quickly through a series of rippling bankruptcies and defaults. One of the possible trigger points is on the other side of the world – Japan. While Enron has grabbed most of the headlines, it’s Japan’s financial crisis which poses more of a threat. By the time you read this, some of this concern should already be starting to emerge. One underreported and unsettling story is the 60% plunge in Japanese money market assets in January. Investors sold in panic after several supposedly safe money market funds suffered serious losses from Argentinian and Enron bonds. This is not the best portent for another upcoming event in the Japanese financial system. In April, the government will be lifting its blanket guarantee on bank deposits. The resulting jitters could result in turbulence all around. Look for gold and gold mining stocks to do well.

High-Tech Portfolio

After much thought, I’ve decided to sell our Intel holding. The reason: the PC industry has turned from a growth industry into a cyclical one. But Intel’s P/E ratio and price-to-sales ratio doesn’t reflect this. We’re going to keep its competitor AMD because it’s a cheaper stock though certainly more volatile. Over the five years we’ve held Intel in the portfolio it has appreciated 40%. We also recommended a partial sell of the stock in March 2000, when it had zoomed up 125%. It’s time now to move on to greener pastures (...well, less brown ones at any rate). So long, Intel, and thanks for all the chips.

We’re going to do some more hedging by buying Microsoft January 2003 US$40 Put LEAPs for $1.50. Microsoft is seen as the Teflon stock, untouched by the slide in technology stocks. But its P/E of 55 reminds me of Cisco’s last year. Microsoft is not immune to a slowdown and its X-box game platform will be siphoning cash for a while. Add on the cyclical PC software market and I think it’s about to have a rude awakening.

Our JDS Uniphase Put LEAPs expired in January, so they’re going to be taken off the list. They turned out very well with a return of 370%. Note that the big returns in our specialty list hide the fact that these are high-risk speculative instruments. Many options expire worthless. I’m using the Put LEAPs as insurance against a strong chance of a market decline, since they rise in value when the underlying security falls in price.

Investing web site of the month: www.bylo.org. This is run by Bylo Selhi and it’s one of the best independent Canadian investing sites. What I like are the links to interesting articles that are updated every month on subjects ranging from mutual funds, index investing, market myths and so on. Of recent note: a link to a CBC "Disclosure" news story about how business TV shows hosted by the likes of Garth Turner and Diane Francis have accepted fees to promote the companies they profile on their programs without disclosing this fact to viewers. Oh yes, if you’re in the mood for a smile, read Bylo’s disclaimer at the bottom of his page.

Wynn Quon, MBA, Chief Technology Analyst, Legado Associates, 410 Bank Street, Suite 204. Ottawa, Ontario K2P 1Y8 wynn_quon@hotmail.com

Canadian MoneySaver, PO Box 370, Bath, ON K0H 1G0 613-352-7448 - Published March 2002

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