Leithner Letter No. 26
26 February 2002

In 44 years of Wall Street experience and study I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever [calculus] is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.

Benjamin Graham
The New Speculation in Common Stocks
The Analysts Journal (1958)

Genius Fails – Again

The $US63.4 billion (according to the assets tallied in its most recent quarterly report) disintegration of Enron Corp., the erstwhile energy distribution and latter energy trading and “market making” concern, is the largest in American history. At its peak and at current rates of exchange, the Houston-based behemoth’s revenues ($US100 billion) were a quarter of the size of the entire Australian economy. Once America’s seventh biggest company, the U.S. Congress, Department of Justice, Financial Accounting Standards Board and others are investigating (or contemplating investigations of) various aspects of its collapse.

In addition to its sheer magnitude, Enron’s demise is in two respects startling (alas, it comes as no surprise that only weeks before its failure became public 16 of the 17 ‘analysts’ who followed the company recommended it to their firms’ clients). First, it was held in far higher esteem than the other massive failed enterprises of the past couple of decades. Indeed, for the past six years Enron was voted by Fortune’s readers as the most innovative company in America; its peers regarded its managers and ways of doing things as first class; and management gurus, financial journalists and others hailed it as one of the up-and-coming great companies of the 21st century. Second, Enron’s failure is harming (and in some instances devastating) far more than the usual number of stockholders, employees/pensioners and creditors. Enron’s failure thus poses disturbing questions. If such a universally admired and seemingly well-managed company can go to the wall, then is any company truly safe? And if a company affecting so many people can fold, then can anybody reasonably expect to escape the consequences of a corporate collapse?

Some Recurrent Debates

The Enron disaster refuels several debates whose reverberations extend to Australia. (An excellent overview of its causes and possible consequences, “What’s Been Learned From the Enron Saga? At the Very Least, These Six Crucial Lessons” by Jeanne Cummings et al., appeared in The Wall Street Journal on 15 January).

One question is whether, to what extent and in what form the accounting profession requires clearer and tougher rules. On the one hand, the larger the corporation the more likely it is to engage a Big Five accounting firm to audit its books; further, corporate disintegration and capitalism’s creative destruction are closely-related phenomena; accordingly, and for a variety of reasons, over time a small number of a Big Five firm’s audit clients will become bankrupt. Yet Enron’s implosion is the latest in a series of incidents since the late 1990s in which global auditing firms approved practises and transactions that, aided by the luxury of 20-20 hindsight, were arguable. Considered as a group, these decisions tended to attenuate the audited company’s liabilities and exaggerate its assets and earnings. In so doing they presented a rosy view of the company’s financial condition – until it suddenly staggered and fell under the load of what were revealed to be meagre profits (or huge losses) and massive debts.

Prominent accountants and firms are quite well unaware of these developments, and aver that changes are necessary in order to combat them. In their view, certain current rules are so ambiguous that they invite incomplete, arbitrary, obfuscatory – and, in the wrong hands, manipulative – measurement of revenues and earnings, declaration of liabilities and contingent liabilities (particularly derivatives) and valuation of assets (particularly intangibles).

Enron’s collapse draws belated attention to two possible causes of these developments. Many contemporary corporations, corporate transactions – and hence much of today’s corporate accounting – are forbiddingly complex. What were never simple but usually tractable and objective concepts are now often hopelessly convoluted and subjective. At the same time, companies (particularly in America) have sought more and more to disclose less and less about their operations. These trends’ combined effect has rendered the transactions and accounts of an increasing number of companies confusing and in some instances (Enron comes to mind) impenetrable. If it is reasonable to infer that this complexity and obscurity will perplex investors, analysts and executives, then it is equally plausible that occasionally it will defeat the best efforts of even the most talented and diligent auditors. The bottom line, then, is that the determination of some companies’ bottom lines is less and less a matter of calculation according to clear rules, and more and more a matter of educated guesswork and subjective interpretation.

Enron’s fall has returned another debate to the fore: some market participants (including a former chairman of the U.S. Securities and Exchange Commission) contend that complex accounts and large-scale accounting lapses are symptoms of a more fundamental and insidious problem. Accounting firms, particularly large firms, often earn at least as much from IT consulting, management consulting and other non-audit services to auditing clients as they do from actual auditing. This, according to critics of the practice, creates a conflict of interest: firms have an incentive to acquire, maintain and extend lucrative consulting projects; further, given this incentive they may tend to succumb to an audited company’s interpretation of revenues, assets and the like, or otherwise interpret rules in a manner acceptable to the audited company.

Lessons for Investors

Much of the description and analysis of Enron’s fall from grace has sought retrospectively to identify, blame and denigrate those deemed responsible for its collapse. Thinking prospectively, what lessons might market participants (re)learn from this episode? Richard Lambert’s article (A Ship of Fools, The Financial Times 15-16 December 2001) offers several suggestions. Among the most important:

If You Don’t Understand What a Company Does, Then Don’t Buy Its Securities

The “Who We Are” section of Enron’s website, whose purpose is presumably to describe the company’s activities clearly, begins “Enron’s business is to create value and opportunity for your business. We do this by combining our financial resources, access to physical commodities, and market knowledge to create innovative solutions to challenging industrial problems. We are best known for our natural gas and electricity products, but today we also offer retail energy and bandwidth products. These products give customers the flexibility they need to compete today.”This passage, precisely because it is so opaque, speaks volumes about Enron. It is CorporateSpeak, a commercial variant of the writing that George Orwell excoriated in Politics and the English Languageand which, particularly the section entitled “Meaningless Words,” is a must-read for those who peruse company reports, press releases and websites.

If a Company Makes a Virtue of Its Inscrutability, and Emphasises Its Intelligence Rather Than Its Frugality and the Amount of Cash It Puts into Its Shareholders’ Pockets, Then Don’t Buy Its Securities

Enron’s “Who We Are” web page continues: “it’s difficult to define Enron in a sentence, but the closest we come is this: we make commodity markets so that we can deliver physical commodities to our customers at a predictable price. It’s difficult, too, to talk about Enron without using the word ‘innovative.’ Most of the things we do have never been done before. ... We initiated the wholesale natural gas and electricity markets in the United States, and we are helping to build similar markets in Europe and elsewhere. Every day we strive to make markets in other industries that need a more efficient way to deliver commodities and manage risk, such as metals, forest products, bandwidth capacity and steel. Our passion has enabled us to manage weather risk. ...”

As you read Orwell’s article, focus your attention upon the section headed “Pretentious Diction.” Peter Lynch’s Principle #3, “never invest in any idea you can’t illustrate with a crayon,” is also apposite (Beating the Street, ppbk. ed., Fireside Books, 1994, ISBN: 0671891634).

Read the Company’s Financial Statements: The Longer and More Boring the Fine Print, the More Careful You Should Be

In recent years Enron’s reported profits seemed to grow impressively. Its ability to generate cash, however, was much less apparent. Further, the notes to last year’s accounts stated that the company would quickly encounter trouble if ratings agencies rescinded the investment-grade status of its long-term debt. Agencies, alas, did exactly this late in 2001; and within days the company faced receivership. Conduct Reality Checks At the beginning of 2001, Enron stock sold at a multiple of more than 60 times its 2000 earnings. In sharp contrast, at that time the stocks of other enterprises that also relied heavily upon trading activities (such as investment banks) generally sold for less than one-third of this nose-bleed multiple.

Enron and LTCM

Richard Lambert also states that market participants should regard warily enterprises that stake their survival upon technologically advanced and unproven ways of doing business. So too, and in much more morbid detail, does Roger Lowenstein (When Genius Failed: The Rise and Fall of Long-Term Capital Management, ppbk. ed., Random House, 2001; ISBN: 0375758259). Not many years ago, Enron was a humble gas distribution company; and until the 1980s the trading of bonds and the management of hedge funds tended to be dull and conservative endeavours. Technology (mathematical finance, masses of electronic data and ever more powerful computers), mountains of credit not backed by savings (a product of lax monetary policy) and a new state of mind (which venerated new technologies, oblique communications and complicated operations, denigrated hitherto-venerable ways of thinking and doing and downplayed the risks which inhere in leverage) did not just transform each industry’s means: they also revolutionised their ends. Whether they constituted necessary conditions for profitable business transactions is an entirely different matter.

Long Term Capital Management, then, was a sign of its exuberant times: it raised far more capital and utilised vastly more leverage than its predecessors; it armed itself with its principals’ theories and models (as well as the conviction that they were virtually infallible); it disdained others and aimed to earn much greater returns than had been hitherto thought possible. Further, it traded not just government bonds but also corporate paper, securitised mortgages and some equities, and conducted risk arbitrage on a large scale. At its apex, LTCM’s models and the genius of its principals were implicitly deemed applicable to virtually any class of security. Similarly, Enron saw itself in confident (and, at its zenith, missionary) terms. It would create all kinds of markets and deliver all kinds of commodities, physical and financial, to all kinds of customers. Electricity, coal, metals, forest products, steel, bandwidth capacity and weather derivatives: here too, the sky was the limit (indeed, nary a year ago its CEO stated that “there is a very reasonable chance that we will become the biggest corporation in the world”).

Two Still-Unlearnt Lessons

In retrospect, what no one (perhaps least of all these companies’ senior executives) seemed to realise was the scale of the risk that inhered in these activities. It is widely and uncritically alleged that greater risk begets larger returns. But in 2000, Enron’s return on capital employed was less than 10% – and it now appears that this figure has been greatly overstated; similarly, Lowenstein reports that even during its best years LTCM’s return on assets was no more than 1-2%. (Its astronomical leverage delivered its eye-popping returns on equity). These organisations’ leaders would have achieved much better results if they had simply left the cash in the bank.

Lambert asks “was Enron’s failure the result of hubris, incompetence or worse? Did it stem from faulty execution of a basically sound business plan, or was the whole model flawed?” The crux of his answer also applies to LTCM: “the company appears to have built its own doomsday machine. It created a financing structure that was critically dependent on [favourable treatment from bankers] and then [maintained itself] through off-balance sheet [manoeuvres. ... While things worked well, the results were impressive. But as a highly leveraged market maker..., Enron could survive only on the goodwill and trust of its financiers, customers and shareholders. When it turned out that those qualities had been betrayed, the company was lost.”

This diagnosis makes sense. Yet Lambert, it seems to me, does not extend it deeply enough. Enron’s rise and fall yields two more fundamental lessons for investors. The first questions the conventional wisdom about the proper subject matter of an investor’s training. Most people think that investment is an arcane, technical and forbiddingly difficult endeavour whose successful pursuit requires a post-graduate qualification and proficiency with higher-level mathematics. Peter Lynch, perhaps the most successful funds manager of the 1970s and 1980s, disagrees: whilst hardly an easy undertaking, “as I look back on it now, it’s obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics. Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage . ... All the math you need in the stock market ... you get in the fourth grade” (One Up on Wall Street, Simon & Schuster ppbk. ed., 2000, ISBN: 0743200403). The second lesson questions the amount of innate intelligence (as opposed to developed diligence and character) required in order to invest successfully. According to Mr Buffett, “you don’t need a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ” (Fortune 1990 Investor’s Guide).

The demise of Enron thus shows that, as it is currently understood, ‘genius’ (i.e., the veneration of arcane theory, convoluted logic, elaborate structures and transactions, pretentious diction and cheap credit; and the denigration of traditional probity, frugality and common sense) has failed. Yet again. What is perhaps most unsettling is that these bastardised characteristics of genius raise no eyebrows (let alone protests) within many business schools and among many businessmen in America, Australia and elsewhere. Mozart’s demonstration that genius and simplicity are near-synonyms finds few contemporary adherents.

In Alan Abelson’s words (Up & Down Wall Street, Barron’s, 28 January), “under [simple] capitalism, you have two cows. You sell one and buy a bull. Your herd multiplies; you sell out, invest the money and retire on the income. With Enron, you have two cows. You borrow 80% of the forward value of the two cows from your bank, then buy another cow with 5% down and the rest financed by the seller on a note, bearing interest at twice the prime, callable if the market cap of your publicly listed company, whose stock you’ve put up as collateral, goes below $20 billion. You sell the three cows to your publicly listed company, using letters of credit opened by your brother-in-law at a second bank, then execute a debt/equity swap with an associated unit, so that you get four cows back, plus a tax exemption for five cows. ... The milk rights of six cows are transferred via an intermediary to a Cayman Islands firm secretly owned by the majority shareholder, who sells the rights to seven cows back to your listed company. The annual report trumpets that the company owns eight cows, with an option on one more. All of the above transactions are cheerfully blessed by your independent auditors, who, of course, served as consultants on said transactions, but only after the fact.”

Given these gilded attitudes and practices, a final disturbing question presents itself: how many other ‘geniuses’ remain undetected? Where, in other words, is The Next Enron?

Chris Leithner


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