Read all about it! How to learn just
how stable a company is
When a mighty tree like Enron falls,
the whole forest shakes. Shell-shocked securities analysts scurry
for cover, nervous corporate bean counters scramble to update their
overhead slides, pension fund administrators pass the smelling salts
and giant banks speed-read their portfolios for any signs of undiagnosed
All have ample reason to be alarmed. Not only did
the sudden collapse of the nation's seventh largest corporation
wipe out a significant number of 401(k) life savings, but coming
on the heels of the tech stock tumble and global economic recession,
it left the rest of us seriously reconsidering the mattress as our
best investment option.
"The timing of it was awful," says Louis
Thompson Jr., president and CEO of the National
Investor Relations Institute. In less than two years, millions
of investors watched a go-go market make a not-so-soft landing.
Many people lost in the neighborhood of 30 percent on mutual funds
or 401(k) investments. The result: a consumer confidence crisis
the likes of which few of us have ever known.
"I think this is the closest environment to 1929
that we've had since then," says Al Hartgraves, senior associate
dean at Emory
University's Goizueta Business School in Atlanta.
The market will recover in time, but right now the
average shareholder is nervous. Where can you invest? Who can you
trust? And how can you protect your portfolio from "Enronitis?"
Put both hands on your wallet and read on.
The emperor's new clothes
Remember the tale of the Emperor's new clothes? The fall
of Enron is roughly the point in the story when the little boy points
and laughs at His Royal Highness in his skivvies. Everybody else
-- well, they saw what they wanted to see.
Thompson places much of the blame on the stock analysts.
"How in God's name do you have 16 of 17 analysts maintaining
'buy' ratings on Enron almost to the week it declared bankruptcy?
I mean, come on!" says Thompson.
and Exchange Commission also played a role in the mess.
"The SEC is really feeling a lot of pressure
at this point," says Hartgraves. "I think the SEC had
dropped the ball in terms of putting pressure on the accounting
profession to deal with the standards problems, and then they hadn't
done a good job in terms of reviewing Enron's financials."
Just what exactly should have been spotted in those
financial reports? And now that we've seen Enron in its underwear,
can we trust the information published by other public companies
feeling a similar squeeze in these lean times?
Finding the good stuff
Investors typically learn about a prospective investment
through materials generated by the company itself: a stock prospectus,
a quarterly or annual report or the 10K report that public companies
with more than $10 million in assets or 500 shareholders must file
with the SEC.
Typically, these reports contain a mix of hard financial
data and more interpretive information that places a company's performance
in context. The latter is normally found in the introductory chairman's
letter and toward the back in the Management Discussion & Analysis
section, or MD&A, of a 10K.
"The MD&A is designed to give the investor
the top executive's perspective on the company. If you had a chance
to sit down with the executive and talk to him about the financial
statement, what would he probably tell you that's not in the financial
statement? That should be in the MD&A," says Hartgraves.
Let the reader beware
Just as typically, when times get tough, it is not uncommon
for the interpretive material to diverge slightly from the hard
reality of the numbers, says Karl Groskaufmanis, a partner in the
Washington, D.C., law firm of Fried, Frank, Harris, Shriver &
"I don't think that it is nefarious or a reflection
of someone trying to hide something," he says. "I think
there is an element of human nature to it that the disclosure requirements
are trying to overcome."
Corporations, like people, tend to shout the good
and whisper the bad, especially about themselves. Rest assured,
the SEC will be taking an extra-hard look at MD&A spin when
those 10Ks arrive on its desk this month.
"Oh, you better believe it," says Thompson.
"Moreover, the SEC has laid out the kind of things a company
must affirmatively report in a current report instead of waiting
for the periodic reports or the quarterlies. Get it out like now!"
Reading between the lines
Even when difficulties aren't spelled out, here are warning
signs that a company's financials may be headed in the wrong direction:
- Frequent restructuring.
- Increase in non-recurring
profit relative to recurring profit. If the percentage
of the total profit that comes from non-recurring (one time) transactions
goes up, that's a flag.
- Decline in cash flow-to-profit
ratio. "If cash flow starts deteriorating and profits
do not deteriorate as fast, that is definitely a negative sign,"
says Hartgraves. "That's what happened at Enron. Enron had
huge amounts of cash flow in the year 2000, $4.8 billion, and
profits of about $1.2 billion. But beginning in the fourth quarter
of 2000, they started sort of manufacturing profits through these
special-purpose entities but they weren't generating a lot of
cash and their cash flow started declining significantly. Anybody
who was looking closely at their cash flow last year certainly
would have seen things coming."
- Anything that will
adversely affect a company's debt rating with S&P, Moody's,
etc. This includes return percentages, gross profit margins,
income margins and debt-to-equity ratio. "You want to look
for two things: changes over time and how their numbers compare
within their industry," says Hartgraves. "Anything that
is likely to weaken your debt rating is likely to weaken your
stock price. If they're going in the wrong direction, it's time
to consider bailing out."
Rising above the data
Reading between the lines of the MD&A may take a bit
"If they're using language that sort of skirts
the real issues, if they're talking in very glowing, but vague,
terms, there might be reason to be concerned," Hartgraves says.
Look for some new players to start showing up in the
near future, too.
"There is more attention being paid now to related-party
transactions with someone who happens to be either a director, a
director-nominee, an executive officer or a 5-percent shareholder,"
says Groskaufmanis. "Those disclosures are going to be more
The experts continue to stress investment basics,
such as proper asset allocation and portfolio diversification. These
days, it also helps to stay up on local, national and even international
news. If possible, subscribe to trade journals that deal with the
industries in which you are invested. And check the filings of similarly
situated companies. They are updated weekly on the SEC's EDGAR
Now that you know where to look, will it bolster your
confidence in the companies you are entrusting with your nest egg?
"For people who've been burned, it's going to
take some time," Thompson admits. "If you haven't been
burned too badly and you're more or less invested for the long-term,
it may be a shorter time of winning it back. You hate to see an
Enron happen, but I think what Enron is going to result in is a
much more transparent marketplace.
"The flip side of that is investors are going
to have a lot of information, much more information than they can
digest. Nonetheless, it's out there and that's what's important."
Jay MacDonald is a contributing
editor based in Florida.
-- Posted: March 22, 2002