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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 risk.

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.

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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.

The Securities 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 & Jacobsen.

"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 more intuition.

"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 pronounced."

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 Web site.

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

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See Also
10 retirement plan warning signs
Don't put retirement eggs in one basket
Quiz: What's your real risk tolerance?

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