TCS Daily


Investing After Enron

By James K. Glassman - September 2, 2005 12:00 AM

Reading Kurt Eichenwald's fascinating book on Enron Corp., "A Conspiracy of Fools," is enough to make an investor throw up his hands (or his lunch), sell all his stocks and buy a bundle of nice short-term U.S. Treasury bonds.

Eichenwald shows, in vivid detail, how Enron executives used every trick, legal and illegal, to display healthy, rising profits each quarter. The business itself meant little to these manipulators. A lust for sexy earnings reports drove the company. Even dispassionate professionals were fooled. At the conservative and independent Value Line Investment Survey, an analyst wrote in late 2001, after Enron shares had already fallen sharply: "We think fears are overdone... and... markets for both wholesale and retail services are still growing strongly." She concluded that the stock had "above-average growth potential."

The smart folks at Fidelity's energy sector fund made Enron their largest holding. Janus was so high on Enron that its fund managers owned 5.6 percent of the company's stock. The truth was that Enron, which once had a market capitalization of $80 billion and ranked seventh on the Fortune 500 list, was bankrupt. Its stock, which had peaked at $90 a share, slid to $32.76 at the time of the Value Line pronouncement, and a couple months later to less than a buck.

How on earth could an amateur investor discern the true value of Enron? Or of WorldCom, a company whose fraudsters registered billions of dollars in operating expenses as capital investments, thus boosting profits in the short term?

Have corporations mended their ways since the scandals came to light? Don't count on it. American International Group, the giant insurer, on June 1 issued a new financial report restating five years of results and knocking $2.3 billion off net worth. Among the adjustments: AIG improperly counted tax credits, to the tune of $731 million, as net investment income, "a measure closely watched by insurance-industry investors," according to the Wall Street Journal.

But don't despair. There are ways to invest intelligently even in a market of deceivers. Here are some guidelines:

Diversify. Only a few businesses are crooked. Realize that, in most cases, you won't be able to identify them, so your best protection is to own lots of different companies, so if one or two disintegrate, your losses will be small. If you own 30 stocks, equally weighted in your portfolio, then even if one of them goes to zero, you are out just 3 percent of your total assets. Be sure to rebalance your holdings every year, so that a few stocks that have soared don't become large chunks of your holdings.

Consider broadly based mutual funds. In January 2001, Enron represented just 0.5 percent of the value of the Standard & Poor's 500 stock index, a good proxy for the U.S. market. For owners of S&P index funds, the vaporization of Enron was barely noticed.

Beware the "Beautiful Line." Business is choppy by nature; some years are great, others terrible, through no fault of management. While it's natural to be attracted to companies whose earnings rise in what I called a "Beautiful Line" -- increasing by, say, 10 percent year after year - you should to be skeptical of such outstanding performance. It could be a sign of cooking the books. Making adjustments (delaying purchases until the next fiscal year, for example) to produce smooth profit growth can be perfectly legal, but eventually it catches up with a company, and earnings (and, thus, share prices) can drop unexpectedly.

Don't obsess over earnings. Use alternative data when you can find them. American Express (AXP), for example, publishes key numbers in its annual report that have nothing to do with conventional financial statements but which may be just as valuable. For instance, the number of credit cards in force jumped from 35 million in 2002 to 40 million in 2004; 90-day past due loans on cards dropped over the same period from 1.3 percent to 0.9 percent.

Buy dividends. Earnings exist on paper, but dividends are real dollars. In 2002, when I was asked by a congressional committee to give testimony on "how to protect investors against another Enron," I advised ending the double-taxation of dividends in order to give companies an incentive to increase their payouts, which are the most transparent evidence of profits." I said this would be the "most important legislative step that can be taken to protect shareholders." Since then, the tax rate on dividends has been cut to 15 percent, and payouts have indeed increased.

A recent report by Bernstein Investment Research and Management noted that "stock prices are volatile, as investors' expectations of the future are often whimsical in the short term" -- and frequently driven by quarterly earnings reports. "Dividends, however, are not based on investor perception; they're based on a company's actual operations and available cash -- so they tend to change much less radically than stock prices." A Bernstein study found that companies that paid out more of their earnings to shareholders outperformed those that paid out less -- by a wide margin.

Several mutual funds specialize in companies that increase their dividends regularly and substantially. One of the best is Franklin Rising Dividend (FRDPX), which for the three years ending June 2, 2005, returned an annual average of 9 percent, compared with a 3 percent loss for the S&P 500. Among the fund's top five holdings are Roper Industries (ROP), which makes scientific measuring equipment and has doubled its dividend since 1997; General Electric (GE), the finance, manufacturing and media conglomerate, which has raised its dividend for 29 consecutive years (now yielding 2.5 percent); and Family Dollar Stores (FDO), a discounter that has increased its payout from 7 cents to 35 cents since 1992.

But can an investor tell by looking at financial statements that a company is fooling around with its numbers? Sometimes. And, as with dividends, you should focus on the real dollars. Cash is king.

When firms trumpet their quarterly earnings, they report their profits according to the accrual method of accounting -- basically, commitments they have made to spend and deals they have made to sell. Accrual accounting gives chief financial officers and their underlings a lot of leeway since they can make guesses about things like restructuring charges, stock options, bad debts and pension expenses.

What's the alternative? Cash flow. Look at the money that actually goes in and out the door. Economists long ago concluded that the value of a company today is determined by its cash flows in the future. But "most studies find that [accrual] earnings do not predict future cash flows," says Baruch Lev of New York University, one of the best accounting minds in America. It is cash flows today that tend to predict cash flows in the future.

All publicly traded companies produce what's called a "consolidated statement of cash flows," which you can find on the Form 10-K that's reported to the Securities and Exchange Commission or on free websites like Yahoo Finance. For example, in 2004, American Express earned $3.5 billion under the accrual method. But its cash from operations came to a whopping $9.1 billion after adding back non-cash expenses like depreciation, loss provisions, increase in the value of Travelers checks and other items.

The next big heading in the statement is "cash flows from investing activities." Some of that money goes to buying buildings and equipment while some goes to investments in stocks and bonds. The third category of a cash-flow statement looks at financing activities, like redeeming or increasing loans. These figures are far less important than operations -- although heavy debt is a bad sign. In the end, Amex produced a net cash flow of $3.8 billion in 2004, up smartly from previous years.

Investors who paid attention to cash flows might have discovered something amiss at Enron, where reports showed that earnings were impressive but cash was a serious problem. Even more obvious was WorldCom. It was treating operating expenses as though they were capital expenses ("investing activities"). For accrual purposes, operating costs come off profits immediately while capital costs reduce profits over many years. But, for cash purposes, capital costs come off immediately. WorldCom was bleeding cash.

Analyzing cash flows isn't easy. But there are shortcuts. Value Line includes a "cash flow per share" figure in the annual statistics it presents on thousands of companies. You can use such numbers to verify that a Beautiful Line of earnings is not bunk. For example, Johnson & Johnson (JNJ) has been increasing its earnings powerfully and consistently -- with cash flows rising at double-digit rates at the same time. Between 1990 and 2004, earnings increased from 48 cents to $3.10 per share; cash flow, from 65 cents to $3.84.

Value Line also provides a weekly list of the biggest cash-flow generators. Topping the charts in mid-August were NVR Inc. (NVR), a homebuilder; Medicis Pharmaceutical Corp. (MRX), maker of specialty drugs for acne and the like; and Westwood One (WON), radio programming, with cash flow that's tripled in past 10 years.

Manipulation and fraud are part of the investing game. Yes, they increase risks, but, after all, as an investor, you get paid handsomely to take such risks. Stocks, after all, have returned an annual average of 10.4 percent since 1926, about twice as much as Treasury bonds. You don't get double-digit returns without taking some chances.

A version of this article originally appeared in Kiplinger's Personal Finance. Of the stocks mentioned, Mr. Glassman owns General Electric.

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