Editor’s note: This article was first published in October 2014. ‘Almost 14 years ago’ refers to the 2001 Enron collapse, and Energy Future’s bankruptcy filing (April 2014) and the Gowex fraud (July 2014) were recent news when it was written.
When people talk about Enron today, the name may not mean much to new investors, but in its day, almost 14 years ago now, it was a financial scandal of huge proportions.
Fortune magazine went as far as calling Enron one of the most innovative and admired companies in the world. Something similar happened with the Spanish company Gowex, which was held up as an example of Spanish success, with some media describing its CEO, Jenaro García, as the Spanish Steve Jobs.
Still, the Gowex scandal was just a small firecracker next to the Enron bomb.
Both cases lead us to the same lesson for investors: the failure to analyse a company’s fundamentals and to understand how it uses leverage, and the need to follow the trail of the cash.
When we’re about to invest large sums of money in a company, we should make it say those famous words from Jerry Maguire: “Show me the money!” Where the money comes from, how it moves and where it goes.
First, let’s go over the story of Enron.
Enron was a US energy company based in Texas, which grew until it dominated the US electricity industry. But it was much more than that.
Its business spanned broadband, paper, oil and gas, and weather derivatives, among other things. In the investment world, Enron was the most prosperous business of the new millennium. It was the company that had reinvented the wheel and was making a fortune from it.
Unfortunately for the investors who thought they had made a “safe bet”, in 2001 the whole of Enron turned out to be a Ponzi scheme designed to hide the truth: the company was haemorrhaging cash and its profits were a mirage.
As with Gowex, the auditors either had not done their job or were in on it, hiding the truth from investors. Enron’s CEO, Jeffrey Skilling, was sentenced to 24 years in prison.
In any case, given the scandals that have followed Enron, investors no longer place much trust in audit firms, which have shown, at the very least, enormous incompetence when it comes to listed companies.
Follow the money.
Companies create value by selling goods and services at a margin over the cost of production and other associated costs. That surplus generates a positive cash flow, which shows up clearly in a company’s accounts.
That money can be kept in a bank as an asset, reinvested in the business, or handed to investors as dividends.
But companies can also create value through the appreciation of their assets. For example, if a company owns property, its assets can grow as property prices rise, but that would only be an asset on its books.
The use of special purpose entities.
Enron relied on special purpose entities (SPEs), which moved risky assets off the balance sheet to hide their impact on the parent company.
In these circumstances, understanding a company’s consolidated report and following the money becomes a truly difficult task, even for the most experienced investors.
I myself am unable to understand and get to the bottom of the accounts of a company that is deceiving investors in this way.
That said, during Gowex’s heyday, for example, I never managed to understand where the money it made was coming from, when the rest of its competitors couldn’t find a way to turn a profit. But the truth is that I never imagined there was a mastermind behind Gowex falsifying the accounts and lying about its profits.
See also: The Nueva Rumasa affair
If we had said “Show me the money” to Gowex’s balance sheet, we would probably have struggled to follow it. And that brings us to the next lesson.
Information hides in plain sight.
We all have access to the reports of listed companies. For some people they are just figures showing a company’s profits and progress; for others, those figures are a goldmine of “almost privileged” information. That is where real value investing comes in: we should not only interrogate those financial figures, but also compare them with all the company’s competitors and look at how every company in the sector is doing.
Good investors of the calibre of Warren Buffett, Charlie Munger or Bill Ackman can take weeks to analyse a company before investing in it.
In fact, Warren Buffett never invested in America’s company with the most potential (Enron), because it did not meet the standards Buffett demands of a company. Ironically, Buffett made a $2 billion investment in Energy Future, and the company has filed for bankruptcy protection. Not even Warren Buffett is immune to getting the analysis wrong.
The example of Gotham City Research.
If there is one person who knows how to interrogate a company’s financial figures, it is Daniel Yu, the man in charge of Gotham, the investment firm that uncovered “the scam” in Gowex’s accounts. Daniel Yu certainly knows how to follow a company’s money.
But there are more investing lessons.
The stock market is probably the only industry where, if 99 out of 100 people say a company is fantastic and just one person says something is off, we are duty-bound to ignore the 99 and focus on the argument of the one person who sees something wrong. The herd mentality in the market leads even the most respected investment analysts to get carried along by everyone else.
Until you can refute the argument against your decision using your own judgement, you shouldn’t invest in that stock. It’s a way to avoid investment biases.
Likewise, when serious rumours of possible fraud at a company appear, under no circumstances should you take advantage of the falls to buy cheaper until the matter has been cleared up.
Many investors took advantage of Gowex’s falls to buy, swayed by media coverage biased by patriotism that refused to take seriously the firm accusing Gowex of fraud.
When the word “fraud” comes up around a company, we are not talking about a drop in profits or a poor earnings forecast for next year. And in all the years I’ve been following the stock market, the word “fraud” has rarely come up for nothing.
First of all, negative rumours hurt a company in the short term, and in the long term they have to be proven. In any case, the market will temporarily treat a rumour as true in the short term, and in the long term, statistics say that in most cases they turn out to be true.
Further reading
- How Warren Buffett warned us about Gowex
- 19 investing secrets everyone should know before they invest
- It’s not what you buy, it’s what you pay for what you buy
- Warren Buffett’s 16 best investing tips
Featured image: Alex, CC BY 2.0, via Wikimedia Commons.
