With a click of the mouse that wasn't divorced from reason, thousands of investors bought into the largest company blowup in American history. We easily could have, too.
We could have easily purchased Enron (OTCBB: ENRNQ) at any point between 1998 and 2001. In 1999, we hosted a nine-month study of energy stocks. Before the study even began, Enron was the company that many readers, perhaps a majority, suggested we purchase.
When our study ended without a purchase because we didn't understand the industry well enough, many readers again suggested Enron. They pointed out that Enron was different from your typical energy business and was growing rapidly.
So it's easy to see why tens of thousands of investors decided to invest in Enron's stock.
Enron was large and, despite what Lucent (NYSE: LU) taught us, most of us still equate larger companies with investing safety. Enron was growing rapidly. Analysts and the media lauded the company. Finally, Enron represented diversification for many investors whom were heavily weighted in tech companies.
One big lesson
Thousands who purchased Enron made a single large mistake that most of us have made before: They didn't understand the company's three financial statements to a high degree of comfort. Those are the income statement, the statement of cash flows, and the balance sheet. There is no way that they could have understood them. Even company executives now admit that they didn't understand Enron's financials.
If you can't see clearly how a business's money circulates through its three financial statements -- clearly enough to explain it to others -- you're better off not investing. In such scenarios, if you make money, it's luck, and when you lose money, you usually won't understand what went wrong since you didn't understand the financials in the first place.
Lacking financial understanding, most Enron investors rationalized the purchase: "Sure, its numbers are confusing and the business sort of is, too, but look at the stock go. And everyone loves the company. I want in on this giant."
Who hasn't made this mistake, raise your hand
I used the same logic to justify similar action, but even worse, I did it in a book. Perhaps the only part of The Motley Fool's Investing Without a Silver Spoon that I wrote and really dislike lurks in the chapter about choosing companies.
When buying stocks, the chapter advises seeking a long history of sales growth, predictable earnings, competitive advantages, new opportunities and so forth. Knowing that the book was meant for beginning to intermediate investors, I then listed some of my favorite companies: Johnson & Johnson (NYSE: JNJ), Intel (Nasdaq: INTC), Pfizer (NYSE: PFE), Coca-Cola (NYES: KO), some others and… Lucent Technologies (NYSE: LU).
Lucent? What is Lucent doing there? I've never praised Lucent in this column. In fact, I've written that it's difficult to understand. However, I felt that the book needed another great technology leader that offered a Drip, and in March 1999, Lucent seemed to be one. The stock was up more than 600% since its 1996 debut and -- gasp, I can't believe I put it in the book -- it traded at a 90 P/E.
I rationalized adding Lucent to the book the same way that many investors rationalized buying Enron. It was a quickly growing company that everyone owned and praised. "Hey, good enough for me."
I've learned: Never again. Never again buy or praise something just because it is large, is loved by most, and is rapidly growing. (JDS Uniphase (Nasdaq: JDSU) had fit this bill, too.) Size isn't always security, widespread praise that borders on love is a warning sign, and rapid risers, like rockets, have a greater chance for something to go wrong and blow up.
You need to dig into a company's financial statements and understand why (or really if) a business is truly growing, how it will keep growing, and look for any warning signs that it won't. Warning signs were present with both Lucent and Enron. Lucent had ballooning inventory and accounts receivable, which the Fool warned about, and Enron -- as one big warning sign -- wouldn't release a timely balance sheet (a balance sheet for goodness sakes) and was defensive about inquiries.
Had we bought Enron
Our earliest investments are often our most important because that money has the most time to compound.
In our case, we bought Intel and Johnson & Johnson first. So far, both are performing well. Had we bought Enron first instead, we probably would have lost everything we put in it. Our portfolio would be down about 25% after four-and-a-half years, instead of being up more than 20%. We probably would never recover from that to reach our 20-year goal, which is 15.5% annualized returns.
That's right: Just one early mistake could have made our goal unreachable. This emphasizes how careful investors in individual stocks, including modest Drip investors, need to be.
Conclusion
It's very hard to protect against fraud, and what happened to honest Enron shareholders is a literal crime, but understanding what you're buying is a giant first step toward protecting yourself, and is a step that no investor should skip. If you won't do the homework necessary, buy an index fund and rest easy. For only with true understanding does there come a much greater chance of investing success and an avoidance of trouble. From Lucent, Enron, and others, hopefully we recognize how this equation works:
Your Level of Understanding = Your Long-Term Investment Success
If you need to learn how to truly analyze financial statements -- and learn in a friendly way -- consider the Fool's new seminar on financial statements.
Investing Without a Silver Spoon isn't the only book Jeff "I was wrong" Fischer has written, but he doesn't have any misgivings about his recent book of fiction. He owns the stocks in the Drip Portfolio and those listed in his profile. The Fool has a disclosure policy.
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