The trial of Ken Lay is upon us. More than four years after pipeline-utility-bullcrap conglomerate collapsed into a $70 billion dollar fraud-riddled industry, it's worthwhile to look back and write about what we have learned following the demise of a company where everything the market believed was wrong.
So here's a list of what's different about investors in the post-Enron, post-WorldCom, post-who's-the-dirtier-analyst world:
All hail the Jedi mind trick
If anything, I think we've backtracked, because now we have Sarbanes-Oxley to protect us. Or maybe stop-losses. Unfortunately, both will be about as much help as a French ally in a time of real Refco- and Enron-style fraud and collapse.
The real reason we're back where we started is that we're still greedily willing to believe. And doubt hurts. That's why when an analyst downgrades, or a journalist or online stock analyst writes something unfavorable, we attack like a swarm of crazed bugs (like the ones from that weird 1975 movie Bug).
Folks bought into Enron because they believed. They believed that a company could generate money from weather futures. They believed that -- although in the rest of creation it took telecommunications companies 30 days or more to get long-haul telecom bandwidth turned up -- Enron, having never competed in the business before against the Sprints (NYSE: S ) and AT&Ts (NYSE: T ) of the world, could turn up a dedicated circuit for you in 24 hours.
Well, I came to The Motley Fool after five years in the telecommunications business, and I didn't believe a word of it.
Yes, you did
Oh, yeah, that's right. I did.
By the way
I hear that Ken Lay's attorneys pressed for his trial to be moved from Houston, where they believed that he would be unable to find a sufficient number of unbiased jurors to give him a fair shake in court. The demon in me hoped that the judge would accede and transfer the trial to another jurisdiction. Like Portland. Nope, nobody up there has heard of Enron. But the realist in me, wanting to ensure that our court system actually does operate under the innocent-until-proven-guilty founding principle, believed that one of two jurisdictions would have been much better.
1. New Orleans. Don't like innocent until proven guilty? Well, they flip that on its head in Loosiana, where they have the Napoleonic Code. Besides, what better way to help the city get back on its feet economically than a long, expensive, high-profile trial that will be covered by half the journalists in the free world, plus some guy from Granma? It's almost too perfect.
2. Alabama. Call this the Dick Scrushy plan. Boosters of the squeaky-clean-according-to-the-criminal-justice-system former HealthSouth CEO have disclosed that they were paid during his trial to show support by sitting in court and planting favorable news stories. I'm not saying this is true. I am saying that I believe it to be true.
All hail David Langford
If you look back at the Fool's content during 2000, you'll find some glowing praise of Enron. Look, we're really sorry about that. In fact, we hope that you never find out that on a radio interview that Tom and David Gardner somewhat jokingly asked the same Ken Lay to come be the CEO of the Fool. Yep, that's buried. You'll never find it. We missed many of the signs, until things started to fall apart. We recovered, but mainly our warnings were met by threats, invective, bile, and questions about who paid us to trash Enron.
One of our guys got it right early. David Langford strolled in from the frozen tundra one day in early 2001 and tore a California energy crisis-sized hole into the story Enron was selling. "They're a market maker," he was paraphrased by me as saying, using passive tense in the process, "in a bunch of random markets where things will become more efficient as trading increases. Why on earth would anyone buy that?" And then he finished the beast off with this:
"Enron just issued another $1.25 billion in debt. Let's see, that's less than $0.7 billion in cash, and now more than $15 billion in debt. Ick. Well, that's one way to expand your business. Why isn't Enron using cash to expand? Maybe because it can't -- the latest net margin came in just below 1%. Double ick."
David didn't find the fraud -- it took Jim Chanos, a hedge fund manager with forensic accounting experience, and a crack Wall Street Journal reporter named Jonathan Weil to really start asking questions.
And guess what, all you "journalists who ask negative questions and talk to hedge funds are totally corrupt" ninnies? Weil had a point. So did Chanos, so did Langford, so did Bethany McLean at Forbes, and so, eventually, did I. (Still feel bad about the telecom thing, though.)
This is not to say that the market isn't beset by corruption .
In fact, we still buy garbage companies
To my mind, there is nothing to account for people plowing their money into hopefests. What Enron should have taught people was that they ought to become a bunch of Missouris when it comes to investing: Companies have to "show me" before a nickel of invested capital is risked on them. Instead, speculators place a burden of proof on companies no heavier than the "Did you pack explosives into your suitcase?" question at the airport.
"Yes! I mean, No!" That's a tricky one.
Wait, they don't ask that question anymore. The point is still the same. Enron took people in and really hurt them because they suspended their doubt, and really, really wanted to believe. Plus, they were getting wealthy as the stock soared, so how could things not have been great?
"Dream a little" is not an investing thesis. "We can turn petrified dinosaur poop into high-grade jet fuel" isn't one, either. And yet, companies with stories nearly that absurd are garnering substantial market interest. Those who buy into them can look forward to the nearly inevitable losses that are coming their way.
The lesson Enron taught me is important: "Doubt saves."
Yes, doubt saves in a way that the protectors of our markets cannot. If you are invested in a company that happens to be a total fraud, no one can restore to you anything more than a tiny fraction of your investment. And yet, whenever one of my colleagues expresses doubt about any one of the, uh, low-probability investments that exist on our stock market, the level of vitriol we receive is too intense to be believed.
Do I think that GlobeTel (AMEX: GTE ) will ever generate appreciable revenues from a dirigible network over Colombia? I find that unlikely. Will KFx (AMEX: KFX ) -- after more than a decade of near-revenueless operations from its clean coal technology -- finally justify its $1.2 billion valuation? Again, I'm doubtful that shareholders will ever see economically beneficial outcomes at current share prices -- just a long, long line of further share dilution through additional secondary offerings.
These companies even have the imprimatur of being traded on one of the three major exchanges (well, the AMEX is nominally major). What, then, must we say of the people who have plowed money into micro-cap penny stocks, many of which don't fully report to the SEC (if they report at all)? I know what I say to them: "Good luck."
The trouble is that the human greed gene seems to have the prudence gene overmatched. Enron was a real company even if, after all of the false representations, it was a pretty average one. (It never generated much in the way of free cash flow and earnings didn't follow a huge rise in revenue.) But its marketing of its stock was phenomenal.
That's the lesson, I think. You'll never see the great companies of the world, the Johnson & Johnsons (NYSE: JNJ ) , the Fastenals (Nasdaq: FAST ) , or even smaller great firms like Hidden Gems selection Drew Industries (NYSE: DW ) market their stocks. They don't put out press releases for events that lack economic substance. They don't address the evil shortsellers. They just execute.
Enron's management was great at convincing people that the company's stock offered the greatest opportunity since the Oklahoma land rush. It didn't. The fact that people continue to bet on hope means that the Enron lesson is sure to be repeated.
Drew Industries is a Hidden Gems selection.
Bill Mann is co-advisor to the Motley Fool Hidden Gems newsletter, the leading source for small-cap stock ideas. A free30-day trialis free. No, really, free. Bill owns none of the companies mentioned in this article.