How to Avoid the Next Enron

There is a concept known as a "moral hazard," which holds that people who do not believe they will suffer from risky behavior are more likely to engage in that behavior. This makes me wonder.

Because in the aftermath of the scandals at Enron, WorldCom, and Fannie Mae (NYSE: FNM  ) , Congress passed new laws, funded new corporate governance watchdogs, and increased funding to the Securities and Exchange Commission. And lo and behold, the stock market has taken off. Since its 2002 trough, the S&P is up more than 60%. The small-cap-laden Russell 2000 has more than doubled.

Is it because investors feel safer?

Meaningful safety monitors
Now corporations have to comply with Sarbanes-Oxley, and executives are required to certify financial statements. Many believe these improvements have made the markets safer and created a sense of security for U.S. investors.

Check that -- I mean a false sense of security. Just as Mayan mythology talks about the tendency to prepare for the previous menace, the next Enron won't look like the last Enron -- and the improvements that regulators and legislators have put into place will be helpless to stop the next Enron from happening.

Fortunately, you are not helpless in preventing it from happening. Or at least, you're not helpless in limiting the risk that a corporate scandal will harm your assets. In fact, you're the best watchdog there is -- because you care the most about what happens to your money. And your best way to keep from being harmed by the next Enron is to not own it.

There's no surefire way to do this, of course, but companies that are most likely to hose their shareholders do share some traits -- and the ones that are least likely to do so have some commonalities as well.

Pleeeeeeeeeeeease buy our stock!
For example, if you look at the companies that have been embroiled in scandal, one commonality was that management cared a lot about the price of their stock. All the way down, Ken Lay exhorted people that Enron shares were undervalued. Some other companies that have been laid low by scandal, including giants like American International Group (NYSE: AIG  ) and Lucent Technologies (NYSE: LU  ) , famously, savagely attacked analysts and others who questioned the value of their shares. In other words, if short-term share price seems to mean too much to management, it doesn't mean that company is the next Enron, but it is a red flag.

On the flip side, Motley Fool Hidden Gems Tiny Gem Arden Group (Nasdaq: ARDNA  ) has no investor relations department and once told one of my colleagues that the company didn't care at all what we wrote about it -- and he was planning a glowing article! Similarly, Hansen Natural (Nasdaq: HANS  ) absolutely, resolutely refuses to respond to short sellers who have questioned its valuation. This is not the behavior of a company with a management trying to pull one over on shareholders.

Rapid growth doesn't last forever
Back in 1999, someone asked me why Cisco Systems (Nasdaq: CSCO  ) shares couldn't grow by 15% to 20% for the next decade. To me, the answer was simple: Unless the company aggressively bought back shares, something it had never done, such growth implied a minimum valuation of $1 trillion in fewer than five years. As Cisco sits at $110 billion, we can see how poorly it underperformed expectations from its peak. This isn't an indictment of Cisco; rather, it's an indictment of the market.

Many investors are wonderful at overpaying for growth. That's why one of the hardest times for companies is when they start to make the inevitable transition from rapid growth to slower growth -- since they're disappointing so many formerly optimistic investors. So you can see why companies with high expectations are more likely to engage in accounting shenanigans. They need to prop up the price of their stock.

In the late 1990s, MCI -- later WorldCom -- "met" its growth rates through multiple acquisitions. Only when its $120 billion merger with Sprint (NYSE: S  ) hit the rocks did the wheels fall off the train -- a fact of life when questionable management meets eager investors.

The Foolish bottom line
The thing to recognize is that among investors, greed will always trump fear in aggregate, and there will be another Enron. Heck, there will be plenty more. That's why when Fool co-founder Tom Gardner and I scour the market for promising small caps each month in Hidden Gems, we pay particular attention to the quality of the leadership teams at the companies we're analyzing. Not only is quality of management among the top three things that we find in the best small-cap investments, but managers who care more about their company than their stock are also less likely to engage in Enron-type dishonesty.

To avoid the next Enron, protect yourself in advance. Simply avoid the situations where fraud is a possibility and invest in the situations where management is on your side. If you'd like some help finding great management teams, join us at Hidden Gemsfree for 30 days.

Fool on!

Bill Mann is the co-advisor of Hidden Gems , the Fool's small-cap investing service. He owns none of the companies mentioned in this article. Fannie Mae is an Inside Value recommendation. The Fool's disclosure policy predates the collapse of Enron.