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A Nation of Enrons

Here's an understatement: We're living through a time of considerable market and economic turmoil. Since we stand to see trillions of dollars' worth of assets vaporize in the ensuing mess, we ought to examine history to see how we got into it, and how investors can get out.

Half a decade ago, the entire nation was shocked when award-winning "innovator" Enron turned out to be little more than a cash-shredding pyramid scheme. The crucial failing for investors was Enron's use of opaque "mark-to-market" accounting. When the market is batty (or doesn't exist), this method lets you instead mark your assets to a model. That becomes a serious problem if the model is wrong, either because you made an error, or because you based it on exceedingly generous assumptions.

In the end, we learned that Enron's accounting was pretty much mark-to-fairy-tale, with the company booking enormous gains from assumed future profits on schemes (like bandwidth trading) that sounded great, but had little chance of producing anything besides headlines.

Andy Fastow, meet Fred and Ethel
You might think we'd learned our lessons about fantasy accounting after Enron, but you would be wrong. Things actually got worse. The infection moved to the comfy-sounding "homeownership" market. Against a star-spangled, feel-good backdrop touting the "American Dream," our recent mark-to-model mania tripped up a lot more than one big company. In fact, it swept through the entire banking world. Fifth Third Bankcorp (Nasdaq: FITB  ) , KeyCorp (NYSE: KEY  ) , and National City (NYSE: NCC  ) were not the first to choke on bad loans, and I'll eat a Miami condo if they're the last.

But more dangerous yet was the way this mania also infected millions of aspiring real-estate moguls. The most widespread mark-to-model fantasies were actually committed not by some easy-to-blame Wall Street suit, but by Fred and Ethel down the street.

Really ...
In Fred and Ethel's model, house prices always go up. They assume you can pay any price for a home, so long as you can make the monthlies with a teaser-rate ARM -- never mind the upcoming adjustment to 9%. In their model, you avoid that via a refinance down the line, with an equity cash-out to boot. In their model, it's OK to buy on a less-than-forthcoming, Alt-A "liar's loan," because there's no real punishment for lying on a mortgage application -- particularly if everyone's doing it. And it makes sense to extract HELOC cash from the home, based on fantasies about continually increasing "equity."

This is not so different from what Enron was doing. Fred and Ethel were marking up the value of their assets (the home) to a model (their belief that real estate prices always go up) and then spending the "income" immediately. This happened all over the country, and millions of people behaved the same way.

Last year's model got ugly
Alas, this "income" wasn't actually matched by real cash flows, just bank loans -- precisely the problem at Enron, but those loans are still out there. Since so many people can't pay those bills, the mortgages are defaulting in huge numbers, and now, we are all paying a price, even those of us who didn't throw our money into a flimsy, overpriced McMansion.

Many stocks have been creamed. The losses at those companies most directly victimized by their own housing-bubble ineptitude are easy to understand. But, of course, the losses have extended much further than that. Once-proud Chico's FAS (NYSE: CHS  ) has been brutalized as its fashion faux pas ran head-on into a rapidly dwindling pool of consumer discretionary spending.

And if consumers can't cough up for flowery, stretchy pants, what's the fate of firms that cater to pricier aspirations? Probably not great, which is why the market pummeled the makers of luxury and leisure items big and small, such as Tiffany (NYSE: TIF  ) , Arctic Cat (Nasdaq: ACAT  ) , and Callaway Golf (NYSE: ELY  ) .

Consumers are spending less, their confidence is at lows not seen for decades, and we appear to be headed directly into a recession, if we're not already there.

So ugly it's cute?
By now, it ought to be clear that I have been, and remain, one of the most vocal econo-bears you will find on these pages. I am certain that systemic failure has steered us into a terrifying run at the ditch, to be followed by a painful, protracted rough patch. Yet I believe history will prove this to be one of the best times to have invested in stocks, especially attractively priced small caps. Here's why:

  • The market is in panic mode, and when markets panic, no one's thinking.
  • Small caps have been crushed more than the rest of the market, as investors seek "safe" large caps.
  • Over time, value-priced small caps produce some of the most amazing returns in the market. Really.
  • There are loads of small caps out there poised for years, if not decades, of fantastic growth, but the market is pricing them as if they are dead and buried.

The not-so dead and buried
Take oven-maker extraordinaire Middleby, down some 40% so far this year, despite a history of amazing returns on equity and capital, and its leading position in a megatrend -- the global move toward dining out. Yes, the uncertainty ahead means a rough ride, and some of the small caps out there won't survive. That's why, at Motley Fool Hidden Gems, we advise opportunistic buying of cash-strong companies, long-term holds, and, above all, a steady temperament.

At Hidden Gems, we're on the lookout  24/7 for solid small caps with the capital to survive the downturn, and the superior businesses destined for major growth once things turn around -- as they always do. In the next issue, we'll be reviewing our recommendations and finding the best bargains for new money.

If you'd like to take advantage of the market's panic and lay the groundwork for some great future gains, a free trial is just a click away.

This article was first published March 20, 2008. It has been updated.

Seth Jayson is co-advisor at Motley Fool Hidden Gems. At the time of publication, he had no positions in any company mentioned here. View his stock holdings and Fool profile here. Middleby is a Hidden Gems recommendation. Fool rules are here.

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