Lessons From Enron
It's only when the tide goes out that you find out who has been swimming naked. Since the economic tide went out in March, two large frauds have come to light: Lukin Coffee and Wirecard. This isn't unusual. Frauds tend to cluster at the end of the business cycle when investors take off their rose-tinted glasses.
In the spirit of learning from the mistakes of others, I revisited Enron's rise and fall. I discovered that Enron's story, as told in pop culture, is wrong. It's not the story of an evil genius conspiring in a dimly lit conference room. The real story is scarier.
The real story involves smart and energetic managers sitting besides their lawyers, auditors, and bankers, all the while believing that what they're doing is right. Yet what they did turned out to be one of the largest frauds in history.
Like most companies, Enron went bankrupt slowly and then suddenly. It slid down a slippery slope to its demise. Incentives slowly overcame the traditional system of checks and balances and created an unstoppable positive feedback loop. Enron's market value peaked at $60 billion and ended at zero. At the time, it was the largest US bankruptcy ever.
Incentives
Unusual incentives produce unusual results.
One of Enron's unusual practices was to fire the bottom-performing 15% of its employees annually. This created an eat-or-be-eaten culture with a "what have you done for me lately" mindset.
Another unusual practice for a company like Enron was marked-to-market accounting. Marked-to-market allowed Enron to realize all of a contract's projected profit upfront. For example, to value a 20-year contract to deliver natural gas Enron would make an assumption about its cost of natural gas in each year. These assumptions would determine the contract's profitability, and this profitability would directly impact the next quarter's earnings.
Enron's "what have you done for me lately" culture encouraged dealmakers to use rosy assumptions that produced larger profits and earned them bigger bonuses. Officers and Board members never held dealmaker's feet to the fire if contracts subsequently underperformed. RAC, Enron's internal risk-management department, were yes men with no real veto power.
Without checks and balances, Enron grew rapidly. But it didn't produce much cash. To fund itself, it needed to borrow.
Positive Feedback Loop
Capitalism is designed to put capital to its most profitable use. Lenders and investors avoid companies earning little to no profit, which limits those company's growth. This is a healthy negative feedback loop.
Enron used off-balance-sheet entities to avoid this. It exploited accounting loopholes to keep debt off its balance sheet. At bankruptcy Enron reported $10 billion of debt but actually owed $38 billion. Remarkably, this accounting was technically legal even though it deliberately mis-represented reality.
Auditors are supposed to ensure accounting represents reality as closely as possible. However, the incentives proved overwhelming. Arthur Anderson was making $100 million per year off of Enron which encouraged a "the customer is always right" attitude. This broke the checks and balances that should have prevented Enron from growing. Instead, deceptive accounting allowed Enron to borrow enormous sums. This fueled more deceptive accounting and allowed Enron's market value to rise exponentially.
A Slippery Slope
They say that if you put a frog in boiling water he'll jump out. But, if you put a frog in tepid water and slowly turn up the heat, the frog will boil. I don't know if that's true about frogs, but I do know that it's true about people.
A common misconception about accounting is it is black and white. It's not. Accounting has large grey areas that require substantial judgement. Accounting can be aggressive or conservative and optimistic or pessimistic.
It's difficult to pin-point exactly when Enron crossed the line. Like a Ponzi scheme, it required ever more capital to meet ever higher earnings expectations. As earnings expectations racheted higher, so did the incentive to play accounting games. As Enron grew, so did its payments to its auditors and bankers. The lure of more fees and bigger bonuses lulled Enron's managers, auditors, and bankers through the grey area of the law. Step-by-step, they perpetrated on of the world's largest frauds.
Lessons
1. Unusual incentives produce unusual results.
Look no further than Wells Fargo. Employees felt they needed to fraudulently open accounts to keep their jobs, so they did. Insufficient checks and balances let it get totally out of control. Managers get exactly what they incentivize, whether they like it or not.
Tesla is another example. Elon Musk's compensation package is worth over $1 billion and tied, largely, to Tesla's market capitalization. Over the last 12 months, Tesla's stock has risen 10x, despite unremarkable financial results. Could Musk's unusual behavior and Tesla's unusual valuation be influenced by Musk's unusual incentive package?
Berkshire Hathaway understands the power of incentives. It vows never to fire someone for writing too little insurance. Insurance policies are only valuable to Berkshire when they're profitable. If people feel that they need to write policies to keep their job, they will. They just won't be profitable policies.
2. Culture Drives Long-term Returns
Culture creates incentives, and those incentives reinforce culture. That's why culture is the most important driver of a stock's long-term results. Yet, culture is rarely discussed because it's hard to quantify. But, as Yogi Berra said, you can observe a lot just by watching.
We aim to only invest alongside honest and able managers that we like and admire. Are they plain spoken and down to earth? Do they talk about FCF and EPS and ROIC? Or do they distract analysts from the bottom line with made-up internal metrics like Enron's "Total Contract Value?"
In hindsight it's obvious Skilling and Lay were monsters. But how obvious was it at the time? After all, Fortune Magazine named Enron "America's Most Innovative Company" for the six consecutive years leading up to its bankruptcy.
There were hints something was amiss for those willing to look. Short sellers, like Jim Chanos, and journalists, like Bethany McLean (ironically at Fortune) sounded the alarm. Few listened. The same thing happened at Wirecard. Investors asked regulators to investigate Wirecard years ago and instead got investigated themselves.
The most obvious red flag at Enron was the April 2001 earning's call. A fund manager asked Skilling why Enron couldn't produce a balance sheet -- a reasonable question. Skilling responded by calling him an "asshole." At this point Enron's stock was still above $50 per share but only eight months from bankruptcy.
3. Think Independently From First Principles
A little common sense goes a long way. How was it that a business based on trading and dealmaking could produce consistently rising profits? Profits at similar companies with similar business models (Goldman Sachs, Morgan Stanley) report lumpy profits. Investors who couldn't answer this question should have known Enron was outside their Circle of Competence. How many investors even asked themselves this question?
No two people on Wall Street have the same incentives. Yet, Wall Street is full of group think. Most banks had Buy ratings on the stock until it declared bankruptcy. There were simply too many investment banking fees up for grabs to rate the stock anything less than a Strong Buy.
The antidote to group think is doing the work, from the ground up, yourself. We spend virtually all of our time reading SEC filings and conference call transcripts. We don't read 3rd party research. This is valuable precisely because it is rare. Analysts from S&P said, under oath, that they'd never read Enron's proxy statement which disclosed the off-balance-sheet entities. The Wall Street Journal reported that General Electric's 2013 annual report was only download 800 times that year. To outperform the herd, investors must think differently (and better) than the herd. There's no substitute to doing the work yourself.
4. The Map Is Not The Territory
Accounting is an abstraction of reality, not reality itself. It cannot be taken at face value.
Last year Berkshire Hathaway reported an $81.4 billion profit, which is among the highest corporate profits ever achieved. But about $60 billion of that, as Warren Buffett candidly explained, was non-recurring marked-to-market gains on securities. An accurate appraisal of Berkshire's recurring earnings power required picking apart the company's financial statements. Good managers guide investors though this. Good investors double check management.
Investors didn't have to dig too deep to see something strange was going on at Enron. For the three years ended 2000, Enron reported $2.6B of net income and $1.0B of free cash flow. But, after backing out one-time asset sales, free cash flow was -$4.5B. This alone wasn't evidence of fraud, but it was evidence that Enron was a bad business. Who would pay $60 billion for a company losing $4.5 billion a year?
Dissecting a company's financial statements helps to reveal its true economics. It also reveals how candid and conservative management is. These are valuable hints about a company's culture. It can also help confirm if a company is within your circle of competence.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.