2nd Annual Financial Darwin Awards

“In America, everybody does it.”Jamie Lee Curtis, in “A Fish Called Wanda”

“One of my highest priorities is to restore investor confidence in Enron,” Ken Lay wrote via email to employees on August 27th. “This should result in a significantly higher stock price.”

Why did they care so much about the share price? Aren’t profits the more important number? And, what about the satisfaction that comes from providing a good service, doing a good job, and running a good business?

Enron’s shareholders, management, and even many of its employees, seemed to care only about the price at which Enron’s shares changed hands.

Was the world a better place if the share price rose? When things were going well for Enron, were people happier, healthier, more saintly and honorable? No, they were just more entertaining. It was fun to watch people lie, cheat and make fools of themselves in a spectacular way. And it was educational.

Here at the Daily Reckoning, we are a bit disappointed by the way our colleagues in the financial press treat the Enron story. The same journalists who celebrated Ken Lay when he was riding high on lies and greed…now spit on his body as he lays honestly in the dust.

But that is the problem with an open, democratic market – it invites every investor (and analyst, strategist, fund manager, journalist, broker…etc.) to participate in a fraud. Investors are encouraged to believe that they can get something for nothing…just as surely as they think they can vote themselves another man’s money. All that is needed is the right lie at the right time – and the great mob of investors rushes to its own ruin… as if it were a national election.

But the mob is fickle. A man be a hero one day and a fool the next…for the same reason each time: helping investors defraud one another.

“It’s all as American as apple pie,” wrote Richard Russell yesterday. “Wall Street’s not much different. Phony earning statements, leaving out regular expenses in statements, “pro forma” earnings statements, no dividends being paid (you need actual earnings in order to pay dividends).

“Greed, greed, greed – it’s the story of Wall Street and its analysts and accountants and brokers and customers over recent years. Now we’ve got the Enron story – the biggest bankruptcy in U.S. history. From Wall Street to Washington, the story is one of corruption, dishonesty, greed and the lust for money.”

We tend to look down our noses at people who lose large amounts of money. If they lose their own money – making a public spectacle of themselves in the process – we think they are stupid. If they cause others to lose their money, they are calumnied as knaves. But what is oft forgotten is that the dimwits and knaves perform a valuable public service: both help separate fools from their money.

What’s more, they offer valuable moral lessons to us all. “They are like the human mine detectors used by the Soviets in WWII,” I wrote in my preface to last year’s awards. “Punishment battalions were simply marched forward across the minefield. Those who didn’t blow up showed the way forward. Those who did, well…they cleared away the mines. How grateful the troops following must have been! Their comrades had cleared the way – and marked it with little scraps of uniform, blood and bootlace.”

So, let us take this opportunity to show some gratitude, and honor a fallen hero by awarding our Second Annual Financial Darwin Award to Ken Lay, Jeffrey Skilling and their colleagues at Enron.

Enron is the clear winner. Not that it did anything other companies did not do.

“Corporate America went long in debts and short in assets,” says Dr. Kurt Richebacher. Management joined the “shareholder value cult,” he explains, seeking “the quickest and most effective devices to maximize [short term] profits and shareholder value. The result was the well-known collective shift towards mergers, acquisition, downsizing and restructuring.”

Stock prices rose, explains Richebacher, as “corporations, stampeded into debt, retiring equity across the board through mergers, acquisitions and stocks buybacks, while downsizing their capital spending on new plants and equipment.”

None of these things added appreciably to the real goods and services – and long-term profits – the companies could produce. But they provided company chefs with plenty of books to cook…

“Deal making offered numerous opportunities for companies to generate phony financial profits that were sold as emblems of new corporate efficiency,” Dr. Richebacher concludes. “In reality, a large and growing part of the company-reported profit bonanza had accrued directly or indirectly from gains in the stock market. As the bear market unfolded, this source of profit growth essentially dried up. The consequence is that desperate CEOs have to pursue ever more aggressive tricks to hide the dismal profit truth.”

Everybody does it. Business Week reports that 400 companies have had to restate earnings in the last 3 years.

Enron merely pursued “shareholder value,” with greater energy. It reinvented itself as a New Economy company in the late ’90s…and then began acting as if the old rules of accounting and business management no longer applied. It misstated earnings of more than half a billion dollars – from ’97 forward. And it managed to run up some $27 billion in debt – without mentioning it to shareholders. But why bother? Shareholders wanted lies…Enron gave them plenty.

As the Enron success story reached its peak, Enron’s insiders sold their shares. A New York Times article says “29 Company Executives Pocketed $1.1 Billion by Selling Firm’s Stock.” Meanwhile, lower-level employees held Enron shares in their 401 (k) plans. Half the assets of the plans were in the form of Enron shares – about $1.2 billion worth. Now they are worthless.

That is a small part of the loss suffered by investors. Enron collapsed faster than almost any major corporation in history…and provided the bankruptcy courts with their largest case ever. Investors are out $61 billion…more or less.

All of this seemed to come as a shock to Mr. Lay. Asked about the off-the-books debt, he seemed unaware of not only the details but the big picture too. “You’re getting way over my head,” he protested.

Ken Lay may or may not have been out of his depth in a puddle in the company parking lot…we don’t know. But his successor, Mr. Skilling, claims to be equally ignorant. He said he knew nothing of the critical off- balance sheet partnerships and resigned “for personal reasons” in August.

There was no shortage of ignorance in the Enron story. Ron Barone, an analyst at UBS Warburg, covered the company. After a meeting with Mr. Lay on August 17, Barone was quoted by Bloomberg: “Ken met with us to reassure us that there is nothing wrong with the company. There is no other shoe to fall and no charges to be taken.”

But less than 3 months’ later, a whole leg fell off Enron when the company announced that $600 million was wiped out as the company restated earnings for the previous four years. By November 28, when Enron’s shares were nearly worthless, Barone changed his recommendation from “strong buy” to “hold.”

Congratulations…and with much appreciation for them all,

Bill Bonner
January 15, 2002

Health club memberships can cost more than $100 per month. And members must know that they could get the same effect from running around the block and doing sit ups at home. So, typically, health club sales track GDP. They boomed in the ’80s…then fell off in the early ’90s…and then boomed again in the late ’90s. Lately, consumers have been going bankrupt at a record rate… and unemployment is still climbing. But they are still buying health club memberships.

“Economists say the statistics show how truly peculiar the 2001 recession is,” says the Arizona Republic. “While the nation has fallen on hard times, consumers have continued to spend, demonstrated by strong auto sales, solid home sales and steady sales of health club memberships.”

Consumers are taking a long time coming to terms with recession. They were told it couldn’t happen. And now that it has happened, they believe it is almost over. So, the recession passes, they believe, without even giving up much of anything…even the pleasure of going to the gym to look at people who are in even worse shape than you are.

College students are still spending too. A GAO report says a third of college students have 4 or more credit cards and the average student graduates with $19,400 in student loans and $2,748 in credit card debt.

But eventually, debts and recessions need to be reckoned with. The latest numbers show health club sales may be easing off. They’ve grown at a 10% rate since the mid-’90s. Experts expect between only 3% to 5% growth into 2002. And people under 25 are turning to the bankruptcy courts in record numbers. And stocks! Earnings are falling. But in terms of their best earnings ever – recorded at the end of the ’90s boom – the S&P is priced at a P/E of 22. The previous record high – set in ’29 and again in ’73 – was 22.

So, Eric, how did those over-priced stocks do yesterday?


Eric Fry in New York…

– Farewell 10,000. Farewell 2,000…it too soon to say, “Farewell 2002?”

– The Dow fell through 10,000 last Friday. The Nasdaq followed up that sorry performance with one of its own, by tumbling through 2,000 yesterday. The volatile index dropped 31 points to 1,991, while the Dow slid 96 points to 9,891.

– In short, 2002 is not unfolding as marvelously as the bulls had imagined. “Better to travel hopefully than to arrive,” as the saying goes. The year is far from over, of course. By the time champagne corks fly next New Years Eve, the stock market may yet soar to the heights that Abby Joseph Cohen predicts.

– On the other hand, this might be as good as it gets. The Nasdaq clings to a 2% gain for the year, despite trading for a gazillion times earnings…(its pro forma operating earnings before one-time charges). If an investor were to pocket that 2% and roll the money into a one-year CD, he would be sure to earn about 5% on his money in 2002. By year’s end, many professional investors might wish they had gained as much.

– Some folks are shuffling anxiously toward the door already. Yesterday, Merrill Lynch strategist Richard Bernstein lowered his recommended asset allocation for stocks to 50% from the previous 60%. “There is a thin line between a liquidity-driven market that anticipates improving fundamentals and a bubble,” Bernstein warned. “The equity market may have stepped over that line.”

– You don’t have to look very hard to find individual stocks or sectors that have crossed the line. Many stocks are soaring despite no visible trace of improvement in the underlying fundamentals.

– For example, the shares of Starwood Hotels & Resorts have nearly doubled since last September, even though the luxury hotel sector is still reeling from the post- September 11th shock. Testifying to the sector’s troubles is the fact that the travel industry shed 32,000 jobs in December.

– Meanwhile, over in Fantasyland, a.k.a. the technology sector, the growth prospects are even more dire. But that did not prevent technology funds from surging 37% in the fourth quarter. Numerous stocks in the sector have more than doubled or tripled off of their September lows.

– “We ought not conclude that just because stocks have been rising recently, that economic recovery is just around the corner and that corporate profits will shortly begin to rise again,” warns Marc Faber in the latest issue of Strategic Investment.

– The man has a point, as the tech sector illustrates so graphically. Back in the “New Era” 1990s, capital spending on high-tech equipment spearheaded economic growth. But in 2001, the tech sector suffered a nightmarish reversal of fortunes. Semiconductor sales tumbled 32%, while telecommunications equipment sales collapsed 40%.

– “Over a comparatively short span,” Moody’s observes, “the rate of capacity utilization for high-technology manufacturers plummeted from 2001’s highly profitable 88.8% to November 2001’s loss-written record low of 60.0%.”

– Until demand for technology products recovers, we should expect the river of red ink to continue flowing out of the tech sector.

– Ironically, robust demand for technology STOCKS has recovered already. Folks can’t seem to buy enough of these things, no matter the price. That’s because it’s much more exciting to buy a red-hot stock than to forage for shares of a well-run company. The two are not necessarily the same thing, as the Enron debacle illustrates.

– “What the world is now awakening to,” says the New York Times, “is that the Enron Corporation was not much of a Company, but its executives made sure that it was one hell of a stock”…until it wasn’t…and the casualties are numerous. Even the “smart money” got hurt. (Enron execs’ behavior earned them the top slot in this years 2nd Annual Financial Darwin Awards…Bill reports below).

– Remember how we’re always hearing about how smart all those institutional investors are? Are you sitting down?…Some of those institutional investors aren’t so smart after all. Leading the pack of the “aren’t” category is the California Public Employees’ Retirement System (CalPERS).

– After chalking up sizeable losses investing in venture capital during the 12 months ending June 30, 2001, CalPERS stubbed its toe again by taking down a whopping position in Enron. The pension Goliath’s stake, which was once worth more than $252 million, is now worth about $2 million. That’s a large loss, even for a $143 billion pension fund.

– Lesson One from the Enron morality play: It’s better to invest in good companies than “good” stocks.


Back in Paris…

*** Robert Mugabe can’t be all bad. The aspiring dictator is making “war on democracy,” says the TIMES. There’s something to be said for that…At least, a dictatorship tends to protect the morals of the masses. Only the elite are corrupted by power, whereas, in a democracy corruption is shared out like campaign bumper stickers. Voters go into the polling booth and pull the levers they think will bring them more of someone else’s money. Their hearts must whither a little more every election day.

*** “I want to assure you that I have never felt better about the prospects for the company,” wrote Ken Lay, CEO of Enron, on August 14. Poor Ken was once the toast of the town. Now he is just toast. But we salute him, nevertheless, below…

*** “You could probably get bigger numbers by crunching them differently,” said Dan Denning in a note to Strategic Investing (formerly Daily Reckoning Investment Advisor) subscribers. But we do not crunch numbers here at the Daily Reckoning. We have nothing against them… so we try to treat them with respect.

*** So, what do we get when we merely stack up the figures in a humane and decent way?

*** “For all 12 positions, we averaged a total return of 7.57%,” Dan continues. “Our best performer last year was Franco Nevada, up 29%. AngloGold was next, at 16.8%, followed closely by Oxford Health Plans, up 15.4%.” Not a spectacular return. But a lot better than the S&P, which was down 10% last week.

*** But Dan is excited: “This year is starting off with a bang…with Oxford Health Plans up 25% last week alone.”

The Daily Reckoning