Published by Nick McCullum on July 22nd, 2017
Although more than a decade has passed, the name ‘Enron’ continues to hold notoriety in the investing community.
Enron’s 2001 bankruptcy destroyed more than $60 billion of shareholder value.
At the time of its bankruptcy, Enron was the seventh-largest company in the United States. Additionally, Enron’s $63.4 billion in assets made it the largest bankruptcy ever (until it was surpassed by Worldcom’s bankruptcy in the following year).
The devastation of the Enron scandal can also be seen at the security level. Between mid-2000 and the company’s bankruptcy announcement, Enron’s stock declined from a high of $90.75 to a low of below $1.
Clearly, Enron was a poor investment.
However, these types of isolated, terrible investment returns should not discourage market participants from continuing to invest moving forward.
Every failure is an opportunity to refine your investment strategy. Enron is no different.
With that in mind, this article will describe 5 actionable investing lessons that can be learned from the Enron scandal.
Before diving into some actionable lessons that can be taken away from Enron’s bankruptcy, it will be useful to understand the company’s complicated business model.
Enron was an American energy company that formed in 1985 after the merger of Houston Natural Gas and InterNorth.
The merger was primarily facilitated by Kenneth Lay, who was Houston Natural Gas’ CEO before the merger was completed. Post-merger, Lay served as Enron’s Chairman and CEO for most of its existence. Lay was indicted for more than 10 counts of securities and wire fraud after the Enron accounting fraud was exposed.
In some ways, Enron’s business was similar to an Exxon Mobil (XOM) or Chevron (CVX). Enron owned and operated assets in the oil and gas industry such as pipelines, refineries, and electricity generation stations.
What complicated Enron’s business structure – and differentiated it from larger peers like Exxon or Chevron – was the company’s involvement in the financial markets.
Enron made extensive use of commodity derivatives to make money. This differs from the use of derivatives by many of the larger oil & gas supermajors because these larger businesses use derivatives primarily to reduce risk – or to hedge, in other words. In particular, many energy companies use derivatives to hedge against unwelcome changes in commodity prices.
Enron’s risky, profit-driven derivative activities were encouraged by the economic climate of that time period. It was a period of deregulation in the financial markets, which allowed companies like Enron to place large, risky bets on the future prices of various commodities.
Enron’s bankruptcy also came directly after the dot-com bust, when overvalued Internet stocks came crashing down from peak valuations and resulted in a widespread market recession. Surprisingly, Enron was a part of this mania before the bubble popped.
In 1999 – the middle of the dot-com bubble -the company created Enron Online, an electronic commodity & commodity derivatives trading website. Amazingly, Enron was the counterparty to every transaction made on Enron Online. For obvious reasons, this presented risks if commodity prices moved against the company.
However, the markets failed to accurately perceive these risks. In fact, Fortune named Enron ‘America’s Most Innovative Company’ for six consecutive years between 1996 and 2001, partially because of the then-unheard-of commodity trading website that it had created.
In the initial years, trading volumes on Enron Online expanded exponentially; by mid-2000, Enron Online was on pace to execute $350 billion in trades per year. For context, Enron’s entire business had only ~$60 billion in assets. It is not hard to see that Enron had overextended itself.
When the dot-com bubble finally burst and Enron began to suffer from its significant exposure to the most volatile areas of the commodity market, the company’s executives began looking for ways to hide its tremendous losses.
The most widely used – and dangerous – technique used by Enron accountants is called mark to market accounting.
Under this accounting technique, assets are held on a company’s balance sheet at their current value (instead of book value, which is more typical for large corporations). Under a traditional book value accounting scheme, assets are listed at their purchase value less any accumulated depreciation.
Mark to market accounting can work well for businesses that hold many securities (Enron included), but can be very dangerous when extended to other types of assets. This is exactly what happened at Enron.
To hide losses in its commodity business, Enron accountants began applying mark to market accounting to fixed assets, such as pipelines or oil refinery assets. To estimate the current value of these assets, Enron likely used discounted cash flow valuations.
This created a problem for Enron accountants.
Discounted cash flow valuations are very tricky because they rely heavily on the quality & accuracy of assumptions about future cash flow, discount rates, and growth rates.
If any of these assumptions prove wildly inaccurate (which is often the case; even the best accountants cannot predict the future), then a discounted cash flow model becomes useless.
At Enron, this inevitably happened. Under legal accounting policies, Enron would be required to report an asset write-down on any asset that become less valuable due to variances from previous discounted cash flow assumptions.
These write-downs would lower the company’s GAAP earnings-per-share – Wall Street’s favorite yardstick of corporate performance.
For obvious reasons, Enron executives were incentivized to avoid asset write-downs – and earnings declines – whenever possible.
To do this, Enron would transfer there assets to off-the-balance-sheet corporations, which would record the loss and avoid reporting declining profits at the Enron parent company.
These accounting policies were simply kicking the can down the road for Enron.
Just because the parent Enron company was not reporting these losses did not mean they did not occur in reality. Even worse, Enron’s parent company did report the gains associated with mark to market accounting. In other words, the Enron parent company reported only the beneficial consequences of this accounting scheme.
At the same time, Enron’s capital allocation began to deteriate noticeably.
Amid the mania of the dot-com bubble, Enron’s board of directors began investing significant sums of capital into broadband telecommunications equipment – expensive assets that never generated a dime of profit for the company’s shareholders.
It is hard to overstate the negative impact of Enron’s poor investments outside its circle of competence. In one of the company’s last quarterly earnings releases before bankruptcy, its fledgling telecommunications segment reported an operating loss of $137 million.
In 2001, everything began to fall apart for Enron executives and shareholders.
Kenneth Lay resigned as CEO in February, to be replaced by Jeffrey Skilling. Skilling resigned in August, Lay resumed the CEO post, and Enron eventually declared bankruptcy in December. Enron was delisted from the New York Stock Exchange in the following month.
Moving on, the next sections will discuss 5 actionable lessons that investors can learn from the Enron scandal to improve their personal investment strategy.
Lesson #1: Don’t Invest in What You Can’t Understand
Thanks to its heavy involvement with commodity derivative trading and Enron Online, Enron had a very complicated business model that many investors did not fully understand.
In fact, Warren Buffett – literally the most successful investor ever – claimed that even he did not understand some of the transactions described in Enron’s financial statements:
Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.”
– Warren Buffett in the 2002 Berkshire Hathaway Annual Report (emphasis mine)
If Warren Buffett – someone with decades of experience reading financial statements – does not completely understand Enron’s financial statements, then it is highly likely that the majority of the company’s investors were also oblivious to the company’s true business model.
This observation can be generalized to other common stock investments. It is very important to have a deep understanding of a company’s business model before committing any capital as an investor.
This is a belief that legendary investor also Peter Lynch held very strongly:
“Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth.” – Peter Lynch
Importantly, much of our ability to understand a company’s business model comes from the business’ presentation of its business in financial statements.
Thus, investors should be quite wary of any observations that lead them to doubt the accuracy of a company’s financial statements.
“Creative accounting is an absolute curse to a civilization. One could argue that double-entry bookkeeping was one of history’s great advances. Using accounting for fraud and folly is a disgrace. In a democracy, it often takes a scandal to trigger reform. Enron was the most obvious example of a business culture gone wrong in a long, long time.”
– Charlie Munger, Berkshire Hathaway’s Vice Chairman (emphasis mine)
In particular, caution should be exercised when a business makes extensive use of non-GAAP financial metrics.
In many cases, the use of non-GAAP financial metrics is useful, and genuinely helps an investor to understand a company’s true financial position.
In other cases, non-GAAP financial metrics can be used to hide a company’s true expenses.
One example of this would be an asset-heavy business that makes use of EBITDA. For a company with a large amount of money invested in fixed assets (think railroads, telecommunications providers, utilities, and energy infrastructure companies) depreciation is a very real expense, and ignoring it is not likely a wise decision.
Warren Buffett extends this belief to all companies (not just the capital-intensive examples shown above).
“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?”
– Warren Buffett in the 2002 Berkshire Hathaway Annual Report (emphasis mine)
For other, more capital-light business models (like asset managers or banks), EBITDA will tend to be close to earnings.
Aside from the use of non-GAAP financial metrics, investors should be wary of flashy or distracting investor presentations.
In fact, vanilla investor presentations should be welcomed by investors because they save money on investor relations and media expenses.
A famous example of this is Berkshire Hathaway (BRK.B) (BRK.A). The company’s website is remarkably straightforward, and Berkshire’s company documents are similarly plain. Berkshire investor documents and conference calls are also completely devoid of forecasts for earnings, cash flow, and other financial metrics adored by Wall Street analysts.
This lack of forecasting stems – unsurprisingly – from Berkshire’s inability to predict future business results with any reliability.
“Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).
Charlie and I not only don’t know today what our businesses will earn next year – we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future – and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.”
– Warren Buffett in the 2002 Berkshire Hathaway Annual Report
Jeff Bezos from Amazon shares a similar belief:
“When somebody congratulates Amazon on a good quarter, I say thank you. But what I’m thinking to myself is – those quarterly results were actually pretty much fully baked about 3 years ago. Today I’m working on a quarter that is going to happen in 2020. Not next quarter. Next quarter for all practical purposes is done already and it has probably been done for a couple of years.”
Jeff Bezos in a 2017 interview
These quotes from two of the best businessmen of our time are in stark contrast with statements made in Enron investor communications.
The following is an excerpt from the company’s 2000 Annual Report (the last annual report published by Enron before it declared bankruptcy).
Enron has built unique and strong businesses that have tremendous opportunities for growth. These businesses — wholesale services, retail energy services, broadband services and transportation services — can be significantly expanded within their very large existing markets and extended to new markets with enormous growth potential. At a minimum, we see our market opportunities company-wide tripling over the next five years.
Enron 2000 Annual Report, page 2 (emphasis mine)
Enron’s firmly optimistic outlook for future growth was dramatically different from what actually materialized for the company’s investors. Personally, I find the company’s use of the phrase ‘at minimum’ particularly troubling.
This underscores the risk of blindly believing corporate growth forecasts.
All said, Enron’s complicated business model and excessive growth forecasting contributed to the company’s eventual downfall. These two characteristics should be viewed as red flag in potential stock market investments.
Lesson #2: Avoid Companies That Employ Fancy Derivatives
Before discussing the perils of using excessive derivative contracts, I’d first like to share Warren Buffett’s opinion on the subject.
Buffett – known for conservative risk management and a long-term track recrod fo market-crushing returns – has the following to say about derivative trading:
“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.”
– Warren Buffett in the 2002 Berkshire Hathaway Annual Report
When Warren Buffett calls a particular financial instrument a ‘time bomb’, I am personally highly inclined to avoid them.
As mentioned in the first section of this analysis, what was particularly dangerous about Enron’s use of derivatives is that they relied on these speculative contracts to generate earnings for their businesses.
Because of the company’s mark to market accounting scheme, these profits were recorded before the derivatives matured – which could result in profit clawbacks if the derivative’s underlying instruments moved against the company.
“Before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.”
– Warren Buffett in the 2002 Berkshire Hathaway Annual Report
All said, Enron’s extensive use of financial derivatives was one of the main differentiates between this business and other large companies in the energy industry. Enron was also the only energy business of this size to declare bankruptcy.
I do not see this as a coincidence. Investors should avoid companies that rely on derivatives and other complicated financial instruments to generate earnings.
Lesson #3: Beware of Excessive Leverage
Enron’s excessive amount of leverage magnified its poor financial performance.
The easiest way to demonstrate Enron’s excessive leverage pre-bankruptcy is to compare its current balance sheet composition to today’s energy giants (whose balanced sheets are presently stretched thanks to prolonged low oil prices).
The Liabilities and Shareholders’ Equity section of Enron’s year-end balance sheet for fiscal 2000 can be seen below.
Source: Enron 2000 Annual Report, page 33
Enron reported shareholders’ equity of $11.5 billion and total liabilities and shareholders’ equity of $65.5 billion. A quick difference calculation gives total liabilities of $54 billion.
Some additional quick math shows that Enron had a debt-to-equity ratio of 4.7x (computed as $54 billion of total liabilities divided by $11.5 billion of total shareholders’ equity).
Here’s how Enron’s 4.7x debt-to-equity ratio compares to the current ratios for the 6 oil & gas supermajors:
- Exxon Mobil: 0.25x
- Chevron: 0.31x
- Eni SpA (E): 0.51x
- Total (TOT): 0.54x
- Royal Dutch Shell (RDS.B): 0.48x
- BP (BP): 0.63x
Clearly, Enron’s leverage ratio of 4x+ is well in excess of today’s oil & gas supermajors, even given the tough operating environment that oil companies face today.
Here’s Warren Buffett’s opinion on leverage:
“I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.” – Warren Buffett
The takeaway from this observation is this: avoid businesses that have volatile business models and excessive levels of debt.
With that said, high debt levels are not always a bad thing.
In fact, high debt levels can be used to fuel growth for businesses with very stable business models. This strategy is being used by telecommunications giants Verizon Communications (VZ) and AT&T (T) in today’s economic environment.
Berkshire Hathaway is, again, another notable example of this of the prudent employment of leverage. However, Berkshire has not used debt in the traditional sense.
Interestingly, Buffett has created billions of dollars of shareholder value by using leverage in the form of insurance float.
However, Buffett’s leverage has two notable characteristics that are different from the leverage used by Enron (and most other companies).
Buffett’s insurance float is simultaneously:
- Cheap (or free, if Buffett’s insurance companies report breakeven underwriting results)
Close imitations of Buffett’s leverage strategy can be used to improve investor returns at the individual investor’s level. More specifically, prudent levels of cheap leverage can be used to improve risk-adjusted returns in a low-volatility investing strategy.
There are generally two scenarios where leverage should definitely not be used while investing:
- When cheap leverage is unavailable
- When an investment strategy has a high degree of volatility (even if average returns are attractive)
The significance of these two factors in an Enron case study cannot be overstated. Thanks to Enron’s high leverage levels, its debt was quite expensive. Here’s what the math looks like.
Enron incurred interest expenses of $876 million in fiscal 2000. The company ended the same time period with short-term debt of $1.7 billion and long-term debt of $8.6 billion.
Source: Enron 2000 Annual Report, page 33
Dividing the company’s total interest expense ($876 million) by its total debt level ($10.3 billion) gives a weighted average interest rate of 8.5%.
For context, the yield on the 10-year U.S. Treasury Bill was 5.1% on the last trading day of 2000. While rates during this time were significantly higher than they are today, Enron’s debt was still expensive based on its spread above the risk-free rate.
Enron’s expensive debt combined with its highly volatile business model combined to create excessive losses for the company’s investors. When analyzing a company’s balance sheet, prospective investors should keep these two factors in mind.
Lesson #4: Understand and Assess Counterparty Risk
Enron’s shareholders were not the only ones who were significantly harmed by the Enron scandal.
Many of the company’s counterparties also suffered extreme financial losses.
By and large, this is because they did not properly assess the counterparty risk that they assumed when entering agreements with Enron.
Counterparty risk is defined as:
“The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk is a risk to both parties and should be considered when evaluating a contract.”
There are many different types of counterparties that suffered financial losses after the Enron scandal.
Many of them were on the other end of the many derivative contracts held by Enron at the time of its bankruptcy.
In fact, the importance of assessing counterparty risk can be tied directly to our earlier discussion on derivatives.
“Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them.”
– Warren Buffett in the 2002 Berkshire Hathaway Annual Report
Additionally, Enron’s many creditors lost money when the company went bankrupt. Enron’s total debt of $10.3 billion and total liabilities of $54 billion means that a significant number of large investors saw their debt holdings take a haircut in December of 2001.
Derivative counterparties and lenders aside, there is one notable Enron counterparty whose bankruptcy-related financial distress is still widely remembered to this day.
I’m referring to the accounting firm Arthur Anderson, which was hired to be Enron’s official auditor.
At the time of the Enron scandal, Arthur Anderson was one of the five largest accounting firms in the United States and had a robust reputation for high operating standards and quality risk management.
In fact, the involvement of Arthur Anderson in Enron’s accounting was seen as a vote of confidence among many market participants who were skeptical of the accuracy of Enron’s financial statements.
However, the company did not live up to its reputation. Its involvement in Enron’s accounting fraud is undisputed.
On June 15, 2002 – roughly six months after Enron originally declared bankruptcy – Arthur Anderson was convicted of obstruction of justice.
Unsurprisingly, the Securities & Exchange Commission is unable to accept audits from convicted felons. Arthur Anderson was forced to stop auditing public companies (its major source of revenue) and dissolved as an accounting firm.
Arthur Anderson is the foremost example that you do not need to be an investor to be harmed by a company’s poor financial management.
Assessing counterparty risk is an important aspect of business and of life.
Lesson #5: The Importance of Management Integrity Cannot Be Understated
It is hard to overstate the importance of having high-quality management at the helms of the businesses that we invest in.
Outstanding managers with great capital allocation skills and a laser-sharp focus on building shareholder value have tremendous potential to deliver market-crushing total returns over long periods of time.
Conversely, bad managers produce unsurprisingly bad results.
Enron is a very extreme example of this.
Rather than simply failing to build shareholder value, Enron executives succeeded in destroying billions of dollars of shareholder value.
So how can investors know when a company’s management team is of the highest quality?
Truthfully, it can be difficult as an individual investor to gain any insight into the quality of corporate boardrooms. We are unlikely to ever meet these executives in person, so our assessment of their character & competence must be done at arm’s length.
With that said, there are three major tools that investors can use to monitor the performance of their executives (even from a distance). I’ll briefly explain each tool and then discuss how it could have been usefully applied prior to the Enron bankruptcy.
The first is quarterly investor conference calls. These calls are when executives discuss ongoing corporate events and financial performance with analysts and sometimes large shareholders.
The executive’s tone, transparency, and willingness to answer hard questions on these calls is a rough yardstick to measure management’s commitment to building value for shareholders.
In the past, investors had to pay for expensive subscriptions to access quarterly conference call transcripts. The Internet has changed that dramatically.
Seeking Alpha provides free conference call transcripts to its reader base. This is a tremendously powerful tool for individual investors and has dramatically lowered the barrier between professional and retail investors.
So how could reading conference call transcripts have helped prior to the Enron bankruptcy?
Reading company conference call transcripts could have signaled potential instability among Enron’s management team. More specifically, blatant vulgarity from the company’s CEO on an April 17, 2001 conference call was a sign to potentially avoid this stock.
An excerpt from this call can be seen below:
Operator: Richard Grubman of Highfield Capital.
Grubman: Good morning. Can you tell us what the assets and liabilities from price risk management were at quarter-end, what those balances were?
Skilling: We do not have the balance sheet completed. We will have that done shortly when we file the Q. But until we put all of that together, we just cannot give you that.
Grubman: I’m trying to understand why that would appear to be an unreasonable request, in light of your comments about daily control of all your credits. I mean, you have a trading desk with a $21 million matched book that’s two times your book value, and you cannot tell us what the balances are?
Skilling: I’m not saying we can’t tell you what the balances are. We clearly have all of those positions on a daily basis, but at this point, we will wait to disclose those until all of the netting and the right accounting is put together.
Grubman: You’re the only financial institution that cannot produce a balance sheet or cash flow statement with their earnings.
Skilling: Thank you very much, we appreciate that…a**hole.
For context, Highfield Capital was a hedge fund that had a significant short stake in Enron at the time of the conference call which paid off handsomely when the energy company declared bankruptcy. Interestingly, Grubman also accurately predicted the 2007-2009 housing bubble pop.
Calling someone an ‘a**hole’ is unacceptable in any setting, particularly for a chief executive on an analyst conference call. Today’s investors can learn to watch for such red flags on future company conference calls.
The next tool for assessing management’s true intentions is insider trading transactions.
Notably, Enron’s then-CEO Jeffrey Skilling sold a significant portion of his Enron stake in August of 2001 – about four months before the company declared bankruptcy.
Company insiders – including CEOs, board members, and other important executives – are required to disclose any insider trading activities by filing a Form 4 – Statement of Changes in Beneficial Ownership of Securities – with the U.S. Securities & Exchange Commission.
Investors who followed Skilling out of Enron’s stock would have avoided much of the devastation that followed. It appears that Skilling sold his stock around ~$50, while the securities bottomed at less than $1/share.
It should also be noted that insider selling is not always a bad sign, so long as substantial ownership still remains.
This does not mean that Buffett or Bezos’ companies are likely to have a fate similar to Enron’s.
The main difference is that each executive still holds most of their net worth in company stock.
Nowadays, most corporate executives are required to hold a certain multiple of their base salary in company stock. Most seasoned CEOs exceed this requirement by a wide margin.
However, insider trading activities should still be monitored by investors, as they can sometimes provide key insights into management’s perception of future business prospects.
The last source that investors can use to monitor the executives of their investees is the broader news media. Generally speaking, poor behavior reported in the media may indicate underlying problems at the executive level.
This is likely the rarest opportunity that investors have to become apprehensive of their investee’s CEOs. For Enron, there are two events that could have alerted them to what was yet to come for this stock.
First was the aforementioned vulgar comment on Enron’s April 2001 conference call. This needs no further discussion, other than to mention that it was published in various news outlets including a Fox News article titled ‘Enron CEO Uses Vulgarity in Attack on Fund Manager‘.
The second media-sourced clue that investors could have used was Skilling’s surprising resignation in August 2001, roughly 4 months before the company declared bankruptcy. The previous CEO Kenneth Lay resumed his post as CEO.
Generally, corporations as large as Enron tend to have very well-defined corporate succession plans. Calling in a previous CEO to resume the top job does not have the appearance of a premeditated resignation. Thus, investors could have reasonably assumed that all was not well in Enron’s boardroom.
To sum up, Enron’s dishonest and incompetent management team was arguably the largest factor that led to the business’ downfall.
From all the facts we have about the Enron bankruptcy, the most important lesson is this: buy high-quality businesses with management teams that have both character & competence. Enron would have failed this test (although I admittedly benefit from extreme hindsight bias in saying this).
The Enron scandal provides a fascinating case study on corporate governance and board room management.
One of the best reasons to study history is to avoid making mistakes that have already occurred in the past.
Five actionable lessons that investors can take away from this unfortunate bankruptcy are:
- Don’t invest in what you can’t understand
- Avoid companies that employ fancy derivatives
- Beware of excessive leverage
- Understand and assess counterparty risk
- The importance of management integrity cannot be understated
For investors interested in reading more about the Enron bankruptcy, the following articles may be of interest:
- Investopedia – Enron Scandal: The Fall of a Wall Street Darling
- Fox News – Enron CEO Uses Vulgarity in Attack on Fund Manager
- History.com – Enron Files For Bankruptcy