TRADING INSIDER: The Four Lessons From Enron Every Investor Should Understand

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Former Enron Chief Executive Jeffrey Skilling. Image: Johnny Hanson/Getty Images

A lot of water has passed under the bridges of the global financial markets since the collapse of Enron in December 2001.

In the minds of many traders and investors Enron may not register much today, but it was a financial scandal of immense proportions at the time. Indeed Fortune magazine had once called Enron one of the world’s “most admired companies” and regularly named it “America’s most innovative company”.

So its collapse was a big deal with important lessons. Indeed if they had been learned, then arguably the global financial crisis might – just might – never have happened.

These lessons include the use of leverage, of structuring, of special purpose entities, of mark-to-market valuations and of cash – or crucially a lack thereof.

But first a little history.

Enron was a US energy trading firm based in Houston, Texas which grew to dominate the US electricity industry. But it was more than that, trading in many different futures markets and industries. It built power plants and dominated power supply and power grids.

It played in broadband, pulp and paper, oil and gas, weather derivatives and more. In the world of investing up to 2000 where the Nasdaq bubble saw stocks with the idea of a business plan gain multi-billion dollar market capitalisations, Enron looked like a new-millennium version of a 19th century Utility business.

They had done the impossible. They had reinvented the wheel.

Unfortunately as investors found out in 2001 the whole Enron company was a ponzi scheme set up to hide the truth that the company was haemorrhaging cash and its “earnings were a mirage”.

So what do we learn from Enron?

First: follow the cash.

Companies create value through selling goods and services at a margin over their cost of production and other associated costs. This surplus earned generates a positive cashflow which is obvious in the companies’ balance sheets.

It is either stored at the bank as an asset, reinvested into the business or repatriated to investors via dividends.

But companies can also build value through asset appreciation.

Think Australian property prices recently. Most home owners are wealthier than they were 6 or 12 months ago. But without borrowing against it there is no cash – it’s just an asset on your books.

Now imagine if accounting rules let a company set the value of its assets based on “mark to market” rules and then book that as a profit. There is no cash generated but the company can announce a “profit”.

In this case the courts tell us we can think Enron.

So the first lesson of Enron is, like Jerry Maguire said, “show me the money”.

The second lesson stems from Enron’s use of special purpose entities (SPEs). These vehicles – not unlike the special purpose vehicles that drove CDOs and CDO-squared structures that precipitated the GFC – enable assets and risks to be shifted off balance sheet to obscure or enhance the impact on the parent entity.

That’s not to say all SPEs are evil, not by a long shot.

But investors need to ensure that they they both understand the consolidated reports and also break the consolidated report down into cash in the parent entity as well.

Equally the third lesson is to understand the use of accounting rules by the company. It was Enron’s booking of mark-to-market – or as many coined it in the dark days of GFC, mark-to-make-believe – that was the heart and soul of the company’s obfuscation which deceived investors and ultimately lead to CEO Jeffrey Skilling receiving 24 years in jail.

But besides the big issue of Enron being to follow the cash trail, the lesson missed by most investors at the time, was that all the information was hidden in plain sight.

So while accounting standards in Australia are different to the US, and US accounting standards have been changed since Enron and the collapse of its Accounting firm Arthur Andersen, investors need to interrogate the financial data.

The notes to financial statements are there for a reason – read them, especially the parts about related party transactions.

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