Empty Pockets

The Enron Debacle: Lessons To Be Learned

Empty Pockets

In December 2000, with its stock trading at a peak of $85 per share, Enron had a market capitalization of over $60 billion, making it one of the largest U.S. companies. Less than one year later, with the stock trading at well under $1 per share, the company declared bankruptcy-the largest case in U.S. history. Over $60 billion in shareholder wealth was lost, and billions more of losses are likely to be incurred by creditors. The company had $31 billion in debt on its balance sheet, with billions more in counterparty risk off balance sheet-a result of trading activity. What lessons can be learned from this debacle?

1) Never confuse the highly likely with the certain. No matter how great you might think a company might be, it might turn out to be a very bad investment. History's trash bin is filled with once great "sure things," including once nifty-fifty companies such as Polaroid.

2) Never have too many eggs in one basket. This is a corollary to the first point. Unless there is no risk (like with U.S. Treasury bills) an individual should create a diversified portfolio, not concentrating his eggs in one basket.

3) Don't make the mistake of overconfidence. Two very common errors made by individual investors are to be overconfident of the likelihood of success of their employer, and to be overconfident of their stock-picking skills. They may believe that because they work for the company they know better than the market the company's future. They may also "know" that there is little risk, so why diversify? A very common practice is for employees to place a high percentage of their 401(k) or profit sharing plan assets into the stock of the employer (too many eggs in one basket). It is likely that many Enron employees lost a large percentage of their net worth when the firm declared bankruptcy. At the same time, they may lose their jobs.

4) Diversify all your assets, including your intellectual assets (earning power). This means considering your employment as part of your asset allocation. If company does poorly, your ability to earn income could be dramatically impacted. Allocating your financial assets to the stock of your employer is like "doubling up" your bet. Diversification is the prudent strategy.

5) Don't confuse the familiar with the safe. Just because you work for a company and know something about it, doesn't mean either that it is a safe investment, or just as importantly, that the market also doesn't have access to the same information, and thus that information is already incorporated into the price of the stock.

6) Active management is not likely to protect you. Among the ten largest shareholders in Enron (and the percent of the fund in Enron shares), was Alliance Premier Growth (4.1%), Fidelity Magellan (0.2%) AIM Value (1%), Putnam Investors (1.7%), Morgan Stanley Dividend Growth (0.9%) and four Janus funds-Janus Fund (2.9%), Janus Twenty (2.8%), Janus Mercury (3.6%), and Janus Growth and Income (2.7%). Note that while the reporting dates varied (based on the latest available information from Morningstar), none was later than September 30, 2001. Among the "true believers" in Enron, were the following funds, and the respective percent of the fund's assets in Enron (again reporting dates varied, but none were later than September 30, 2001). Rydex Utility (8%), Fidelity Select Natural Gas (5.7%), Dessauer Global Equity (5.6%), Merrill Lynch Focus Twenty (5.8%), AIM Global Technology (5.3%), Janus 2 (4.7%), Janus Special Situations (4.6%), Stein Roe Focus (4.2%), Alliance Premier Growth (4.1%), and Merrill Lynch Growth (4.1%). Obviously all the intensive research these firms performed did not protect them, or their investors, from massive losses. It is particularly noteworthy to point out the Janus family of funds, whose commercials tout their superior research efforts and skills. Janus's flagship fund was the largest absolute holder of Enron, holding over 16 million shares. On April 30, 2001, the last time it reported individual fund holdings, 11 Janus funds collectively owned more than 5 percent of Enron. As of Sept. 30, Janus still owned more than 5 percent of Enron. Another touter of their superior stock-picking skills is the Fidelity family of funds. As of September 30, 2001, together they owned 154 million shares.1 So much for the value or research. The market is a great humbler.

Hopefully the Enron debacle will provide investors with a lesson that will help prevent them from making any of the six mistakes described above. The Enron case also provides further evidence supporting our belief that building a globally diversified portfolio of passive asset class/index funds is the prudent strategy. It is the one most likely to allow you to achieve your financial goals. That is why it is called the winner's game.

1. San Francisco Chronicle, December 3, 2001.

Larry Swedroe is the author of What Wall Street Doesn't Want You to Know and The Only Guide To A Winning Investment Strategy You Will Ever Need. He is also the Director of Research for and a Principal of Buckingham Asset Management, Inc. in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management. [/:Author:]