Investing Lessons For All From The Rise And Fall Of The Infamous Enron

One of my favourite books of all time is The Smartest Guys in the Room by Bethany McLean and Peter Elkind.

The book focuses on the rise and fall of Enron Corporation, an infamous corporate fraud case from the U.S. The company, for those unaware, was a high-flying energy trading firm listed on the New York Stock Exchange until its highly publicized bankruptcy toward the end of 2001.

Enron’s story may be more than a decade old by now, but the investing lessons that are contained within are timeless.

Where it all began and how it all ended

The story of Enron can be traced back to the 1930s when it was a nondescript natural gas producer based in Omaha, Nebraska, USA. Through a series of mergers over the years, Enron Corp was formed in the 1980’s.

After its formation, Enron was able to grow its accounting profits over the years using a string of accounting manipulation techniques.

Along the way, it also evolved into a completely different beast from it humble roots as a simple company that processed, transported, and marketed natural gas – it had become an energy-trading conglomerate with an incredibly complex business and a multitude of special purpose vehicles (SPVs) that were created to hide its true liabilities.

In fact, Enron’s business was so abstruse that many analysts were unable to fully wrap their heads around the energy firm’s business model. (During trials related to Enron, many analysts from brokerages acknowledged that they had assessed Enron’s prospects based largely – sometimes solely – on the company’s own prepared statements; the analysts did not manage to understand the business themselves.)

But the opacity was not a deterrent: Many investors had continued to invest in Enron due to its ever-growing accounting profit and share price. At its peak in 2000, Enron’s market capitalisation was more than US$60 billion and it was trading at 70 times its earnings and 6 times its book value – such was Enron’s popularity with investors.

Enron only started on its downward spiral after McLean, a Fortune magazine writer, had questioned its business and share price in an article titled “Is Enron Overpriced?

After the article, cracks began to surface on Enron’s business-veneer. Subsequently, a series of accounting manipulations were discovered, which led to the company’s implosion and eventual bankruptcy in 2001. It took Enron around 16 years to grow into a prominent company in the U.S. stock market. But, its collapse took roughly a month.

The lessons

There are a few key takeaways for investors from the Enron debacle. Here’s my list:

  1. There will always be dishonest management in the market. There have also been some frauds discovered in Singapore over the years with Eratat Lifestyle Ltd (SGX: FO8) being a good example. The Chinese company had claimed that it had hundreds of millions of yuan in its bank account when it really only had thousands.
  2. Always invest in a business you understand. In investing, simple businesses can be good investments too. Sometimes, they can even beat the complex ones.
  3. Shorting a company’s stock might not always work out as the timing is incredibly important yet maddeningly hard to grasp. Enron’s a good example; its shares had climbed for more than a decade before collapsing sharply.

Foolish Summary

It is always exciting to chase a climbing share price. Who wouldn’t feel good with an investment that can double in a year? But, investing becomes a dangerous game when you focus largely on a stock’s price only.

The danger’s compounded when the share has a very complex business model. Thing is, there are so many other investing choices out there in the stock market; why should we spend our time on something we can’t understand?

When I feel myself getting attracted to rising share prices from businesses that are complicated and which I know nothing about, I think back to Enron to remind myself about what’s really important here: When investing, focus on the business.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim does not own shares in any companies mentioned above.