Investing In A Post-Enron World
Tactics to help “Enron-proof” your portfolio, a fast course in becoming
a “financial sleuth”, methods of learning the true value of stocks
AUTHOR: Paul Jorion
PUBLISHER: McGraw Hill
DATE OF PUBLICATION: 2003
NUMBER OF PAGES: 244 pages

THE BIG IDEA
Investing In a Post-Enron World by Paul Jorion
• The high-profile implosions of America’s top
corporations like Enron, and the questionable
accounting methods of Arthur Andersen, forces
investors to become wary of a company’s ethical
standards, and creates a need for clear warning signals
and information to be able to protect oneself.
• Digging deep into the footnotes of annual reports, and
searching for the true story of what really went on with
those inflated numbers
 this book educates the investor in the complicated game of
deception played by the inner circle of this giant.
 The bigger they are, the harder they fall indeed.

ENRON 101
Investing In a Post-Enron World by Paul Jorion
• The bottom line is this: Enron’s management had
constructed far better protection for itself than for its rank
and file workers.
 Enron employees saw their entire life/retirement savings
vanish.
 The captain and his crew basically got off the sinking ship
first in their luxury-style million-dollar lifeboats and left
everyone else to drown.
• A brief chronology of a giant’s fall from grace:
In the 1990’s, there emerged a new market for broadband

or high-speed Internet access through fiber-optic cables.
Enron established Enron Broadband Services (EBS)
-
to sell this bandwidth product as a commodity.
Enron’s stock price soared from $44 to $90

The broadband market collapses, Enron’s quarterly filing

for the third quarter of 2001 to the Securities and Exchange
Commission states “ Non-core businesses are businesses
that do not provide value to Enron’s core businesses. “

ENRON 101
Investing In a Post-Enron World by Paul Jorion
This referred to the broadband segments.
-
- The plan was to exit the $8 billion broadband venture.
- This led to opening up of new businesses to cover the
losses of the failed one.
Enron was a fashion victim to the fads and gurus of the day.

- In 2000, CEO Jeff Skilling harped about their being
“asset-light”, or intellectually driven capital.
- Arrogance combines with the willing accomplice
accounting firm Arthur Andersen.
October 2001. Enron’s stock price is $33.17.

October 16, 2001. Enron issues a press release stating it had

to report “non-recurring charges totaling $1.01 billion after-
tax”
Two weeks later, Enron’s stock price is $13.90


ENRON 101
Investing In a Post-Enron World by Paul Jorion
November 8, 2001.

Enron issues a restatement of reported income for
-
1997 to 2000, $586 million.
Andersen decided the financial results of the
-
complicated Enron partnerships should have been
consolidated with the parent company from the
beginning.
By February 2002, Enron stock price had fallen to 26 cents

a share.
Chapter 11 Bankruptcy filing takes place soon after.

• Lessons for investors: Caveat emptor. “The buyer
beware”…
If the nation’s seventh-largest public company, the Wall

Street and business school star can engage in deception,
you need to watch out for your own interests.

ENRON 101
Investing In a Post-Enron World by Paul Jorion
Do your homework.

Don’t believe everything corporations report to you.
-
Do your own research.
-
Even the brightest are baffled by statements made by

Enron.
The figures simply don’t add up.
-
Beware of fads.

Gurus claimed “asset-light” was the way to go, today
-
they are saying it’s good to invest in “boring”
companies.
Avoid fads altogether.
-
Diversify.

Your portfolio should reflect the real risks of doing
-
business.

HOLDING THE ACCOUNTING FIRM ACCOUNTABLE
Investing In a Post-Enron World by Paul Jorion
The question of materiality, where a reasonable person
•
decides whether or not to invest in a company.
a history of non-disclosure, dismissing certain gains and
•
expenses as irrelevant or immaterial to a company’s
financial statements.
Andersen released an audit report in 1995 that was

materially false and misleading.
The firm had also conspired with Waste Management Inc.

and painted a different picture of reality in its reports.
In June 2001, Andersen paid a $7 million fine in a

settlement with the SEC.
Andersen also tried to clear its reputation by saying it
•
was David Duncan, the member of the Andersen team
working at Enron, who ordered the shredding of
documents on October 21, 2001.
The company fired him, and tried to tell the public that he

was the only bad apple in the company.

HOLDING THE ACCOUNTING FIRM ACCOUNTABLE
Investing In a Post-Enron World by Paul Jorion
Whereas for Harvard-educated MBA Jeff Skilling to imply
•
he left the reins of Enron completely in the hands of
Andersen accountants was an incredible suggestion, but
there is some truth to the statement that Andersen did
provide very bad accounting advice.
• The emergence of check box accounting
A smart Chief Financial officer can find a way around the

rules, and make clever use of any legislative loophole.
- This is following the letter of the law, rather than its
spirit.
During the time of SEC chairman Harvey Pitt; the

government wanted a less adversarial type of relationship
between the organization and the companies it regulated.
- This further contributed to the emergence of a check
box style of accounting where CFO’s, accountants, and
lawyers look at what isn’t in the rulebook, and together
find a clever way to get around the law.

HOLDING THE ACCOUNTING FIRM ACCOUNTABLE
Investing In a Post-Enron World by Paul Jorion
• What makes an accomplice?
When two companies work together toward a mutual goal,

and share the same value system (or lack thereof) and
think alike, you have a perpetrator and a willing
accomplice.
- Proof of this is the dismissal of Carl Bass, Andersen’s
internal head of Professional Standards.
- The Enron-Andersen relationship was strong enough
that Andersen would kick out anyone calling for ethical
practices.
The basic question investors should have asked was

“When is Enron going to make some real money?”
In fact, they should have demanded Enron “show them
-
the money” in terms of proper dividends.
The basic proof of any profitable enterprise is a
-
payment of dividends.
Investors simply ignored this basic measure of a
-
company’s value-creating ability, getting caught up in
the hype of the “Mother of All companies” and stock-
price appreciation.

HOLDING THE ACCOUNTING FIRM ACCOUNTABLE
Investing In a Post-Enron World by Paul Jorion
• Lessons for investors
Auditors are supposed to make independent assessments

of a company’s finances. The auditor is not supposed to
help pick out strategies and structure deals.
An accounting firm and a high-flying company should not

be in such a cozy relationship.
Marking to market, a time-honored valuation technique,

cannot work in contemporary businesses where there is a
constantly accelerated pace of change, technology, and
where you cannot assess future values.
Taxing dividends more heavily than capital gains provides

a huge incentive for “bubble thinking”.

SHARING A CAPITAL GROWTH - OR NOT
Investing In a Post-Enron World by Paul Jorion
“The method by which we accumulate capital in this
country is to have an investor anywhere in the country buy
a share of stock based on the belief that the financial
statements represented by that corporation and approved
by accountants is a fair and honest representation of what
is happening inside that corporation. If that trust is broken,
and I believe it was in the Enron situation, it undermines the
method by which you accumulate capital for our system of
capitalism.” - Senator Dorgan
• Investor options:
 Charging rent prorated on the loan amount or claiming a
share of capital growth.
- When charging rent, investors are only exposed to
default of the borrower, and risk is low.
- When holding a share, the investor (capitalist) shares
capital growth with the borrower (entrepreneur).

SHARING A CAPITAL GROWTH - OR NOT
Investing In a Post-Enron World by Paul Jorion
With low capital growth, it is in the interest of the

investor to buy corporate bonds and in the interest
of the entrepreneur to issue shares of stock. With
high capital growth, it is in the interest of the
investor to buy shares of stock and in the interest
of the entrepreneur to issue corporate bonds.

THE PRICE AND VALUE OF A SHARE OF STOCK
Investing In a Post-Enron World by Paul Jorion
• Remember that IPO’s are overpriced.
 It pays to wait a few months to see what happens.
 In most cases, the prices go down.
• We cannot restate it enough, do not invest in companies
that do not pay out dividends!
 Dividends are the only reliable indicator of a stock’s value.
 Insist the company play by the rules and show you the
money.
• Set your price and stick with it, and know exactly when you
will decide to sell.
 Leave a standing order with your broker
 go find a good book to read.

THE PRICE AND VALUE OF A SHARE OF STOCK
Investing In a Post-Enron World by Paul Jorion
• How Shares Are Priced
 You can deal with the earnings-obsessed Enrons of the world
by using a filter strategy or the swing strategy.
 Prices of shares are dynamic.
- They go up and down on the trading floor where grown
men scream at each other and frantically wave their
hands.
- The buyer quotes a bid, the sellers quote an asking price,
and all this results in a settle price.
- When transactions take place, new settle prices are born.
 The general rule of thumb is to stick with the herd.
- Buy or hold if the market is buying
- sell when the market is selling.
 The basic tenets of the filter system are to cut your losses
early, and let your profit grow.
- People tend to get caught up and may hold on for too
long, or they reassure themselves prices will go back up.
- Traders are usually stubborn to accept a loss.

HOW ENRON GOT EARNINGS-OBSESSED
Investing In a Post-Enron World by Paul Jorion
The six critical factors in the decline and fall of Enron:
• Factor 1: An entrepreneurial culture run amok
 Enron CEO perpetuated a buccaneering style of
entrepreneurship that got the CFO Andrew Fastow in on
several shaky deals that were plainly conflicts of interest.
 Fastow awarded himself $30 million in commissions from
LJM2 and no one in Enron’s senior ranks raised any
objections.
 The Enron entrepreneurial culture was such that Skilling
encouraged such excesses and management strategies that
were disastrous.
• Factor 2: The failure of project summer
 This refers to the failed attempt to raise cash for Enron in the
summer of 2000.
- The company failed to complete a deal to sell the bulk
of its international energy holdings for about $7 billion
to a group of Middle Eastern investors.

HOW ENRON GOT EARNINGS-OBSESSED
Investing In a Post-Enron World by Paul Jorion
- Sheik Zayed, longtime president of the United Arab
Emirates, had to undergo hospitalization, and being the
leader of the group of investors, the deal came to
nothing.
- Fastow began selling foreign assets to a variety of off-
balance sheet partnerships as a temporary measure to
improve the company’s cash holdings.
- The transactions normally take six months
minimum, but Fastow was closing them in two to
three weeks, according to New York Times
correspondent David Barboza.
• Factor 3: Broadband and model risk
 Enron pioneered in coming up with the first standardized
bandwidth product.
- Being the first in the market to come up with such a
product, they had to make good guesses about the level
of buy and sell orders, and the model risk or risk that
grows out of an inaccurate representation of the
fundamentals of the market, leads to locating the bid
and ask quoted to others -at the wrong level.

HOW ENRON GOT EARNINGS-OBSESSED
Investing In a Post-Enron World by Paul Jorion
 “Because Enron was dealing in commodities where there
was no established public market to set prices, a trader had
to decide on a price curve, the expected direction of prices
in the future – on which to value each deal in the present”.
 Calculating a forward for energy products and bandwidth is
very difficult.
- If the forward turns out to be way off the mark, the
irate customer will likely demand renegotiation of
contracts, as what became clear in the California
energy crisis of 2000-2001.
- By April 2002, the electricity forwards bought in 2000
were priced 3 times the spot price for electricity.
Factor 4: California, energy, and nomads
•
 The story behind California and Enron is similar to that of
farmers and a group of nomadic raiders.
- In lean times, the nomadic raiders can help the
farmers by selling goods they have stolen elsewhere.
- But more often than not, the raiders are a nuisance;
sometimes even dangerous.

HOW ENRON GOT EARNINGS-OBSESSED
Investing In a Post-Enron World by Paul Jorion
 So in the California situation, Enron was a raider in the
sense it jammed transmission lines, used futures and
derivatives to buy and sell the same electricity 15 times in
order to inflate the price.
 The deviousness was made worse by the jokes Jeff Skilling
made about California, caricaturing it as worse off than the
Titanic, because at least “when the Titanic went down, the
lights were still on”.
• Factor 5: Buying time with derivatives
 “Under generally accepted accounting principles, a company
is generally precluded from recognizing an increase in value
of its own stock as income.”
 A firm is forbidden to capitalize on its own stock - period.
 Instruments known as derivatives provide a way to evade
such prohibitions as long as some distance is maintained
between the derivative and the underlying product.
- Enron treated its stock as the underlying product rather
than the product itself.

HOW ENRON GOT EARNINGS-OBSESSED
Investing In a Post-Enron World by Paul Jorion
• Factor 6: Hooked on a bull market
 Enron’s managers were not alone in betting that the bull
market would last forever.
- Vivendi Universal, a French media and utility
conglomerate, revealed in 2001 it had sold “put
options” on tens of millions of its own shares.
- The premiums were used to finance the executive
stock option plan.
- When the stock price falls, the seller of a put option
loses the difference between the current price and
the so-called strike price.
- Even telecommunications companies like France
Telecom, Deutsche Telekom and Telecom Italia
were using puts on their own stock, not for financing
stock option plans but for acquisitions.
 The escalator goes up and down.

HOW ENRON GOT EARNINGS-OBSESSED
Investing In a Post-Enron World by Paul Jorion
 The only thing that works in a bull market aside from the
poor strategy of Enron are the equities of your 401k plan,
all executive stock option plans, and index funds.
- Short selling only works when things are going
downhill.
- Sooner or later any strategy that assumes prices only
go one way will fail.
• Lessons for investors:
The CEO’s sense of humor can be a moral compass to the

culture of the company you want to invest in.
Is the entrepreneurship sensible or is it buccaneering?

How are top people getting paid and how much? Is it

appropriate?
Consider including a contrarian in your portfolio.


STOCK OPTIONS:
THE WAR BETWEEN MANAGEMENT AND A TOCKHOLDERS
Investing In a Post-Enron World by Paul Jorion
• The stock option was introduced during the late 1980’s
to make management think less like bureaucrats and
more like owners of the company they worked for.
 Investors received dividends, while top executives
received salaries and bonuses plus the stock option plan.
• Earnings may be used for acquisition growth,
reinvestment to the capital, to retire debt, to buy back
shares of stock, or as extra compensation for
executives.
• It is justifiable and legitimate to use earnings for
acquisition, reinvestment, or debt retirement, but
compensation for executives, and in Enron’s case
excessive compensation at that, seems harder to justify.
• For one, why should a company that is not performing
well reward its management by the millions, when their
performance should be tied to their compensation?

STOCK OPTIONS:
THE WAR BETWEEN MANAGEMENT AND A TOCKHOLDERS
Investing In a Post-Enron World by Paul Jorion
• Lessons for the investor:
The tax system is shareholder-unfriendly.

- It is lenient on corporate debt. Let’s say a stock option
at the $25 level closes at $27, the gain of $2 is
taxable.
Stock option plans involve misappropriation of corporate

profit from shareholders.
A company that expenses its stock options is a wiser

one.
Dump the company that reprices its stock options.

Repricing makes a mockery of the principle that stock
-
options are part of a managerial incentive aligned with
shareholder interests.
Money can be lost after stock options are exercised.

Sell the stock to realize capital gains.
-
Do not borrow money to buy stock.

The lowest value of a share of stock is zero.
-
This is lower than the loan you are taking out.
-

STOCK OPTIONS:
THE WAR BETWEEN MANAGEMENT AND A TOCKHOLDERS
Investing In a Post-Enron World by Paul Jorion
Understand the tax implications of exercising your stock
•
options.
The alternative maximum tax applies to the difference

between stock price at the time the stock option is
exercised and the initial strike price, not to the stock price
when shares are sold.
Wait for the price to rise and then exercise your option.
•
Do not get fooled by bogus share-buyback programs.
•
A share buyback policy is beneficial to the investor if the

stock is undervalued.
Otherwise it can be detrimental to your interest.

Keep an eye out for first indexed options programs.
•
Make sure the stock option program that your money

supports links option exercise prices to broader market
indicators, so they must have a frame of reference for
judging executive performance.

WRETCHED EXCESS
Investing In a Post-Enron World by Paul Jorion
• Do not buy the stock in a company that allocates
excessive executive compensation.
 The company is cheating its shareholders.
• Get involved and write a letter to the board of directors if
you do not like what you read in the fine print of the
company’s annual report.
• Excessive compensation of a company’s executives is
wrong.

WRETCHED EXCESS
Investing In a Post-Enron World by Paul Jorion
• Thomas Stern, managing director of Chieftain Capital,
stated how unacceptable it was that Peter Boneparth,
president of Jones Apparel Company was awarded $35
million in options and $10 million in compensation after
only 9 months at the company.
 He did not even prove he was capable of creating value
for the company in such a short time.
• Excessive compensation of executives simply robs the
shareholders of the capital growth that is rightfully
theirs.
 “perks”-the corporate jets used on weekends
 “borrowing”- of huge sums of money and personal usage
of company resources.

AGGRESSIVE ACCOUNTING
Investing In a Post-Enron World by Paul Jorion
• Aggressive accounting
 is not about producing an accurate picture of a company’s
financial condition
 This is more about painting as favorable a picture as
possible without breaking any rules.
• Pro forma financials
 are informal reports and can be very deceptive.
 Most financial reports employ generally accepted
accounting principles required by law
 pro forma may not be so accurate.
• If there is no established market, be cautious about the
numbers.
• If your company is creating a market and assigning
long-term value to that market, keep your hand on your
wallet.

AGGRESSIVE ACCOUNTING
Investing In a Post-Enron World by Paul Jorion
• Look for the hiding places or these types of words in
financial reports:
“Goodwill”

- an intangible value attached to the business
evidenced by the ability to earn larger net income
per dollar of investment.
- This is the premium paid to shareholders to entice
them into the acquisition process.
“Gain on Sale”

The calculated present value of future profits, creating

earnings out of thin air.
”One-time charges”

When a company purports to announce earnings

before unusual or nonrecurring transactions
“Other revenues”

One-shot gains often used to compensate for losses in

other divisions.

MASSAGING FINANCIAL REPORTS
Investing In a Post-Enron World by Paul Jorion
• Enron found a “legitimate” way to represent its
subsidiaries and affiliates, creating a very misleading
picture:
 Debts should have been fully disclosed in the footnotes of
the minority interests.
 Collateral should have been shown in “commitments and
contingencies” in the balance statement or in the footnote
discussing earnings per share.
 Contingent stock obligations were not included in the share
dilution calculations.
• Enron’s public documents left even the expert analysts
scratching their heads.
• When reading financial statements
 trust the first few pages, that is where the good news is.

MASSAGING FINANCIAL REPORTS
Investing In a Post-Enron World by Paul Jorion
 Bad news is usually hidden in the fine print.
 The closer the information is to the beginning of a
financial statement, the less processed and more
trustworthy the information is likely to be.
• In the days when earnings translated into dividends,
earnings were a good thing.
 Today earnings-obsessed companies are tempted to
manipulate stock prices.
• It is disturbing to find that investment bankers and
research analysts are titles used interchangeably, as in
the case of Enron.Appraisals of stock were overruled by
business considerations, one such example of this
overruling follows:
 Broker Chung Wu of Paine Webber sent a message to
clients in August of 2001 that Enron’s financial situation
was deteriorating. Enron stock was worthless, and the
company was in bankruptcy court.

MASSAGING FINANCIAL REPORTS
Investing In a Post-Enron World by Paul Jorion
 Analysts report companies routinely stop communicating with
them if they issue a sell recommendation on a company.
 There is a conflict of interest between research and investment
banking. Consider the services of independent researchers like
www.investars.com, www.thomsonfn.com,www.starmine.com,
and www.jaywalkinc.com.

AN OPTIMIST VIEW
Investing In a Post-Enron World by Paul Jorion
• Ultimately there are more decent people in publicly
regulated markets and it will eventually force an
improvement in ethical standards and in surrounding
industries.
• The Final Word
 Do not buy stock in a company whose good health
depends on the support of a stronger parent. Be wary also
of investing in an unstable parent company whose
numbers are being rescued by one or two star
divisions.
 Do not buy stock in a company whose main asset is its
good reputation.
 Do not buy stock in a company whose fate is linked to a
particular credit rating.
 Do not buy stock in a company whose credit rating
depends on the government’s implicit support.

AN OPTIMIST VIEW
Investing In a Post-Enron World by Paul Jorion
 Do not buy stock in a company whose fate depends on a
low-probability event not taking place.
 Do not buy stock in a company whose business depends
on a legal or tax loophole.

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Investing In a Post-Enron World by Paul Jorion
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