In Enron’s Aftermath, Investors Rethink Strategy

The collapse of Enron Corp., which caught even many heavyweight professional money managers by surprise and cost them billions, has exposed the shortcomings of Wall Street’s supposedly sophisticated “buy side,” critics say.

“You would think that the mutual fund portfolio managers being directly affected by this apparent fraud would be in the lead screaming for reform” in accounting and other areas, said Mercer Bullard, founder of Fund Democracy, a Chevy Chase, Md.-based company that calls itself an advocate for investors.

“The reason they’re not is that they’re probably embarrassed, because active management failed to detect something that seems so obvious now. It’s a slap in the face to active management,” Bullard said.

Many mutual funds, pension plans and other institutions invested in Enron alongside the company’s workers and retirees and other small investors who in some cases saw their savings decimated.

In the fourth quarter of 2000, when Enron shares were near their peak, purchasers of the stock included the Alliance Premier Growth fund, which bought 3.2 million shares; AXP New Dimensions, which bought 2.4 million shares; and Vanguard U.S. Growth, which bought 1.6 million, according to mutual fund tracker Morningstar Inc. Prominent funds that listed Enron among their top 10 holdings at year-end 2000 included the Janus Fund, Janus Mercury and Janus Growth & Income.

Even at midyear 2001, when the stock already was in decline, many funds still held big chunks of Enron. AIM Global Infrastructure, for example, had 6.9% of its assets in Enron as of June 30, according to Morningstar; Turner New Energy & Power Technology had 6.2%; and Stein Roe Focus had 4.8%.

The presence of so many big names reveals the level of groupthink about the stock, and the general lack of original research in the fund business, critics say. In the wake of the dot-com bust of 2000, professional money managers should have exhibited more skepticism about a highflier such as Enron, some say.

Though numerous fund companies were hurt by Enron’s plunge last year, some commentators have skewered Janus Capital Corp. in particular, noting that the firm’s long-running advertising campaign highlights its in-depth stock research.

“Janus pretends to know more, to dig deeper. At least that’s the line the marketing department uses. But it doesn’t seem like it would have taken a whole lot of sleuthing to have known Enron wasn’t all it was cracked up to be,” said Jonas Max Ferris, editor of Maxfunds.com, a Web site that covers the fund industry.

Critics of the fund industry say numerous red flags were ignored before Enron tumbled into bankruptcy, including a proxy statement released in March 2000 showing that Enron’s chief financial officer stood to gain from the company’s array of offshore partnerships, and a Fortune magazine article in March 2001 questioning Enron’s “opaque accounting and dubious rationalizations” for its generous stock valuation.

“It drives me nuts that people say they didn’t know Enron had problems,” said Sean Reidy, co-manager of the Olstein Financial Alert Fund in Purchase, N.Y., a stock fund known for its research and for its contrarian approach to investing.

In addition to the proxy statement indicating the CFO “may have had somewhat of a divided interest,” Enron had a rising debt load, negative cash flow and a “belligerent” attitude when questions were raised in conference calls with investors, Reidy said. “There wasn’t a smoking gun,” he said. “But there were just too many question marks, too many red flags.”

Perhaps the most worrisome sign was that Enron was a business few, if any, investors could make sense of, Reidy said.

“I had neither the expertise nor the time to put into understanding what the company does. All I know is it’s not something I wanted to be investing in.”

Bruce Veaco, a portfolio manager of the Beverly Hills-based Clipper Fund, said his firm felt the same way. “We could never get our arms around the company,” Veaco said. “We couldn’t grasp how they were making money, and we try to be like Warren Buffett: We won’t invest in something we don’t understand.”

Russ Kinnel, Morningstar’s director of fund analysis in Chicago, said it’s reasonable to ask why other fund managers didn’t follow the same instinct.

“The most galling thing is that here was a company putting out a blizzard of confusing news and not going anywhere near full disclosure, but these supposedly sophisticated fund managers were investing anyway,” Kinnel said. “The thing is, you don’t have to buy the stock, especially if you can’t put a firm value on the company.”

Many Enron shareholders were simply playing the momentum game, say money managers who never fancied the stock: As long as it was hot, nobody seemed to bother to ask questions. That strategy worked like a charm in 1999 and 2000, when the stock tripled in two years.

“Enron is the pinnacle of the Internet era, capping the whole thing off,” said John Wakeman, vice president of research at fund company T. Rowe Price Group Inc. in Baltimore. “The prevailing attitude was, ‘Just tell me the story and never mind the fundamentals.’”

Despite their supposed sophistication, portfolio managers have “a long history of falling for a great story,” Wakeman said. “Usually it’s a capital-intensive business where the ‘sell side’ cheerleaders [brokerage analysts] are out in force.”

With Enron, the enticing story was about reinventing the energy trading business via the Internet.

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Some Insiders Call Criticism Overblown

Wall Street’s army of brokerage analysts has long been taken to task for buttering up corporate managements with glowing reports to help generate investment banking business for their firms, rather than honestly critiquing stocks. Money managers--the “buy side”--always have maintained that they aren’t duped by analysts. But the Enron tale suggests otherwise.

“What this shows is that investors at all levels need better discipline,” Wakeman said.

Still, even diligent scrutiny is unlikely to thwart outright accounting fraud, experts note. “It’s difficult even for auditors to detect fraud if management really wants to hide something,” Veaco said.

Some fund industry insiders say criticism over their Enron investments has been overblown.

Shelley Peterson, spokeswoman for Denver-based Janus, said her firm sustained “very minimal losses” overall in its Enron holdings, in part because it got in early, first buying shares in January 1999. Janus was a net seller of the stock from March 2001 through mid-November, when it sold its last shares, she said.

Still, its Enron holdings couldn’t have helped performance last year, when Janus’ diversified domestic stock funds lost an average of 24% on an asset-weighted basis--the worst performance among major fund companies, according to investment firm Kanon Bloch Carre.

But Peterson defended Janus’ research, which, she noted, led the firm to buy Enron early, well before there were indications that the company was less than forthright.

“Our research process is strong, but it’s predicated on a company not hiding information,” she said.

Other funds that had big stakes in Enron last year declined to comment other than to say they have since sold the stock.

Post-Enron, investors of all kinds have grown increasingly skittish, and portfolio managers have become more leery about stock stories, some say.

“The good to come from all this is that as an industry we’re becoming much more independent and doing more critical thinking,” said Bob Bilkie, portfolio manager at Sigma Investment Counselors in Southfield, Mich., which handles private accounts.

“The Enron disaster means you go through all your portfolios looking for companies whose earnings are less than transparent or whose income statements are so complex you can hardly figure them out,” Bilkie said. “You’re going to see a lot less blind faith in management going forward.”

Firms seen as having complex structures or aggressive accounting, such as the conglomerate Tyco International Ltd., are feeling the effects of a jittery market on their stock prices. Tyco’s shares have tumbled 24% this year.

“Whenever there’s even a hint of possible obfuscation of financial disclosures, the company is now punished,” said Jim Lyon, portfolio manager at investment firm Oakwood Capital Management in Century City.

He and Bilkie both said the market probably has overreacted in the case of Tyco, where no evidence of impropriety has surfaced, and the company has strongly denied that its accounting is aggressive. But “people are going to shoot first and ask questions later. Everybody is in survival mode,” Bilkie said.

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Need for Greater Diversification

He pointed to biotech giant Amgen Inc.’s release of quarterly earnings last week as an example of a renewed sense of wariness among investment pros. Bilkie said he will analyze the report more closely than he might have six months ago, and he suspects competitors are doing the same.

Amgen said quarterly net income was reduced by a one-time charge of 15 cents a share for unsuccessful drug collaborations.

“I have to question whether that’s really a one-time charge or the cost of doing business in that industry,” Bilkie said. “Either way, I think it’s still a good company with good long-term prospects, but I basically have to figure out my own pro forma earnings for every company.”

Lyon said the Enron collapse probably will reinforce the need for greater portfolio diversification by fund managers and retail investors.

Another old-fashioned lesson reinforced by the blowup is that, ultimately, valuations matter. Highly valued stocks, as measured by price-to-earnings ratios and other yardsticks, may deserve to trade at a premium to the market because of a superior business, but those inherent lofty expectations carry downside risk: If the company eventually disappoints, the market might crush the shares.

Reidy said his fund looked at Enron last spring when the stock was at $60 and trading for about 40 times earnings per share, but “we determined that it’s basically nothing more than a trading company, and there’s nothing stable about that kind of business.”

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Josh Friedman can be reached at josh.friedman@latimes.com.