What investors can learn from the Enron mess

What investors can learn from the Enron mess; the largest bankruptcy in U.S. history offers valuable lessons on how you should invest in today's market - Investing - Statistical Data Included
Black Enterprise,  April, 2002  by Matthew S. Scott

JOYCE BARRETT DIDN'T DIE, BUT SHE LOST HER life. The former human resources professional was one of the casualties of the largest corporate bankruptcy in history: the fall of Enron. Last November, Barrett, a 12-year employee for the Houston-based energy trading company, discovered that it grossly overstated its earnings by about $1.2 billion and was on the verge of collapse. By the month's end, Enron's stock price had plummeted to a mere 36 cents.

After working 14-hour days with extensive travel and little time off for vacation, Barrett didn't have much show for her years of service. By the time the company filed for bankruptcy, she was wiped out, losing more than $65,000 from her 401(k), another $80,000 in stock options, and more than $65,000 in severance pay to which she was entitled. "My life has changed. Financially, I'm ruined," laments the single mother of two adult children. "[I lost] everything I had tied up in that company. I have no medical insurance and no dental coverage. For the first time in my life I have nothing, I feel like a loser, a second-class citizen."

Struggling to maintain her composure, Barrett adds, "This is a lot more criminal than white collar crimes. I feel betrayed."

She's not alone. Tens of thousands of Enron employees have had their lives, aspirations, and retirement plans destroyed. These workers--many who once held shares valued at $87--must now figure out a way to pick up the pieces.

Don't think for a moment that because you didn't work for Enron this crisis doesn't affect you. Scores of pension funds, endowments, and mutual funds had substantial positions in the entity that was once the seventh largest corporation in America. Moreover, hundreds of thousands of workers--including many African Americans--have invested in 401(k) plans and company retirement programs structured like Enron's. And you just may be among them.

A NEW DAY IN THE FINANCIAL MARKETS

Over the past few months, Enron has become synonymous with corporate duplicity and fiduciary failure. At the heart of the matter is how a corporation used a slew of "off-balance sheet" partnerships to hide enormous losses, and, as the stock took a nose-dive, forced employees to hold on to shares in retirement accounts while top management, including former CEO Kenneth Lay, made millions by exercising stock options. To make matters worse, Andersen, the accounting firm charged with auditing Enron's financial statements, became an alleged participant in the subterfuge by shredding documents.

The meltdown at Enron has produced congressional hearings, investigations by the U.S. Securities and Exchange Commission, and several legislative proposals to protect the accounts of 401(k) investors. In short, it has served to undermine investor confidence and roil the financial markets. "Enron was the light that came on and showed corporations that inefficiencies will eventually catch up with you," says John Ripoll, senior vice president at the Atlanta-based Jackson Securities (No. 5 on the 2001 BE INVESTMENT BANKS list with total managed issues of $29.397 billion). He maintains that corporate accounting practices will continue to be heavily scrutinized by individual and institutional investors alike. "And auditors will force companies to adhere more closely to GAAP (generally accepted accounting practices)," he says.

Stocks from a number of companies that have restated earnings have been hammered on Wall Street. Such blue chips as Procter & Gamble (NYSE: PG), AOL Time Warner (NYSE: AOL), and General Electric (NYSE:GE) have been among them. It appears that the more complex the entity, the bigger the sell-off from investors. Take Tyco International (NYSE: TYC), the industrial conglomerate that was once the darling of the Go-Go '90s. The stock plunged to a staggering 49% in the first four weeks of 2002, due in part to its complicated structure and questions about its accounting practices. Adds Ripoll: "The question [is whether] investors see Enron as an isolated incident or will they feel that the system has been abused for years."

WHAT ENRON MEANS TO YOU

The Enron mess provides solid lessons on investment decision making and portfolio protection in today's environment. Heed the following:

* Lesson No. 1: Diversify your investments

There's one rule of risk management--diversification. Before you think about making an investment decision, clarify your investment goals and then structure an asset-allocation model to help you achieve them. Your diversified portfolio should extend across a range of asset classes, including stocks and bonds. (See "Getting the Scoop on Investing," this issue.) The most devastated Enron employees were those who neglected to hold a mixed bag of assets. "The notion of diversification has won out because portfolios that were properly diversified have not been experiencing these pains," says Garry Bridgeman, a certified investment-management analyst with Merrill Lynch. "The more evenly your funds are diversified, the less risk is built into the portfolio. Maybe you don't have the maximum upside potential, but you'll stay in the ball game and have a much more [consistent] rate of return over time."

* Lesson No. 2: Limit single investments

Don't invest heavily in a solitary stock, bond, or security. Even if your employer seems like a sure fire or safe investment, such a tactic can actually place your portfolio in jeopardy. The Enron employees broke this role, placing as much as 62% of their 401(k) money in company stock. To make matters worse, Enron matched employee contributions with company stock. And 25% of companies with 401(k) plans make matching contributions in the same manner.

According to the Institute of Management and Administration Congressional Research Service, corporations with retirement savings plans where company stock dominated total assets included Procter & Gamble (94.7%), Sherwin-Williams (91.6%), Abbott Laboratories (90.2%) and Pfizer (85.5%). For other company stock-laden 401(k) plans, see chart "Risky Business."

Like Enron, 85% of these plans restrict the sale of their stock, and many force employees to hold their shares until age 50. Companies often change 401(k) administrators and place "lockdowns"--also known as "blackouts" and "quiet periods"--on retirement savings plans, restricting employees from making any investment changes until accounts are transferred. Enron employees were prevented from moving out of company stock as its price tumbled.

How much of your portfolio should be devoted to the stock of a single company? Limit investments to no more than 5% of your holdings. "When you start getting more than 5% of a concentration in any one area, that position is going to start to have greater influence on what your overall performance is likely to be," says Bridgeman.

While Dale Bryant, CEO of The Bryant Group in New York, agrees with the 5% rule, his preference is for investors to steer clear of their employer altogether. If you receive company stock as a 401(k) match, or must take it as part of your compensation package, "sell it as quickly as you can and reallocate the money among other investment choices in your 401(k) or elsewhere." For one reason: Small investors who hold individual stocks are more likely to be at the mercy of volatile markets. "The regular investor doesn't have the time to react [to volatility]. They're not a professional looking at a screen all day checking price movements," he says. "When something bad happens, the speed of the market will pull your portfolio down in a matter of seconds."

* Lesson No. 3: Evaluate your mutual funds

Although a mutual fund offers less risk than your company's stock, thoroughly examine its holdings. At one point, notes John Kartsonas, an industry analyst with Standard & Poors, institutional investors held roughly 64% of Enron's outstanding shares (as of October 16, 2001). As a result, such Enron-heavy funds as the Galaxy II Utility Index (IUTLX), AIM Global Infrastructure (GIFAX), and Turner New Energy & Power Technology (TNEPX) racked up huge losses over the past year. (See chart on this page.)

So know what you're buying. Before investing a single dollar in a fund, examine its current holdings and review their prospectus to gain a full understanding of its investment policies and guidelines.

Also, make sure there isn't an overlap of your stock funds' holdings. "You could have an AIM Fund and a Fidelity Fund that appear to be different, but they're not," Bryant says. "Check the top ten holdings of your mutual funds, just to make sure that they don't duplicate each other."

* Lesson No. 4: Understand the stock you buy

Before you invest, fully understand the business model of the company--even if it's one you work for. Know how your company generates revenues, spends money, earns profits, and invests dollars. Closely investigate how its earnings are measured and presented. By doing so, you may be better able to discern its profit potential and future viability. If you're still fuzzy about the company's prospects, or the numbers, think twice about making an investment. You see, the Enron mess offers you the most important revelation of financial life. Ultimately, the responsibility for managing your portfolio is your's alone.

Risky Business?

Enron's employees aren't the only ones with
401(k) plan rich in company stock.

Procter & Gamble      94.7%
Sherwin-Williams      91.6%
Abbott Laboratories   90.2%
Pfizer                85.5%
Anheuser-Busch        81.6%
Cocoa-Cola            81.5%
General Electric      77.4%
Texas Instruments     75.7%
McDonald's            74.3%
Home Depot              72%
Marsh & McLennan        72%
Textron                 70%
Target                  64%
Enron (Dec. 2000)       62%

COMPANY STOCK AS PERCENTAGE OF TOTAL ASSETS IN SELECTED 401(k)
PLANS, NOVEMBER 2001

SOURCE: INSTITUTE OF MANAGEMENT AND ADMINISTRATION:
CONGRESSIONAL RESEARCH SERVICE
Big Enron Fans

Here is a sampling of mutual funds that had significant
assets in Enron stock as of June 30, according to fund
tracker Morningstar. Also shown are the funds' total
returns in 2001. Most funds haven't yet published
year-end reports, so it isn't known whether these
funds sold their Enron shares, or how much Enron may
have contributed to 2001 losses.

                                 Enron as % of
Funds                            total assets    Fund Total Return:
                                  on June 30            2001

Galaxy II Utility Index               9.0%             -31.7%
AIM Global Infrastructure             6.9              -38.5
Turner New Energy & Power Tech        6.2              -15.9 *
Merrill Lynch Focus Twenty            5.5 **           -70.1
Turner Top 20                         5.3              -38.9
Dessauer Global Equity                5.3              -30.4
Stein Roe Focus                       4.8              -26.5
Galaxy Large Cap Growth               3.9              -16.7
Alliance Premier Growth               2.9              -23.9
Aetna Balanced                        2.7               -4.8

* Fund return from inception Feb. 28

** Portfolio as of July 31

SOURCE: MORNINGSTAR INC. BLOOMBERG NEWS/LOS ANGELES TIMES
COPYRIGHT 2002 Earl G. Graves Publishing Co., Inc.
COPYRIGHT 2002 Gale Group