Portfolio manager’s Letter August 2005
I just finished “Conspiracy of Fools”, a book about Enron’s collapse written by Kurt Eichenwald. The book is a wonderful study of the kind of management behavior that the investor must avoid and their unintended consequences.
If the author is correct, and it seems likely to me that he is, then the two guys at the top of this house of cards (Skillings and Lay) did not have a clue what was going on as the roof began to fall in. It is true that in Skillings’ case, the ignorance may have been intentional. But, it is interesting because, if the chairman and the CEO did not realize that Enron was collapsing, what chance did the shareholders, prospective investors, or outside security analysts have of being able to predict the impending disaster and its unintended consequences?
Ecihenwald gives that impression that Fastow was the real snake. He was able to function with out the benefit of any sort of moral compass. Most of the off-balance sheet stuff was his idea and their sole purpose, as far as he was concerned, was to line his pockets and those of his confederates. My overall impression from the book is that Enron was company whose business was a bad idea to begin with and was blessed with pretty mediocre execution. However, this was successfully hidden for a good while by very rapid internal growth and the equity bubble.
I listened to an audio version of the book and the last disk contained an interview with the author. The interview was interesting and provided Eichenwald’s perspective on the nature and causes of performance fraud at new economy companies.
When asked if the government was doing a good job and what were the chances that the proper legislation would be able to prevent a recurrence of the behavior that destroyed Enron, Eichenwald said that this was “a folly that we were all but certain to see again. You cannot pass a law that is going to keep people from robbing banks”. Or from unintended consequences.
He said that the regulators were always fighting the last war and that in his experience there was, ” … a never ending supply of corporate executives who when confronted with the rigors of the market place, when confronted with the reality that their business plans were failing, or that they were not going to make the amount of money that they wanted to make, would decide to cheat, to make their way around the rules, and decide to misrepresent their companies performance.”
Eichenwald explained that he had been given a temporary assignment in 1987 to cover a story about management corruption and unintended consequences. Now, almost twenty years later, that temporary assignment was still going strong. He does not expect to run out of material any time soon. But the most valuable insight came when he was asked where he expected to find bad behavior in the future.
“The only thing that is sure is that it will occur in some fast growing sector. You don’t find major fraud in a slow growing steel mill; you find it in the high tech wonder-boys, or at the fast growing health care centers.
It seems to be the nature of the crime that when companies can more easily disguise the things they are doing through growth, through the growth of the share price, through the growth of the company, they are more likely to do it, and particularly when things start to turn, when the growth starts to slow down. They have become so imbued with the sense of their own infallibility that they just assume that all they have to do is cheat a little to get over the hump, then the crime just starts to grow bigger and bigger.”
Here, I think that we can clearly see that one of the reasons that Warren Buffett likes boring companies is that they do not attract people like Fastow and Skillings and are not as prone to unintended consequences. Also, it likely explains why so much of the bad behavior we see appears late in the business cycle after a period of rapid growth.
I think this point also raises some interesting questions about the impact of central banks and rapid monetary growth on high-level corporate officers’ behavior. The expansionary monetary policy promotes growth, prosperity, and full employment. But, as always, there are unintended consequences, and when the medicine is applied to an economy too liberally for too long, money becomes so easy that the games begin. Huge sums are available to managements whose primary imperative is self-enrichment. Equity bubbles expand. Companies like Enron appear, flourish, and spread their lust for fast conspicuous wealth as if it were an infectious disease.
Bad behavior is not limited to bubbles, but bubbles are the best possible environment for nurturing securities fraud and unintended consequences. As Eichenwald says, “They (management) just assume that all they have to do is cheat a little to get over the hump, then the crime starts to grow bigger and bigger.”
Today we live in a world where most central banks in East Asia have been competing to buy dollars, so the United States consumers will keep buying their widgets. In so doing, these central banks have created an ocean of liquidity that is floating around the world, promoting rapid growth, keeping interest rates low, and undoubtedly at the same time creating an environment that nurtures the growth of bad behavior and unintended consequences. Even though we have not yet discovered which behavior we should assume, conditions are present that allow it to flourish.
This liquidity is apparent in the real estate bubble, low real interest rates, and huge amounts of capital flowing into hedge funds and private equity funds. Although very little is clear about the immediate future, as an investor, it would seem wise to avoid areas where this liquidity has settled, such as the three areas mentioned above. This huge money flow is likely to attract all sorts of unintended consequences, people, and behavior that will not serve investors’ best interests.
Commercial banks hold a more massive percent of the mortgages they originate while lending standards are being relaxed in response to competition become more prone to unintended consequences. Hedge funds and private equity funds offer the opportunity for investment manager compensation that is likely to attract people whose ethical standards are on the same level as those of Fastow and Skillings.
All bubbles pop — the rub is you never know when. But it is my opinion that now is a time to stand well clear of any structure that is not thoroughly earthquake-proof to avoid unintended consequences. If the next bear market does not expose a great deal of fraud and stupidity in the above areas, it will be a huge surprise.