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Your financial enemy
No risk, no return
Published:
Thursday, February 16, 2012
Do you remember the collapse of Enron? At US$65 billion it was then the largest bankruptcy in the United States. It was, in fact, just over ten years ago and for many it is a distant memory. Except that the ghost of Enron has haunted us many times since and local investors need to be aware for history not to keep repeating itself. It is an all too familiar story where a company suddenly starts to report a rapid rate of earnings growth and it is held to much acclaim. Enron was rated as the most innovate company in America the year before it collapsed. Eventually, the façade that covered rampant mismanagement, inadequate corporate governance, lack of proper regulation and overall negligence, came to light and the company failed costing investors every cent that they placed in the company. At the time of the Enron debacle, I was involved in the fields of auditing and corporate finance and followed the issue very closely. After last week’s article, I recognise that this is another opportunity to highlight the importance of having a suitably qualified adviser on your side.
Last week I advocated the importance of obtaining independent professional advice before making your financial decisions. Even though most people ignore this requirement, they do intuitively recognise the importance when considered in the context of the CL Financial, Stanford and Madoff scandals of the last few years. Enron is the classic case, the poster child, as it were, to highlight why you should seek an independent financial opinion on all your financial matters and get it from someone who is competent to offer such advice. Imagine a system where a network of intermediaries acting on behalf of investors, including banks, mutual funds, insurance companies, financial analysts, rating agencies, external auditors, the US Securities and Exchange Commission, the governing accounting board, the respective stock exchanges, yet none of these entities were able to recognise and warn investors as to what was taking place.
This entire system, which is supposed to act as gatekeeper and watchdog, failed to engage to the point where Enron was able to raise billions of dollars in funding for a highly risky business model and conceal the underlying risks by using a complex network of accounting manoeuvres. If all of this sounds very familiar in the context of the sub-prime crisis of 2008 and the collapse of CL Financial, then it should be clear that we do not really learn from the past. The layperson is not expected to know of or understand the lessons of Enron since, as indicated above, it involves so many failures within the system. Similarly, the average person is unlikely to appreciate the detailed reasons for the collapse of CL Financial. This is the forte of the investment professional and their understanding is important because such professionals are entrusted to deploy client funds.
Risk and reward
Given that the entire system failed, some may conclude that it is better to take your chances and keep money in cash, not taking any risk. If you take nothing from this article, appreciate this fundamental point: one of the biggest risks in investing is not taking risk. Without risk, there is no return, so a preference for safety at the expense of risk limits your return potential over the long run. The entire purpose of investing is to have more money available to you in the future than you currently have. Not earning a return on your existing funds for an extended period goes completely against this objective. Over the past 30 years, there was always an asset class that offered the potential for double digit gains. Falling interest rates allowed for capital gains on bonds, resulted in money flows into real estate, represented a positive for stocks and presented an incentive for consumption, which boosted corporate profits. Today, interest rates are at zero and can no longer fuel the asset price appreciation that previously existed. In a slower growth, lower return environment, the ability to recover from financial missteps becomes more difficult. Once again we come back to the point of having a trusted financial adviser at your side.
So how do you avoid being caught up in another Enron, World Com, Lehman Brothers or CL Financial? The bottom line issue relates to where you get your financial information and advice and what you do with that information.
Clear understanding
Most people invest on a hunch or a piece of gossip. That, of course, is a recipe for disaster. Those that are more diligent simply take a recommendation from a Wall Street firm or even a local brokerage firm as gospel. Did you know that even though Enron went down in December 2001, at least 15 Wall Street firms had the stock rated as a “buy” or “strong buy” as late as October 2001? Even up to the day of its bankruptcy, there were only two “sell” recommendations on Enron and seven analysts had the company as a “hold.” Famously, one analyst from Lehman Brothers had the company as a “buy.” It goes the other way as well. Have you ever wondered how come Apple can always beat analysts expectations without fail every quarter? Clearly, despite the huge following and analysis, there was an underestimation of Apple’s performance across the industry. As I hinted last week, oftentimes analysts succumb to conflict of interests on the part of the firms they represent. One Wall Street firm did the pre initial public offering (IPO) placement for Facebook so you would have their clients invested in the stock.
Can they now come out and say it is not a good deal? If you want the stock brokerage, banking or consulting business of a large firm, can your analysts go about beating up on the company's performance or its management? Whether it is the US or T&T, the issue is the same and it relates to conflicts of interest and a lack of independent advice. You must recognise that there is limited scope for independence in the financial services industry and be guided accordingly. Apart from the standard conflicts of interest in the case of Enron, the issue of auditor independence came into focus during the recent sub-prime crisis it was the independence of the rating agencies. It is important, therefore, to understand where your information is coming from and to be critical of that information. Most investors follow the crowd in making investing decisions because either they are unwilling or lack the knowledge to stand out from the crowd. This is why when the market is going up, I get calls as to why we are not investing and when the market is falling, everyone wants to get out. If you accept that this is human nature, then analysts are human, too, and when the prevailing view is that “this is a great stock,” then it is difficult to go against the grain with a negative recommendation.
Investors must appreciate that they carry their financial destiny in their own hands. If you go around shopping for the best interest rate, shopping for the advice you want to hear, or shopping for the product that promises the best return, then you, by your actions, have turned your financial affairs into a commodity. Shopping around means that anyone good enough to convince you to buy will get a sale. If, instead, you focus on determining what financial objectives you are seeking to achieve and understand what is required in order to achieve those objectives, then the solution provider has to formulate a proposal that is unique to you. Since it is unique, you can potentially have a better understanding of what is being proposed and it is here that you can assess the quality of the advice you are given. Most people instead prefer to run after then next investment guaranteed to “get rich quick.” In doing so, you become your own enemy for it is here that the next Enron awaits you.
Ian Narine is a broker registered with the Securities and Exchange Commission.
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