Many people were surprised by the Enron collapse and lost money as a result. But James Chanos, head of a short-sell investment boutique, was not one of them. His firm profited from anticipating the company's demise. So Congress asked him to testify as to how he knew what no one else did.
How to Spot the Early Warning Signs
Surprisingly, many of the warning signs were out there in full view to anyone with an understanding of accounting. All they needed to do was take the time to study the company's periodic SEC filings, then combine that knowledge with a few other sources of publicly available information. If these few remaining ingredients can be baked into the financial reporting process, accountants and savvy investors everywhere may soon be able to follow the same six-step formula that worked for Mr. Chanos. Here are the six steps:
- Cast a skeptical eye on the company's accounting policies. Enron's financial reports clearly indicated it used the gain-on-sale method of accounting for its trades. This method relies heavily on management's judgment. In a nutshell, it allows a company to book current profits based on the estimated future profitability of a trade made today. In Mr. Chanos' experience, this method of accounting often tempts management to be overly aggressive in its assumptions about the future.
- Analyze key ratios and benchmarks. Enron's 1999 Form 10-K filing indicated a 7% return on capital. Mr. Chanos says this was quite low compared with two important benchmarks: (1) Industry averages for energy trading companies that used the gain-on-sale method of accounting, and (2) Enron's cost of capital. Neither figure was readily available in Enron's financial statements, so Mr. Chanos needed to do some digging and make some assumptions in this area.
- Look for insider trading. Mr. Chanos found what he perceived to be a large amount of insider selling of Enron stock by Enron's senior executives. While not damning by itself, Mr. Chanos says, such selling in conjunction with our other financial concerns added to his firm's conviction that the stock was overvalued. Currently, this information is not reported in SEC filings as quickly as some would like, but more timely information on insider trading is one of the reforms under consideration by legislators.
- Compare management's projections with industry trends. Mr. Chanos says he noticed that Enron was boasting of a huge untapped market in the trading of broadband capacity at a time when a snowballing glut of capacity was developing in that industry. By late 2000, his research indicated that the stocks of companies in this industry had fallen precipitously, yet Enron and its executives seemed oblivious to this.
- Be alert to any loss of credibility with customers and business partners. Press accounts indicated Enron's relationships with customers and business partners were declining during the California energy crisis, as Enron invoked a little-noticed clause in its contract with its California retail customers. Rather than accept what is called counter party risk, Enron was telling a number of very prominent California companies, "This is now your problem, not ours." Enron's credibility in the entire energy retail business began to crumble when it refused to recognize sure losses in California.
- Be alert to any loss of human capital. Mr. Chanos says he heard reports in the spring of 2001, confirmed by Enron, that a number of senior executives were departing from the company. That was a clear warning sign. But the most important sign in this regard were newspaper reports in August 2001 of the abrupt resignation of Enron's CEO for "personal reasons." In our experience, says Mr. Chanos, there is no louder alarm bell in a controversial company than the unexplained, sudden departure of a chief executive officer no matter what official reason is given.
Mr. Chanos is the president and founder of Kynikos Associates, a small investment management firm that specializes in short-selling, a technique that allows to investors to profit from identifying stocks that are overvalued or about to fall in price. Neither he nor anyone in his firm is a CPA or attorney.