I just finished reading a couple of books on the share market, in particular about the early 2000s frauds by Worldcom and Enron: [A Mathematician Plays the Stock Market](http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FMathematician-Plays-Stock-Market%2Fdp%2F0465054803&tag=exaspercalcul-20&linkCode=ur2&camp=1789&creative=9325)
and [The Smartest Guys in the Room](http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FSmartest-Guys-Room-Amazing-Scandalous%2Fdp%2F1591840082&tag=exaspercalcul-20&linkCode=ur2&camp=1789&creative=9325).
The question that struck me while reading the books (particularly the Enron one) was whether or not
I would have bought those shares, and got caught up in the same collapse. What was it about the
Enron shares that ‘smelled’ before the big collapse became inevitable.
This isn’t really a question about making money in the short run, but rather about whether or not
a company’s business is “real”, and there for the long run. In the short run, all kinds of silly
things can make money, so long as you sell in time. But in the long run, there has to be a
real business behind the company.
Enron, as far as I can tell, was a company where the fundamental ‘real’ business was pretty
non-existent, or was losing a lot of money because they weren’t charging enough. A lot of the gains
were coming from mark-to-market accounting (taking the entire profits of a 20-year deal as soon
as it was signed), or the trading operations (which were good, but a very volatile business). As
far as I can tell the actual fraud was a fairly small part of the problem, really only delaying
the final end of the company by a few quarters.
Paying attention to the actual cash flow, rather than just the reported profits, would probably
have helped spot the problems early (as, indeed, it did for some), but I suspect that this rule
would be too strict – you’d tend to eliminate some companies that do have a good business, just
not a lot of cash.
I have a few personal rules of thumb for my own (hypothetical, so far) share purchases:
* Focus on businesses that supply some bit of GDP that is clearly identifiable.
* Avoid businesses that depend on Government decisions for their profitability: health insurance,
airlines, and so on.
* Make sure that the price to earnings ratio isn’t too wacky (normally a good sign that there’s
speculation, or some kind of other problem, going on).
* Understand the actual business of the company (where does it make its money from), as opposed
to what they say the rules are.
By this basis, Enron would have thrown up red flags on at least two, maybe all four, if I’d
looked into it enough.
Which I suppose is the real lesson – if you’re going to invest in a company, you should understand
it in a lot of detail, because otherwise you’re at a lot of risk.