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Integrity
Performance Service
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The demise of Enron has exposed the use of very aggressive accounting treatment by many companies, which was the primary source of their superior earnings showing. Tyco International, Elan, and others have been exposed as draft horses while painting themselves as thoroughbreds. Other companies with complex financial structures have been unfairly victimized. Companies such as General Electric, International Business Machines, and American International Group, with impressive cash flow capabilities based on real assets, have been dragged down. Underlying all the reaction to Enron’s demise are questions about the veracity of the numbers themselves and the truthfulness of the Auditors, who are guardians of the numbers. These events occurred just as the economy is healing from the severe drubbing of early fall. Evidence of an improved economic path is spreading. Durable goods and factory orders generally have improved for two consecutive months. Consumer spending remains resilient even as credit card debt is being paired back. Wages actually increased 2.8% in the fourth quarter. Employment too seems to be stabilizing. Unlike most recessionary periods when productivity has declined, in the current environment productivity advances have remained very strong. Overall, the economic picture remains one of stability leading to a gradual and early recovery. None of these trends are likely to be reversed by the collapse of Enron. The damage inflicted on the financial markets is real. Confusion and doubt about the veracity of financial reporting is understandably widespread. Honest bookkeeping is fundamental to a system in which savings are funneled through stock and bond markets to finance investments that offer a higher living standard for all people. The poisoning of the accounting profession adds to current anxieties. As a result, a strong recovery in stock prices in the fourth quarter has been stopped in its tracks. Of more lasting impact, a greater transparency in reporting will be demanded. In particular, companies which utilize off-balance sheet or esoteric forms of financing without full disclosure will be viewed with suspicion. In addition, acquisitions as a source of growth will be valued less favorably than the "home grown" variety, and there will be an increased emphasis on the quality and sources of earnings growth. Ultimately however the direction of the stock market will be influenced by the overall health of our economy, and individual companies by their business prospects. As unlikely as it might seem now the stock market will not suffer permanent impairment by these events. The effect on the bond market will be more severe and longer lasting, in our judgment. The rapid earnings growth of capital deficient companies with highly complex financial structures is probably over, with negative consequences for some investment banking firms. Some companies will revert to the sum of their pieces, i.e., very slow growth, while others will be forced to shrink by disposing of assets. Weak credits are likely to get weaker. For many capital deficient companies, survival will replace growth as their new business plan. The tendency in recent years to seek higher yields by downgrading quality will prove to be a mistake, in our opinion. Perception often colors reality, at least temporarily. The perception that American corporate accounting has been corrupted is erroneous. Enron is a clear case of hubris and dishonesty through the use of creative accounting leading to outright deception. There is a world of difference between accounting and creative accounting. Like the Long Term Capital Management debacle of several years ago calm will return to the financial markets as investors come to grips with the root causes and extent of Enron’s duplicity. Investment Policy Committee Alfred A. Lagan, CFA, Chairman February 7, 2002
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