“Enroned” an Update On High Prices & Low Quality Stocks

The phrase “I got Enroned” has entered the investing lexicon recently. KCR believes the term is slang to describe the losses being incurred by investors in stocks with indefensible valuations and low-quality accounting.^[1] This piece updates our January work identifying the stocks most like Enron today.

Get our insights direct to your inbox: SUBSCRIBE

Academic Evidence on the Accounting Practices of Overvalued Stocks

The portfolio managers working on KCR’s blogs derive most of their insights from proprietary tools that lean on some of the most rigorously vetted academic research. In 2013 we wrote a brief primer on earnings management research. Done by legendary academics Richard Sloan, Messod D. Beneish, Charles M.C. Lee, and D. Craig Nichols, their work provided powerful empirical evidence that corporate fraud and earnings manipulation could often be detected prior to Wall Street catching on.

As we noted in our original piece, their evidence-based approach to financial statements identified “……12 out of the 17 best known non-financial fraud cases during 1998-2002…using financial information available well in advance of the public disclosure of their accounting problems.”^[2] KCR used their work to build a powerful rules-based system that helps us identify and avoid firms that may suffer similar fates.

In January of 2022, we built an Index of Glamour Stocks with valuations, returns, and earnings manipulation scores that were equal to or worse than some of the most infamous stocks of the dot com bubble. The list of exorbitantly valued firms our evidence-based models identified as being highly vulnerable has suffered terribly since publication. At the request of subscribers, we have updated the trajectory to put their performance in historical context.

*See our January piece for an explanation of “dot.frauds” and inclusion criteria for our Glamour Index

What Happened to Enron Won’t Necessarily Happen to These Overpriced Stocks but Why Chance It?

The collapse of Enron was driven by Enron executives who would take the storied energy trading firm from glory to bankruptcy due to criminal malfeasance. KCR would like to be clear that we did not, and are not, stating that the companies in our Glamour Stock Index are engaged in anything illegal. These are stocks with difficult to justify valuations and also show up on the same screen that identified the Enron Corporation as a high-risk stock long before the Enron scandal became front-page news.

Since we published the piece highlighting these firms’ elevated valuations, negative accounting traits, and poor fundamentals, the stocks have plunged by -40%. KCR believes this is a testament to the power of a rules-based approach to stock selection predicated on evidence from top flight academia. Nobody can time markets, but for those interested in compounding wealth with lower risk, a process that integrates factors like these can help avoid costly losses by avoiding expensive stocks with low quality accounting.

The chart below updates the valuation of our Glamour Stocks post their violent sell-off. When we first built the list, they traded at 10x price to sales, a level of valuation with few precedents of success.^[3] Figure 2 below shows that these stocks now trade at 4x sales. This is still above the level where Enron and other overvalued stocks with low-quality financials peaked in 2000. Historical evidence suggests these stocks have further to fall.

Using Price to Earnings Ratios when Valuing a Stock May Help Avoid “Being Enroned”

KCR recognizes that after falling -40% in just six months, our list of highly valued stocks with uncertain accounting may begin to look inexpensive. KCR does not believe we can time markets.

We believe in the empirical evidence suggesting that these still-expensive stocks with low-quality earnings continue to offer investors poor risk and reward characteristics.

Our piece Anatomy of a Bear Market explains how the fall-out from speculative manias creates violent counter-trend rallies. Those short-term movements in price often lure unsophisticated investors back into speculative stocks like these.

Our list of Glamour Stocks consists of 51 names. In Fig. 3 below, we have created a histogram showing these names’ valuation based on various price to earnings ratios (P/E) ranges. The first bar shows that after the -40% sell-off, there are 4 stocks that now have P/E ratios that are cheaper than the market.

The second bar shows there are seven stocks that are valued between 35x and 50x P/E. The third bar shows there are 12 stocks between 50x and 100x earnings. The fourth bar shows there are 11 stocks valued over 100x earnings. Not only do all these stocks trade far above the market average P/E ratio, but it is also important to remember that they have triggered the accounting manipulation flag built by the academics mentioned above.

The final bar on the right shows that 17 of these stocks are actually losing money.

As our paper on the Vanguard Small Cap Index showed, the evidence is clear: loss-making firms are poor investments compared to profitable firms. The general conclusion when looking at this information is merely to substantiate further the evidence that these stocks are vulnerable compared to the broader market.

Conclusion:

• In January 2022, KCR identified 51 stocks that traded at very high valuations and had also triggered a powerful academic tool for identifying weak accounting standards
• The evidence from academia and KCR’s own research was overwhelming in suggesting the combination of these traits indicated these stocks were vulnerable to significant underperformance
• Since publication, the stocks have fallen sharply, and some readers are wondering if their recent collapse might have created an opportunity to invest

Based on the rigorous academic tools we use in our own rules-based investment processes, the evidence is clear: these stocks will likely face significant headwinds. The table below shows the following three rows of fundamental data:

• The broad US Market’s fundamentals, which represent what you would get if you bought a typical market cap-weighted index fund
• The Glamour Stocks’ fundamentals on the date we “outed” them as high-risk speculative stocks prone to sharp losses at the beginning of the year
• The Glamour Stocks’ current fundamentals post their severe sell-off

While the empirical and fundamental research provides powerful evidence that these firms should be avoided, we recognize that they are also prone to violent price swings. This can be seen in their beta figure, which, at 1.4x, is significantly above the market.

Our evidence-based investment process relies on powerful ranking engines that sort stocks from most to least favorable. The research underpinning these ranking methodologies is based on academic studies and our firm’s proprietary research. Our rules-based approach to investing can be uncomfortable.

When markets are speculative and investors chase highly valued stocks with fundamentals that, based on the evidence, are indicative of poor long-term outcomes, we will underperform.

Over the long haul, however, our approach to investing removes emotion results in low turnover, high tax efficiency, and the potential to compound wealth with an emphasis on reducing drawdowns and minimizing losses.

Please see below the list of companies that are in our Glamour Stock Index.