Remembering the Risks of “The Smartest Guys in the Room”

We recently put out a two-part summary of Bethany McLean and Peter Elkind’s brilliant book The Smartest Guys in the Room. In an earlier piece, we quoted legendary financial historian John Kenneth Galbraith, who quipped that investors’ memories last “at a maximum, no more than 20 years.The KCR team agrees.

We believe keeping mementos of such disasters at hand is a healthy prophylactic against the allure of high-risk glamour stocks in late-stage bull markets. Before we get to the free “Enron merch,” let’s look for signs of possible speculative excess in context to the frauds of the dot.com era. The chart below shows:

  • The rise and fall of the “Dot.Fraud” stocks, Enron, Nortel, WorldCom and SunMicro[1], from 1990 – 2002
  • The rise of what we consider to be the “Glamour Stocks” of this cycle
  • Using Enron’s reported fundamentals, to be in our Glamour Stock Index required:
    • A P/E ratio of 55x or higher – Enron’s multiple at its peak – so you have to be expensive
    • A stock has to have achieved a 1,000% return or more in the period from 2011 – today
    • A stock must have an earnings manipulator score[2] – more on that later
    • A stock must be in the bottom half of our ranking methodologies
  • To be clear, the KCR team is NOT insinuating that these 51 glamour stocks are frauds
  • The chart below is meant to alert investors to stocks that have achieved immense returns, trade at exorbitant valuations, and could fall sharply from simple mean reversion, much less fraud

We believe that a group of firms that have outperformed and are more expensive than Enron, Nortel, WorldCom, and SunMicro1 at their peaks is a group investors should look very closely at.

[1] SunMicro was most emphatically NOT a fraud. But as Scott McNealy so honestly explained, you didn’t need any footnotes to avoid investing in SunMicro at it’s peak. McNealy and Vinod Khoslas’ honesty about this are something we applauded in Glamour Stocks: Investing vs. Gambling.

[2] For the sake of clarity: the stock only needs to have the necessary data to generate a score – a score is not a negative in-and-of-itself

Total Return of Dot Frauds from 1990 2002 Todays Glamour Stocks from 2011 Today

In our list we marked the firms that failed the screen which identified Enron as a fraud in 1998.

As long-time readers know, a group of famous academics put together a powerful screening tool that sought to uncover firms manipulating earnings. That tool helped a group of MBA students identify Enron as fraud and sell the stock in a portfolio they were managing in 1998 – a full 2 years before Wall Street would catch on.

KCR wrote an accounting fraud essay explaining that work and how we had built a far more rigorous and robust tool with significantly better hit rates. The piece was widely read and of great interest when published in 2013. Just a few years after the end of the Great Financial Crisis, investors were understandably concerned about fraud and risk.

Today could not be more different. KCR would note that interest in the work and the associated research tool has collapsed as the bull market has soared higher. After reviewing the fundamentals of today’s crop of Glamour Stocks, we believe it is far more important today than in 2013.

Looking at the chart below, you can see that our crop of Glamour Stocks are at nearly 10x price to sales. Contrast that with the Dot.Frauds which peaked below 4x sales. Investors who own these stocks may be well served to ask the hard questions.

This is particularly true of the ones that have been flagged by our earnings manipulation tool.

Price to Sales of the Dot Frauds from 1990 2002 vs Todays Glamour Stocks from 2011 Today

For further comparison, we provide the table below. The first row shows the fundamentals of the Dot.Frauds at their peak and the second row shows the fundamental characteristics of our Glamour Stocks today. Even absent the nefarious conduct of characters like Jeff Skilling and Kenneth Lay, we believe the downside risk to these Glamour Stocks may be material.

The Fearsome Fundamentals of the Dot Frauds at their Peak vs Todays Glamour Stocks

Please click here to see the list of stocks that make up our Glamour Stock list.

For anyone who has read about the Enron collapse or watched the Enron documentary, you understand this is nothing to celebrate. The impact was catastrophic for innocent employees who lost their jobs and life savings. The prison sentences handed down, years in prison, and heart attacks suffered by a few Enron executives did nothing to alleviate shattered retirement accounts.

We are highlighting these firms as the Enron story is powerful evidence that we can all fall prey to the idea that a high stock price can suddenly be used to validate even crass frauds. We can think of few publications as reputable as the Harvard Business Review (HBR). Consider the following:

  • In October of 2000, Fortune joined a chorus of investment and financial magazines in fawning over Enron and brought special attention to their remarkable “innovative culture”
  • In January of 2001, two famous professors published “Strategy as Simple Rules” with the piece using Enron, Nortel Networks, Yahoo, Akamai, and other glamour stocks of the time as examples of managerial best practice and exhorted companies to behave more like….ENRON
  • Later, HBR would publish the fantastic “The Fall of Enron” case study which summarized the natural gas firms rise into one of the leading trading companies through its implosion in just 18 pages

We do not write this to mock any of these publications. Quite the contrary: we highlight them due to our profound respect for their commitment to high-quality reporting. When a stock price is going vertical, it almost becomes heresy to ask questions.

Our research indicates it has rarely been more important than today for investors to ask hard questions of their high-flying investments.

Enron Baseball Cap: Free Enron Hat

Having hopefully inspired a few people to look more closely at their holdings here’s a picture of the Enron memorabilia we are offering. The first 50 people to subscribe using promo code “ENRON”, will be mailed the below Enron hat in navy blue or grey. For all existing research subscribers, please email info@nullkailashconcepts.com for your free Enron hat and specify if you would like gray or navy blue.

Enron Hat and Enron Baseball Cap Free for every subscribers

We debated doing Enron T-shirts or mugs with the Enron logo but thought a one-size-fits-all Enron hat would be easier.

As a final reminder: we are doing this NOT to celebrate the catastrophe of Enron’s collapse. We believe memorabilia like this is a healthy reminder to ask hard questions, seek financial advice and beware of the behavioral phenomenon of herding so common with markets at such stretched levels.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

[1] SunMicro was most emphatically NOT a fraud.  But as Scott McNealy so honestly explained, you didn’t need any footnotes to avoid investing in SunMicro at it’s peak.  McNealy and Vinod Khoslas’ honesty about this are something we applauded in Glamour Stocks: Investing vs. Gambling.

[2] For the sake of clarity: the stock only needs to have the necessary data to generate a score – a score is not a negative in-and-of-itself

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

January 7, 2022 |

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