Post-Enron changes are slow and modest
As we had earlier surmised, the negative consequences that many were expecting from the Enron debacle have been rather modest, thus far. Of course, there are lingering doubts about corporate governance and accounting standards, but the main focus of investor attention is again on interest rates, inflation/deflation and earnings growth potential. It is interesting to note how the saga has been removed from the front pages and turned into a sort of television serial by the media – complete with a standard cast of characters. As such, it is well on the way to being classified as an aberrant case. Meanwhile, the accounting firm, Arthur Andersen, is being radically restructured. The entire process is intended to show that the bad elements have been identified, isolated and purged. The rest of the corporate world will then be presented as healthy and clean, needing only some minor corrective measures. Not everybody will buy this story, but there are a sufficient number of people out there willing to believe and to compromise that will make this version of reality acceptable.
The former Enron managers are depicted as villains. But, in truth, what they did was only different in degree, but not in kind, from what every other corporate executive has done, or tried to do, in order to enhance performance. So let us not pass too harsh a judgement on the Enron top brass who maintain that they didn’t do anything wrong, and the downfall only occurred because their creditors became overly risk-averse. At the same time, let's reserve contempt for the Wall Street analysts who continued to trumpet the company's prospects right up to the final plunge. Worse, to this day, they claim that they were irreproachably impartial and objective. This case reminds us of Sir Arthur Conan Doyle's story "The hound of the Baskervilles". You may remember that the essential clue for Sherlock Holmes was that the dog did not bark when the crime was being committed. In other words, the hound knew the criminal. Such was the case with the analysts covering Enron. Instead of barking wildly to alert every investor in sight, they were unusually docile. The lesson is that investors should continue to be wary of Wall Street hounds.
It is very important for powerful vested interests to give the appearance of change without anything radical actually taking place. There is a lot of money at stake, which means that there will be great determination to maintain as much of the status quo as possible. We will hear the language of change, rather than experience the reality of change. As Machiavelli correctly observed, long ago, everything favours the upholders of the status quo, while those who seek radical transformation face high hurdles and run great risks. What is the lesson for long-term investors? They should continue to apply a highly critical approach to equity valuation. This may require more analysis and calculation than would otherwise be necessary but it will pay off in reducing the risk of unpleasant surprises.
Prospects for China
The future evolution of China is of great significance, in terms of its impact on the global economy - as well as geopolitical considerations. There is little doubt that it is building up industries that will be highly competitive across a broad range of sectors and will be able to undercut a slew of competitors in both developed and emerging markets. This is likely to put pressure on prices and profit margins and force many to move higher up the technology and value-added chains or face destruction. At the same time, China will become a major importer of raw materials and energy. Clearly, there are both positive and negative implications for certain sectors in manufacturing, basic materials and agriculture in many countries that will be affected by the pace of Chinese growth.
Within China, economic transformation necessarily involves a good measure of creative destruction, with some sectors leading and others seriously lagging in the growth race. The central issue for the government is how to handle the resulting social dislocation and avoid any explosive political consequences. At present, there are no indications that there is a high risk of this occurring, but the situation bears watching. On the geopolitical front, the Chinese government views itself as the natural hegemonic power in Asia and as its power grows its assertions may bring it into greater disagreement with the United States.
Meanwhile, the economic statistics coming out of China are almost certainly fudged. Even without doing detailed analysis, we can guess that some of the growth numbers are just too high and consistent to be credible. In this respect it is not too different from a host of emerging countries that engage in the same practices. For many purposes, this is not particularly worrying as long as users learn to take the data with a grain of salt and use judgement to revise the numbers in a realistic direction. Portfolio investment in China, beyond some large and well-known companies, requires careful analysis and special expertise. It is properly classified as high-risk investment. But, as such, it may have a place as a small component of a well-diversified portfolio.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.
