During the mid-1980s, the US energy landscape was rapidly changing.
Instead of regulated monopolies, policy makers opened the industry up.
The idea was to invite competition. Energy companies competing with each other would lead to lower prices, which would improve US living standards.
While consumers were happier, it was still a tough slog for providers.
Sure, there weren’t any more regulated monopolies. But providers were now looking at razor thin margins.
Competition was keeping prices extremely low.
It was all too much for a cash strapped gas company with far too much debt.
So, instead of slogging it, this small company decided to pivot.
They would not just be a provider, but a gas bank.
They would buy gas from network suppliers and sell it to a network of consumers. Their profit would come from a fee on each transaction.
Within no time at all, this small gas company became a gas bank titian.
And like many banks, they started to dabble in more than just lending. The gas bank set up its own trading desk to trade gas contracts.
Coupled with mark to market accounting, their trading business was minting profits.
Investors saw this once tiny gas firm as a new-economy company. A group of innovative, forward thinking geniuses.
That was until the stock fell to $0.
How greed can ruin a company
You probably know about Enron.
Like most companies lured by returns, the company got greedy and took risks they couldn’t afford. As The New York Times explained in 2002:
‘As often happens with buccaneering entrepreneurs, it got a case of hubris. It figured if it could trade energy, it could trade anything, anywhere, in the new virtual marketplace.
‘Newsprint. Television advertising time. Insurance risk. High-speed data transmission. All of these were converted into contracts — called derivatives — that were sold to investors.
‘Enron poured billions into these trading ventures, and some failed. It turned out Enron was good at inventing businesses, but terrible at the tedious work of running them, judging by some appalling internal management audits discovered by The Times’s Kurt Eichenwald.
‘For a time, Enron swept its failures into creative hiding places, but ultimately the truth came out, confidence in the company collapsed and you now have a feeding frenzy.’
During Enron’s historic earnings and their stock rise, investors couldn’t get enough. They were buying the stock hand over fist.
Many didn’t bother, or didn’t find anything amiss with Enron’s accounts. But why would you want to find something wrong with easy money?
But the Enron dream quickly turned into a nightmare when investors found out the truth: earnings were seriously inflated.
To this day, investors continue to make the same mistake (especially when stocks are going up). They buy when earnings are seriously inflated.
But let me show you how to avoid this mistake…
How to gauge whether or not to invest
Enron is not the only culprit when it comes to cooking the books.
Many companies actually manage earnings. Sometimes this means recognising more sales then they should in a given period. Or maybe they push expenses back to a later date.
It’s all in an effort to beat expectations.
If management can beat earnings expectations, investors push up the stock. This is great for shareholders and management alike…in the short-term.
But it’s a lie.
The market was misled. And investors buy into earnings which aren’t representative of the business. That’s why, over the long haul, managed earnings only have one place to go…down!
There is one more scenario.
Sometimes investors buy in when earnings are approaching the top of their cycle. It’s common to see this in cyclical industries like autos.
Because demand ebbs and flows, so too do earnings.
Its why when you see Ford or Toyota trading on a PE of 10, it’s probably not as cheap as you think. Earnings might have reached a peak, making the stock look cheap.
But over the next few years, earnings decline with demand and likely the stock price too. Its why some investors like to buy autos when they look expensive, meaning earnings might be in a temporary trough.
Yet I wouldn’t suggest you use this as a rule of thumb. Instead, try to picture what normalised earnings might look like.
A stock might trade at 10 times current earnings, but that could be 30 times normalised earnings. To gauge normality, the easiest trick is to take a long-term average. Or you might want to look at how earnings have behaved at a similar point in time.
There’s no one size fits all formula for this stuff. It does take a bit of research. But it could pay off big time, helping you to avoid the losers and only buy genuine winners.
So when you next look at some of the fastest growing stocks on the ASX, try to think of what normal earning might look like.
After all, no one want’s to buy the next Enron.
Editor, Money Morning
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