"Enronitis": A Disease -- and a Cure

Fear that the accounting plague will spread is sparking a much-needed correction -- and forcing investors to look closer at company books

By Eric Wahlgren

It's about time the market had an Enron scandal. Don't get me wrong: It's horrible that thousands of employees lost their life savings and at least as many investors blew buckets of cash because of the energy trader's alleged fondness for funny business accounting. Let's hope Congress and regulators in Washington find ways to prevent another Enron -- and provide some restitution for those caught in the fallout while they're at it.

Going forward, however, this scandal may be a healthy thing, providing the kick in the pants that companies -- as well as the accountants who audit them and the analysts who rate them -- needed. "In the long run, we'll get crystal-clear earnings, and analysts will get on the ball and do their job," says Jim Stanton, editor of the Low-Risk Strategy newsletter. "Once the dust clears, this will be good for markets."

That's a hard concept to grasp right now. Since hitting a post-September 11 high on Jan. 4 of 1,172.51, the Standard & Poor's 500-stock index has fallen off some 7%, as accounting practices at other companies have come under scrutiny. Conglomerate Tyco International (TYC ) took another beating on Feb. 5, closing down nearly 23%, to $23.10. "This is an Agatha Christie market," says Alan Ackerman, market strategist at Fahnestock & Co. in New York. "It's a 'whodunit?' now."


  Sure, more accounting problems could surface, and questions may be raised that temporarily depress the stock values of outfits with perfectly sound balance sheets. Smart investors won't panic, however. "Enronitis" -- the fear that accounting problems could plague untold numbers of companies -- is simply a trigger for a much-needed correction. "When markets get overvalued, you never know what is going to come along and pop the balloon," says Don Luskin, chief investment strategist at investment firm TrendMacrolytics. "It could be anything. It just happens to be Enron this time."

Before Enronitis spread in January, the market had roared back in the wake of the September 11 attacks. By Jan. 4, the S&P 500-stock index had surged 21% since its post-attack low of 965.80 -- and the Nasdaq leaped by 45%.

Despite recent declines, S&P 500 stocks on average are still trading at 21 times earnings. That compares to the index' p-e ratio range of 11 to 20 before the late 1990s market boom, says Shannon Reid, portfolio manager of the Evergreen Select Strategic Growth Fund. "Even right now, this market is not cheaply valued," says Reid. "It is anticipating an [economic] upturn. If we don't start to see one, certainly those multiples could come into question."


  Portfolio realignment is one thing, but now is probably not the time to be building up positions in stocks as they likely will trade sideways for a while. Jean Keller, president of investment firm Lombard Odier, sees stocks treading water for the next month or two. "I would expect everything to be flushed out in the first quarter," Keller adds.

What to do? Given the welcome increase in accounting scrutiny, investors will do best with stocks that have good balance sheets and strong cash flow, says Ackerman. He suggests biggies such as pharmaceutical company Pfizer (PFE ) and PepsiCo (PEP ), the beverage and snack-food giant. Adds Ackerman: "Look for companies whose businesses are easily understood, where the cash flow is strong, and with management that has been through difficult markets before."

In technology, Reid says he would focus on name brands like networking gearmaker Cisco Systems (CSCO ) and Siebel (SEBL ), which produces customer-relationship management software. "You really want to stay with industry leaders who have been able to take market share and take advantage of their competitors' weakness in a downturn," Reid says.


  Stanton is advising clients to stay on the sidelines for now. "I'm just waiting," he says. "It's slippery out there." And Luskin says to consider lightening up on stocks that carry too-high valuations. "Those are the ones where, if lightning does strike, you're out 50% instead of 10%," he says. Other stocks he says you might want to sell: those of companies with high levels of debt and cash flows not sufficiently robust to service that debt. "If you don't get that economic upturn, these companies will have some pretty massive hits," agrees Reid.

Another factor to consider: The timing of the economic rebound is still up in the air. The surprising preliminary government estimate that the economy grew slightly in the fourth quarter of 2001 gives hope that things aren't so bad after all. But even though consumer spending has held up, business spending has yet to kick in.

Until companies start laying out cash to boost output and enhance their competitive position, the economy won't really get rolling, says A.C. Moore, chief investment strategist at Dunvegan Associates. He's betting on a capital-spending revival late this year or early 2003.


 In the near term, new revelations of impropriety at other top companies could prolong the market's slump. In general, companies have become too bold about stretching the rules to present the rosiest possible earnings picture. Says Moore: "The Enron debacle is unusual in terms of its scope, but it's not unusual with respect to its occurrence."

Still, "counterbalancing the Enron situation is the fact that many, many times over, companies are doing what they have always done, which is giving proper statistics to investors." Over the long haul, says Alan Hoffman, senior portfolio manager at Value Line Asset Management, the Enron scandal is "a hiccup, not a 12-car pile-up."

As the investigation of Enron continues, there's no doubt companies with complicated financial structures will now carry an additional risk premium, says Luskin, which could be reflected in a lower stock price. And while Enronitis has caused the market to wobble, a free fall doesn't appear to be inevitable. Stay cool -- and stay tuned -- is the best advice for most investors.

With Amey Stone and Amy Tsao

Wahlgren covers financial markets for BusinessWeek Online in New York

Edited by Beth Belton

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