Taking Stock: Make Sure Enronitis Doesn't Turn Caution Into A Witch Hunt

The stock market has caught a new disease--Enronitis. It's caused by close scrutiny of a company's financial statements, and the discovery of "something." Something can be real accounting shenanigans or just the perception that complex financial statements always mean trouble. The main symptom stemming from Enronitis is a steep decline in a company's stock price, often well beyond reason.

Contrast this with the market's previous disease, Bubble Fever (just as dangerous, I might add). During that disease, all financial statements and every word from a company's senior management were accepted at face value. There was no room for independent, critical thinking. The symptom was a stock market that rose to giddy highs.

The original outbreak of Enronitis was, of course, caused by the spectacular implosion of Enron, a company undermined by gross manipulation of earnings, Byzantine accounting practices, deceit, and unethical behavior. This scandal has forced many analysts and portfolio managers to once again perform fundamental analysis on the companies in which they invest. Fortunately, my readers know that we actually do look at financial statements when we analyze a company and have gone to great lengths, in some cases, to discuss the manipulation of numbers during earnings season.

Remember, the primary reason to do your own fundamental analysis is that it usually keeps you out of trouble. The analysis provides you with insight into the company's financial health, management's capabilities, and the risks you face when and if you invest your hard-earned money. While there's no guarantee that you'll catch everything, it will prevent the more obvious blunders.

Unfortunately, fear of Enronitis means that every aspect of a company is now called into question, from accounting concerns about off-balance-sheet items to strategy. This newfound skepticism has turned into a witch hunt. An unfounded rumor or information that has long been public knowledge will send a company's stock careening, leading to great buying opportunities for value investors, but not a particularly stable investment environment.

Tyco International (TYC?NYSE) is a recent example of a stock whose price declined well below what we consider fair value based on cash flow generated by its businesses. Does that mean Tyco is free and clear of problems? No. It just means that investors want to look at risk/reward scenarios to determine if risks are more than offset by the company's cheaper valuation.

To keep things in perspective, we note that the stock market has declined for two years, but we're still not finding a lot of bargains. The bubble created in the late '90s was so big that it will probably take a while longer to wring out those excesses. On the whole, the stock market is again somewhere between fairly valued to over-valued. The Standard & Poor's 500 is trading at valuation levels normally associated with market tops, not bottoms. Many investors believe the economy will start to grow in the second half of this year. This has caused a run-up in the market, making many issues overvalued. What we're hearing from most companies, though, is that business prospects remain subdued. Many managers we've talked to during the latest earnings reports say business has stopped declining and growth, if there's any, is tenuous. We expect earnings will grow this year, but not at the pace many seem to expect. Excess capacity remains in several industries, including technology.

This might not sound too promising, but this environment favors "seasoned" stock pickers--so many investors may choose to do this through actively managed mutual funds with seasoned managers.

During this era of Enronitis, smart investors should be ready to take advantage of the situation and examine how severe the case is. If the decline in the stock price is misguided, you should be a buyer. Since the market's volatility has increased substantially in the short term, be prepared to see large swings in a stock's price from day to day until Enronitis has passed.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at [email protected].