Howard Marks Memo – Learning From Enron​ – 2002

The first memo of 2002 is a long one. 21 pages to be precise. As the title will tell you, it focuses on the rise and fall of Enron and the lessons thereof. In a sense, this memo is an in-depth case study of fraud and corruption. The style of the memo reminded me of Genius Isn’t Enough (and Other Lessons from Long-Term Capital Management) that H. Marks wrote in 1998. Everyone should read this memo as the lessons it contains will, most likely, stay relevant across time and space. In other words, future cases of fraud and corruption will just be old ideas embedded in new narratives.

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from Learning From Enron – 2002


“For those seeking an explanation for fortuitous outcomes, luck has been described as “what happens when preparation meets opportunity.” I think Enron inspires a similar explanation for corruption: it’s what happens when exigency meets moral weakness.”

My thoughts: Or more explicitly; corruption/fraud; it’s what happens when greed and envy meets ego and misaligned incentives. Having greed and envy meet ego and misaligned incentives at the top of the organisation means trouble for the whole organisations:


Corporate Rot Can Spread From the Executive Suite 


It certainly appears that Enron was a company where: 

  • hubris was encouraged, 
  • schemers rose to the top,
  • people were rewarded for ends, not means, and
  • no one ever asked “but is it right?” 


And encouraging moral behavior, perhaps above all else, is the responsibility of top management. One thing I’m convinced of is that you can’t have a great organization without someone at the top setting the tone. The Chairman and CEO can’t know everything that goes on in a company, can’t be conversant with the details and merits of every transaction, and can’t participate in any but the most senior hires. But they can create a climate where expectations are high and the emphasis is on means, not just ends. 


Aligning Interests

About a decade ago, Forbes published a special issue on executive compensation. In it, a sage, experienced director said of managers, “I’ve given up on getting them to do what I tell them to do; they do what I pay them to do.” I’ve never forgotten that statement.

When individual compensation gets into the tens or even hundreds of millions of dollars per year (including stock and options), managers profit as if they owned the company and took the risk. They appropriate a major share of profits for themselves in the good years, even though they lose nothing (other than perhaps potential or previously-accrued profits) in the bad ones.

Set up this way, management has lots of incentive to take risk and cut corners. It sure worked that way at Enron. The executives can point out that the board approved the key elements in the compensation program. But once again, I say the board’s control over management is limited.


Management should be incentivized, but constructively. Excessive, short-term focus on stock price performance is not in shareholders’ long-term interest and, in egregious cases like Enron, obviously can bring disastrous results.

My thoughts: As the old German saying goes: “Wes Brot ich ess, des Lied ich sing” (whose bread I eat, his song I sing). Furthermore, I think its fair to say that Enron’s management had a lot of incentives but few disincentives, i.e. they lacked skin in the game.


Where Does the Buck Stop?

Ours is a free market. If undeserving (or crooked) companies get capital they shouldn’t, the responsibility ultimately falls to the providers of equity capital. I’ve read everything I could on Enron, and yet there’s almost no mention that shareholders may have been remiss.

Sure, the shareholders were victims of what appears to have been organized and pervasive fraud. But no one can say there weren’t warning signs. Shareholders held and bought Enron stock although they couldn’t possibly have thought they understood the financial statements, or where the profits came from. They held while the top executives were selling. And they remained unperturbed when the CEO quit without explanation.

And I’m not just talking about individual investors. Al Harrison of Alliance, Enron’s biggest holder, has been quoted as saying he bought on “faith.” He even admits, “The company seemed to be on a deliberate path not to give full information. Shame on me for not doing something about it.” (New York Times, March 3, 2002) Good marks for candor; not so good for due diligence.

I believe many investors underestimate the difficulty of investing, the importance of caution and risk aversion, and the need for their active, skeptical involvement in the process. Caveat emptor. Or as they say on TV, “don’t try this at home.”

My thoughts: In short, grow up, stop being naive and take responsibility for your mistakes of commission (buying Enron) as well as your mistakes of omission (not selling Enron).


“What’s the bottom line, then? The real lessons from Enron, in my opinion, are these: 

  • As long as there are disclosure rules – and that’s forever – there’ll be “technically correct” statements that leave investors in the dark. In order to get numbers with integrity, you need people with integrity.
  • Rules are just the first building block in creating a safe market. We also need compliance and enforcement, neither of which will ever be 100%. Even though it’s the best in the world, our system for corporate oversight is far from perfect. The collective power of directors, auditors and regulators to protect shareholders withers in the face of serious corporate corruption. It’s amazing what con men can get away with for a while.
  • As Enron’s complex, questionable transactions indicate, the people looking for holes in the rules are often highly motivated, well financed and well advised. Those whose job it is to plug the loopholes are often over-matched, and their efforts to do so usually amount to a holding action. The furor over Enron’s accounting shows that we need the ability to insist on adherence to general principles and punish those who violate them.
  • Security analysis and knowledgeable investing aren’t easy. Investors must be alert for fuzzy or incomplete information, and for companies that don’t put their interests first. They must invest only when they know what they don’t know, and they must insist on sufficient margin for error owing to any shortcomings.
  • We all must watch out for unintended consequences, and that’s especially true when promulgating regulations. Accounting rules and option programs were created with the best of intentions, but in the extreme they led to Enron’s noxious transactions and counterproductive incentives. It’ll be no less true the next time around. 

My thoughts: The extract above is a brilliant summary of this lengthy memo. Unfortunately, I think that there is a high probability that the same list of lessons be relevant when evaluating future cases of fraud, i.e. we won’t learn.


Howard Marks Memo – You Can’t Predict. You Can Prepare.​ – 2001

The fifth and final memo of 2001 is focused on H. Marks favorite topic; cycles. Reading the title you’ll get a glimpse of the main takeaway from this memo. This memo is a must read if you have any interest understanding the environment that you interact with when investing and how you should cope with that environment as it changes.

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from You Can’t Predict. You Can Prepare. – 2001


The Economic Cycle 

How can non-forecasters like Oaktree best cope with the ups and downs of the economic cycle? I think the answer lies in knowing where we are and leaning against the wind. For example, when the economy has fallen substantially, observers are depressed, capacity expansion has ceased and there begin to be signs of recovery, we are willing to invest in companies in cyclical industries. When growth is strong, capacity is being brought on stream to keep up with soaring demand and the market forgets these are cyclical companies whose peak earnings deserve trough valuations, we trim our holdings aggressively. We certainly might do so too early, but that beats the heck out of doing it too late.”

My thoughts: The last sentence is absolute gold. Survival is rationality as N. Taleb would say. However, prudence is also cyclical. Extract 2 and 3 will give you some examples of that:


The Credit Cycle


At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. As The Economist said earlier this year, “the worst loans are made at the best of times.” This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.


Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness. Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled. 

[…] Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on. 


In making investments, it has become my habit to worry less about the economic future – which I’m sure I can’t know much about – than I do about the supply/demand picture relating to capital. Being positioned to make investments in an uncrowded arena conveys vast advantages. Participating in a field that everyone’s throwing money at is a formula for disaster. 


The Corporate Life Cycle 


The biggest mistakes I have witnessed in my investing career came when people ignored the limitations imposed by the corporate life cycle. In short, investors did assume trees could grow to the sky. In 1999, just as in 1969, investors accepted that ultra-high profit growth could go on forever. They also concluded that for the stocks of companies capable of such growth, no p/e ratio was too high. People extrapolated earnings growth of 20%-plus and paid p/e ratios of 50-plus. Of course, when neither the growth nor the valuations turned out to be sustainable, losses of 90%-plus became the rule. As always, the folly of projecting limitless growth became obvious in retrospect.


So the latest “wonder-company” with a unique product rarely possesses the secret of rapid growth forever. I think it’s safer to expect a company’s growth rate to regress toward the mean than it is to expect perpetual motion. 


The Market Cycle 

At the University of Chicago, I was taught that the value of an asset is the discounted present value of its future cash flows. If this is true, we should expect the prices of assets to change in line with changes in the outlook for their cash flows. But we know that asset prices often rise and fall without regard for cash flows, and certainly by amounts that are entirely disproportionate to the changes in cash flows.

Finance professors would say that these fluctuations reflect changes in the discount rate being applied to the cash flows or, in other words, changes in valuation parameters. Practitioners would agree that changes in p/e ratios are responsible, and we all know that p/e ratios fluctuate much more radically than do company fundamentals. 

The market has a mind of its own, and its changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves in a highly cyclical manner. 

My thoughts: This reminds me of an extract from the 2000 memo We’re Not In 1999 Anymore, Toto that included the following words of wisdom; “Be conscious of investor psychology”.


Cycles and How To Live With Them 

No one knew when the tech bubble would burst, and no one knew what the extent of the correction could be or how long it would last. But it wasn’t impossible to get a sense that the market was euphoric and investors were behaving in an unquestioning, giddy manner. That was all it would have taken to avoid a great deal of the carnage. 

Having said that, I want to point out emphatically that many of those who complained about the excessive market valuations – including me – started to do so years too soon. And for a long time, another of my old standards was proved true: “being too far ahead of your time is indistinguishable from being wrong.” Some of the cautious investors ran out of staying power, losing their jobs or their clients because of having missed the gains. Some capitulated and, having missed the gains, jumped in just in time to participate in the losses. 

So I’m not trying to give the impression that coping with cycles is easy. But I do think it’s a necessary effort. We may never know where we’re going, or when the tide will turn, but we had better have a good idea where we are.

My thoughts: Cycles are simple, but not easy.