How to Spot the Next Enron

Very early in his career, Chanos exposed such shenanigans at Baldwin-United, a piano maker that diversified into the insurance business. Last year, he blew the whistle on similar mischief at Enron. As Chanos pointed out, companies that adopt fast-buck accounting will find it much too tempting to "create earnings out of thin air" by entering into deals that don't make any long-term sense -- but that look profitable for now.

4. Talk to customers. Do they really use the product? Do they like it? Are they still in business? Anyone who looks at the telecom-equipment industry could have dodged a year of stock-market disasters by noticing in late 2000 that the industry stars (Cisco, Lucent, and Nortel) were selling heavily to independent telecom companies that were teetering on the brink of insolvency. If the customers are going bust, they probably won't be buying much more from even the greatest of vendors.

5. Watch stock sales by top company executives. It's routine for company executives to say that their stock is undervalued and has a great future. But if they all believe that, then why do some of them hurry to unload shares at today's prices? Minor selling to pay tax bills or to finance a few of life's luxuries is one thing. But when executives unload more than $1 billion of stock over the course of a few years -- as they did at Global Crossing -- warning sirens should go off.

Pay extra-close attention to what the chief financial officer does. In many companies that are built on shaky foundations, the CEO, the top sales executives, and even the technological aces may stay committed to the very end. After all, who can fault them for believing their own story? But the CFO usually has the most realistic sense of what the business is really worth.

6. See how CEOs handle criticism. Secure bosses know that not everyone on Wall Street will like their story. They handle critics calmly. CEOs with something to hide are more likely to start shouting when someone challenges their business.

Look at what Enron's now-departed CEO, Jeffrey Skilling, did in the spring of 2001, when he was addressing Wall Street's elite during a quarterly teleconference. One analyst asked him why Enron didn't provide a balance sheet detailing its profit statements. Instead of sharing data -- or even offering a civil explanation -- Skilling publicly dismissed the questioner as "an asshole." Listeners were shocked at the time. Today, they regard Skilling's snide retort as an unforgettable sign of trouble.

Most of all, the short sellers say, stay vigilant. It's tempting to fall in love with a business and believe that it can do no wrong. That's naive. Even the best-run companies are constantly being tugged in many directions. When the accounting practices of such household-name companies as Cisco and IBM are being questioned, there's no substitute for hard-nosed realism.

"Top management is always trying to put as good a spin on things as possible," says Paul McEntire, a periodic short seller and manager of the Marketocracy Technology Plus mutual fund. "I still believe that the vast majority of executives will be straightforward if you just ask them the right questions. But a case like Enron is going to make people skeptical for a long time to come."

George Anders (ganders@fastcompany.com) runs Fast Company's West Coast bureau from San Francisco. Find a catalog of his columns here.