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How to Spot the Next Enron

Want to know how to avoid being fooled by the next too-good-to-be-true stock-market darling? Just remember these six tips from the cynics of Wall Street, the short sellers.

If only we could have spotted the rascals ahead of time. That’s the lament of anyone who bought Enron stock a year ago, or who worked at a now-collapsed company like Global Crossing or who trusted any corporate forecast that proved way too upbeat. How could we have let ourselves be fooled? And how do we make sure that we don’t get fooled again?

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It’s time to visit with some serious cynics. Some of the shrewdest advice comes from Wall Street’s short sellers, who make money by betting that certain stocks will fall in price. They had a tough time in the 1990s, when it paid to be optimistic. But it has been their kind of year. Almost every day, new accounting jitters rock the stock market. And if you aren’t asking about hidden partnerships and earnings manipulation — the sort of outrages that short sellers love to expose — you risk being blindsided by yet another business wipeout.

Think of short sellers as being akin to veteran cops who walk the streets year after year. They pick up subtle warning signs that most of us miss. They see through alibis. And they know how to quiz accomplices and witnesses to put together the whole story, detail by detail. It’s nice to live in a world where we can trust everything we’re told because everyone behaves perfectly. But if the glitzy addresses of Wall Street have given way to the tough sidewalks of Mean Street these days, we might as well get smart about the neighborhood.

The first rule of these streets, says David Rocker, a top New York money manager who has been an active short seller for more than two decades, is not to get mesmerized by a charismatic chief executive. “Most CEOs are ultimately salesmen,” Rocker says. “If they showed up on your doorstep and said, ‘I’ve got a great vacuum cleaner,’ you wouldn’t buy it right away. You’d want to see if it works. It’s the same thing with a company.”

A legendary case in point involves John Sculley, former CEO of Apple Computer. In 1993, he briefly became chief executive of a little wireless data company called Spectrum Information Technologies and spoke glowingly of its prospects. Spectrum’s stock promptly tripled. But those who had looked closely at Spectrum’s technology weren’t nearly as impressed.

Just four months later, Sculley quit, saying that Spectrum’s founders had misled him. The company restated its earnings, backing away from some aggressive treatment of licensing revenue that had inflated profits. The stock crashed. The only ones who came out looking smart were the short sellers who disregarded the momentary excitement of having a big-name CEO join the company. Instead, those short sellers focused on the one question that mattered: Are Spectrum’s products any good?

So in the wake of Enron, you want to know what to look for in other companies. Or, more to the point, you need to know what to look for in your own company, so you’re not stuck explaining what happened to your missing 401(k) fund. Here are six basic pointers from the short-selling community.

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1. Watch cash flow, not reported net income. During Enron’s heyday from 1999 to 2000, the company reported very strong net income — aided, we now know, by dubious accounting exercises. But the actual amount of cash that Enron’s businesses generated wasn’t nearly as impressive. That’s no coincidence.

Companies can create all sorts of adjustments to make net income look artificially strong — witness what we’ve seen so far with Enron and Global Crossing. But there’s only one way to show strong cash flow from operations: Run the business well.

2. Take a wary look at acquisition binges. Some of the most spectacular financial meltdowns of recent years have involved companies that bought too much, too fast. Cendant, for example, grew fast in the mid-1990s by snapping up the likes of Days Inn, Century 21, and Avis but overreached when it bought CUC International Inc., a direct-marketing firm. Accounting irregularities at CUC led to massive write-downs in 1997, which sent the combined company’s stock plummeting.

3. Be mindful of income-accelerating tricks. Conservative accounting says that long-term contracts should not be treated as immediate windfalls that shower all of their benefits on today’s financial statements. Sell a three-year magazine subscription, and you’ve got predictable obligations until 2005. Those expenses will slowly flow onto your financial statements — and it’s prudent to book the income gradually as well.

But in some industries, aggressive practitioners like to put jumbo profits on the books all at once. Left for later are worries about how to deal with the eventual costs of those long-term deals. In a recent Barron’s interview, longtime short seller Jim Chanos identified such “gain on sale” accounting tricks as a sure sign that the management is being too aggressive for its own good.

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.

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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.

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“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.