Taking Stock
UMaine financial analyst Bob Strong says there may be a ‘whole
different way of thinking' about investments in the post-Enron era
Everyone wanted to talk to Bob Strong
in the days following the Enron implosion last winter. Financial
reporters and others sought his perspective on the scandal and the
effects it might have on investor confidence.
Strong is University Foundation Professor of Investment Education and
professor of finance at The University of Maine, and his stock market
insights are widely respected.
Some of the questions people were asking immediately after the Enron
scandal broke have been answered. (No, investors didn't flee the stock
market in droves. Yes, some accounting reforms are needed.) But
anxieties remain, and people still have questions, such as: Should
investors be worried that other big companies — perhaps some in their
own portfolios — are heading for an Enron-like collapse?
While there are no guarantees that it won't happen again, Strong says it
is less likely that companies will be engaging in the sorts of
questionable deal-making and hocus-pocus accounting practices that
turned Enron into a house of cards.
"I think firms will be much less willing to push the envelope and do
things in unusual ways," he says. "Accounting rules have always provided
management with a certain amount of flexibility as to how they handle a
particular transaction, but people are very sensitive to what happened
in the Enron case."
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Bob Strong is University Foundation Professor of Investment
Education and professor of finance at The University of Maine. He
has been a visiting professor of finance at Maine Maritime Academy
and Harvard University. A chartered financial analyst, Strong's
consulting focuses on risk management and asset valuation. His
current research interests center on investor asset allocation. His
fourth book, Derivatives: An Introduction, was published last year.
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In addition to new regulatory
guidelines, he says, "I think we will see voluntary actions on the part
of firms to make sure they avoid accounting scandals. From the
investors' perspective, that is something positive that comes out of the
Enron situation."
Another positive effect may be renewed respect for the traditional
principles of investing, which Strong says were often ignored during the
dot-com mania of the late 1990s. In those days, investors sometimes paid
more attention to the flash and dazzle of new Internet-related companies
than to what the companies were actually delivering, sending stock
prices soaring. Even before Enron became front-page news, many of the
dot-com darlings had failed.
"People were willing to pay huge sums on the basis of good ideas that
they hoped would work," Strong says. "Valuations got very high, but a
lot of these firms weren't making any money.
"Enron has reinforced the fact that you can't spend sales; you can only
spend earnings. So, I think there is going to be a return to the notion
of looking at the extent to which a company is realistically selling its
products for more than it costs to make them."
Daily fluctuations in the price of a stock often are caused by
psychological factors that have little or no direct bearing on the
company or its industry. Alan Greenspan sneezes or a civil war heats up
on the other side of the world, and stocks chase each other up or down.
"But in the long run, it's earnings that overwhelmingly contribute to
shareholder value," Strong says. "If a company isn't making money, then
where is the value going to come from?"
The stock market isn't the only place where people can invest their
money, of course. There are corporate bonds, government bonds, real
estate and savings plans of various kinds.
"How you distribute your money has always been the single most important
decision an investor makes," says Strong, whose primary research
interest currently is asset allocation.
Historically, stocks have earned a higher rate of return than other,
less risky types of investments. However, Strong says it appears that
the size of the difference between the returns of common stocks and
government bonds, for example, is shrinking.
"There is increasing evidence that the historical size of the difference
is not going to be sustainable in the future," he says. "It is not clear
where money is going to come from to support the level of return in the
stock market that we have had in the past."
Does that mean people should take their money out of stocks? Not
necessarily. Stocks in general still outperform bonds and, according to
most experts, will continue to do so. But they are not likely to
outperform bonds and other investments to the same extent that people
have come to expect.
"It suggests a whole different way of thinking about the investment
business than we have been accustomed to for the last 50 years," Strong
says. "It's quite thought-provoking, and it's going to make for some
interesting headlines in the next year or two."
One thing that isn't likely to change is the biggest mistake people make
when it comes to investing: They don't do it soon enough. The money lost
in the Enron debacle is a pittance compared to the amount people lose to
procrastination.
"People say they can't afford to start an investment program now because
they've got to pay for a new washer and dryer or wait until a child
finishes college," Strong says. "Any investment program is usually
better than none at all, but a lot of people never get around to
starting one."
Another common mistake, he says, is not fully understanding the concept
of "risk" and, as a result, investing too conservatively. This is often
true of people who begin investing through a 401(k) plan at work or an
employer's pension plan.
"They think the stock market is too risky when, in fact, as a long-term
investor, if you stay completely out of the stock market, you are taking
a fairly substantial risk that your investment is not even going to earn
the rate of inflation."
This finding is based, in part, on Strong's work with computer
simulations of thousands of investment scenarios. He also found that
putting as little as 10 or 12 percent of one's investments in stocks can
dramatically increase the chance of at least keeping up with inflation.
"Adding more stocks than that doesn't really improve the likelihood very
much," he says. But if the goal is to do better than simply match the
rate of inflation, then putting a higher percentage of money in stocks
is, for many investors, the best bet.
by Dick Broom
Summer 2002
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