“IT’S NOT WHETHER you win or lose, but how you play the game.”
Most of us understand that old saw to be about style — about winning or losing with equal aplomb and sportsmanship. But to a trader, it’s a lesson in technique. It reminds us that whether you win or lose is a function of how you play the game.
I can’t say it often enough: It isn’t what you trade, but how you trade, that ultimately determines success. And nowhere can this be seen better than in the case of energy giant Enron (ENE), whose spectacular 99% decline has left more than a few investors out in the cold.
Most pundits would suggest that Enron’s woes first became apparent in mid-October, when the company took a $1 billion charge and reduced its shareholders’ equity by $1.2 billion as a result of a number of questionable off-balance-sheet partnerships. But from a trader’s perspective, the problems for Enron and its investors actually started much earlier. While Enron’s collapse was stunning, good trading technique could’ve limited the damage to investors’ bottom line.
Many are now blaming the company for their losses, but regardless of any alleged corporate wrongdoing, following a trading discipline would’ve prevented a position in Enron from hurting your portfolio too badly. That’s the essence of investing. You win a few, you lose a few, you keep on fighting.
So let’s say that you bought Enron, and at the high. Not just a high, but the high of $90.75, reached on Aug. 23, 2000.
And if you listened to the analysts, you had good reason. Just two days earlier, both Banc of America and DLJ upped their already aggressive price targets, with DLJ expecting the stock to hit $115. Even pundit Elaine Garzarelli called it one of her top picks. Just over a month before the stock hit its all-time high, Salomon Smith Barney picked Enron as No. 6 on its list of “TEN+ Exceptional Names,” a portfolio of 15 stocks the firm considered to be among the most compelling buys.
The media got into the Enron-adoration act, too. Fortune named the company No. 7 on its widely watched list of 500 top companies. The magazine didn’t have much choice in the matter, since the Fortune 500 are chosen and ranked by revenues. But four months later, it went on to highlight Enron in a special feature piece entitled, “10 Stocks to Last the Decade.” As it turned out, of course, Enron didn’t last the next 16 months.
The issue isn’t that they — and you, if you bought when they told you to — were wrong. It’s whether you were wrong big or wrong small. Probably the most important component of trading technique we’ve discussed is that of position size. It isn’t what you bet on, but how big you bet. More than any variable, the size of our trades ultimately determines their net effect.
Excessive position size was tragic for so many Enron workers, whose retirement plans were dominated by company stock. But they didn’t have any choice. Many pros did, however — and they also bought too much. The 37% year-to-date decline in the AIM Global Infrastructure fund (GIFAX) wasn’t just due to a position in Enron, but to the fact that Enron was the fund’s largest holding. It’s one thing to be bullish, but putting more than 5% or 10% of your portfolio into a single name at a single price is just asking for trouble, no matter how bright the fundamentals look.
Even more damaging is buying more. As we’ve pointed out in the past, losses are just part of the game. So even if you were completely wrong in your timing and bought the stock at $90, you wouldn’t have been hurt too badly providing you didn’t continue to add to that losing position.
But most people don’t want to be profitable. They want to be right. So it wasn’t just that they bought the stock at $90, but — egged on by the analysts — that they also doubled up at $80, tripled down at $70, and so on. The best traders aren’t those who are always right, but those who are able to admit when they’re wrong.
And the truth is that Enron gave investors plenty of opportunity to make that admission, as its stock chart shows. After all, it isn’t as if this stock got halved in one day. It was in steady decline the entire year, but you had to be watching. Although the dire news didn’t come out until October, the aware trader listening to the market would’ve known something was wrong long before Enron hit the single digits (and the front page of The Wall Street Journal). Even looking for the most basic trend indicator — lower lows — you can see how Enron broke significant support in March, in May, in July, August and right up until now. When a stock just keeps moving lower, even on light volume, it’s telling you something: “Don’t buy me.”
But because the news was still relatively positive, you had to be watching the stock — not listening to the supposed experts. As early as late January, even after the stock had corrected some 20%, Prudential upped its earnings-per-share estimate. Morningstar was bullish, too, suggesting that Enron deserved its high price. In February, with the stock down over 30% for the year, UBS Warburg analyst Ron Barone, like many others, still liked the stock. He called it a Strong Buy with a $102 price target, a move that would’ve taken a 78% gain. By October, with the shares at $33 (down 60% for the year), Merrill Lynch upgraded the stock from a Long-Term Accumulate to a Long-Term Buy. And as recently as a few weeks ago, Salomon Smith Barney was reiterating a Strong Buy, with Enron down an exceptional 70% since the firm put it on its list of “Exceptional Names.”
In both the markets and our lives, the answers are usually there if you’re simply willing to listen. While the news didn’t get bleak for Enron until October, the chart had been worrisome the entire year. And even if you knew nothing about the company’s fundamentals, you would’ve known that the stock was weak, which was reason enough to avoid it or reduce a position.
We’ve often heard about how birds chirp warnings just before a surprise summer rain, or how dogs start howling before an earthquake. Maybe you have to be as silly as a bird or as dumb as a dog to understand the evidence that’s staring you right in the face, because it’s something that seems beyond most financial journalists, analysts and other smart humans.
– Originally on Dec 10, 2001 by Jonathan Hoenig
