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With major business scandals back on the front page (Martha gets convicted, Enron's Jeff Skilling gets arrested, WorldCom's Bernie Ebbers gets indicted), pretty much every investor I know is wondering the same thing: How can I protect myself from buying stock in companies that turn out to be respectable-sounding scams? A close look at the scandal companies suggests some answers.
First, let's leave Martha out of it. Though she's been getting most of the attention, for understandable reasons, her case is not a major business scandal. It's a small-time personal matter that briefly obsessed the nation. Oh, she certainly had to be convicted -- you cannot lie to the feds -- but she wasn't cooking the books or swindling investors.
No, the cases to which we must look for lessons are the big ones we all know about: Enron, WorldCom, Adelphia, HealthSouth. These are the high-profile scandals that have led millions of investors to conclude that American business is rotten to the core, and to despair of ever really trusting any CEO or company again.
But think about those companies. Though they operate in a wide variety of industries, they're actually not a representative cross-section of U.S. business. In fact, they all share one striking trait: Every one of them is a company that grew from nothing to huge size, wide acclaim, and stock market success under one man, who was still in charge when the bad stuff happened. At Enron it was Ken Lay, who created the company through acquistions and was its sole CEO except for the six-month period when Jeff Skilling was running the show -- and by then the mind-boggling special purpose entities of Andrew Fastow had already been created.
At WorldCom it was Bernie Ebbers, who built the enterprise through scores of acquisitions and ran it all the way up and all the way down.
At Adelphia it was John Rigas, who built the cable TV outfit over 50 years, starting in tiny Coudersport, Pennsylvania.
At HealthSouth it was Richard Scrushy, who similarly created the company and built it into a personal empire.
In every case the problem was a company that became a business behemoth while remaining stuck with the culture of a one-man candy store. Interestingly, it's exactly the same story with the biggest business scandal in European history, Parmalat: One man, Calisto Tanzi, who created an empire that operated in many ways like an espresso bar, and a tiny one at that.
Note where the scandals did not happen: At the great, old corporations with well established internal controls and a long history of successful CEO succesion, places like Johnson & Johnson, General Electric, DuPont, General Motors. In short, this era's business scandals did not spring from American business overall, but from one highly specific slice of it.
Does this fact mean that investors should avoid companies that have rocketed to fame under their founders? Not at all -- because you can find many such companies that are still performing well and at which it's hard imagine a major scandal. The most obvious examples are Dell, Microsoft, FedEx, and Charles Schwab.
The difference between these companies and the scandal outfits is perfectly apparent, though it may be impossible to measure. It's culture, character, and the vision of the founder. In all of the good examples just mentioned, the founders -- Michael Dell, Bill Gates, Fred Smith, Charles Schwab -- clearly intended to create institutions that would outlive them, and they built corporate cultures that reflected that objective. In fact, in three of the four cases -- Dell, Microsoft, and Charles Schwab -- the founder has handed the CEO title to someone else, demonstrating to the market his seriousness about making sure the company is bigger than himself. Fred Smith at FedEx hasn't done this yet, but no one doubts the company is well prepared to carry on.
These cases, good and bad, remind investors that there's more to stock-picking than analyzing financial statements. We need to understand a company's culture and a leader's character as well. When considering long-established companies and famous CEOs, that task may be a bit easier. But it's exactly the cases in which it's more difficult that it's also far more important, as many investors have so painfully learned.
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