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Thinking Back on Enron

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Everybody's favorite avuncular billionaire, Warren Buffett, has said that the academic theory known as the capital asset pricing model and its underlying notion of beta  (the systemic risk of a particular portfolio versus the market as a whole) is worthless. After all, he says, “a stock that has dropped very sharply compared to the market … becomes ‘riskier’ at the lower price than it was at the higher price.” Value investors, like Benjamin Graham, know better. It may well be a bargain at the lower price, while it was an unreasonable risk while it was still at the higher price. 

Avuncular Charm

Is there really paradox here? Let us now let ourselves be lulled by Buffett’s avuncular charm into seeing paradox where there is none. Let’s analyze this in pieces. I won't make you wait for the conclusion though. My own view is that though there are problems with the CAPM, Buffett's aphorism (if that's what the above sentiment is) doesn't address them. Indeed, CAPM looks rather good when seen through the lens of Graham-inspired value investing. Let's get to it.

Three Possibilities

I submit that the significance of a price drop for an investor considering a purchase depends entirely on why the hypothetical stock’s price dropped very suddenly relative to the market:  dropped so suddenly as to have an impact on the historical vol for that stock. I submit further that there are three distinct possibilities. The stock’s price may have experienced its sharp drop for (1) no real reason, (2) for a reason that is transparent to most market participants – as when a takeover deal has fallen through, or (3) for a reason that is opaque to many market participants.

If the emphasis is on (1), then Buffett is making a Talebian “fooled by randomness” point. That is a possible construction, but far from an obvious one, and it isn’t very Graham-like of him, so I’ll move on.   

Perhaps the emphasis is on (2). Consider a situation in which Smallish Firm’s stock experienced a run-up in its price after rumors, eventually confirmed, that Bigger Firm was interested in buying SF with a hefty premium to market.  One would expect the market price to rise to close that premium, producing something close to Mr. Market’s best estimate of the coming offer. Then (on our hypothesis) Bigger Firm backs away, deciding that the expected operational synergies aren’t there after all. In this case, the backing-away will unsurprisingly cause a sharp drop and an increase in the historic volatility (continuing a process no doubt begun by the rumor-sparked run up of preceding weeks.) But of course, everybody important has been reading the Wall Street Journal and everybody knows why the price of SF stock collapsed.

If this is the sort of price fall Buffett had in mind, I have to rate his point “valid, but not all that interesting.”   Since by hypothesis everybody knows what happened, the new increased vol figure won’t enter as a separate factor in a potential investor’s calculations in any case. The “straw man” here is a very mechanical follower of a very simplified view of MPT – hardly a worthy opponent for someone of Buffett’s stature.

In the Wake of Due Diligence

But let’s move on to (3). This is the intriguing one, IMHO. Suppose the real reason BF backed away from the deal with SF was that when they got into their due diligence in a serious way, when they looked at the books, they encountered reasons to worry: they came to suspect that many of SF’s assets were overvalued on those books, and its liabilities understated.  I have in mind here a situation in which the withdrawal of BF’s offer is not itself the only new information reflected in the price drop:  this drop reflects the leakage into the broader market of BF’s unhappy discoveries in SF’s books.

In this case, I submit, MPT looks pretty good. It may alert us to the fact that, even though we don’t know the reason for the drop (or the drop seems larger than justified by the reason we do know about), there is a reason, and that the lower-priced stock of SF is not a “buying opportunity” but a trap.

Consider late November 2001. A walking-dead stock known as Enron, or NYSE: ENE, receives a boost from news that Dynegy has appeared as a white knight. This doesn’t last long: Dynegy looked at the books and said “goodbye” by November 28th.  This brought more than just a reversal of the preceding bounce – it was a big push toward $0.
By that time, if it took volatility figures to persuade you that buying ENE was not a great plan: well, you would have been historically dense. Still, if this news caused an increase in the vol figure and that caused some mechanistic follower of CAPM to back out of such a purchase: it did that individual a good deed just ahead of the December 2d bankruptcy filing.
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