This is the first of two articles. Read the second one here.
If you want to read a sharp, insightful, bitingly funny, crystal-clear, quick-read book that could help you avoid making fatal mistakes with your business, pick up “Dead Companies Walking.”
After 25 years of making good money on short stock sales, hedge fund manager Scott Fearon has relatively few short positions today. There are a number of factors presently thwarting would-be short sellers, as he notes in his new book (2015, Palgrave Macmillan). If you just took a quick look, you might think that makes the book, in which Fearon recounts dozens of his adventures as a short seller, obsolete out of the gate.
But Fearon — who runs Crown Capital Management, a Marin County, Calif.-based fund that currently manages about $100 million in assets — says he didn’t write the book to provide tips on how to short stocks. His purpose was to inform both investors and entrepreneurs about common errors by publicly held companies that lead to their downfall.
A key aspect of Fearon’s modus operandi is to meet face to face with leaders of companies he’s evaluating for investments. He claims to have made as many as 1,700 visits to about 1,200 unique corporate offices. “There’s not another money manager in America who could make that claim,” he opines.
About 90% of the time, he says, he meets with companies’ CFOs. “You learn a lot more about a company in the CFO’s office than you do on the phone or in a hotel lobby.”
Of his book the author tells CFO, “It’s not about high math, regression analyses, hyper-trading and all of that. It’s about flesh-and-blood people running real companies. That’s what makes it unique. I wasn’t going to write the next ‘Too Big to Fail’ or ‘Fooling Some of the People All of the Time,’ two books I found impossible to read.”
Fearon, who says he has made more money on long investments than short ones throughout his career, believes nonetheless that analyzing failures is more educational.
“You don’t learn from success,” he says. “The theme of the book is that failures by managements of publicly traded companies are more common than people realize, and they offer lessons on how to avoid failure.”
“Dead Companies Walking” identifies several primary types of mistakes leaders make that bring companies down.
Misreading or Alienating Customers
Fearon met with the CEO of Chemtrak, which made take-home medical tests, soon after it went public. Its only product was an over-the-counter blood test for cholesterol levels. It had just received FDA approval, and its stock was soaring, but Fearon told the CEO that he didn’t think the product would be a hit with consumers, though he agreed to test the product, which involved pricking one’s finger.
The CEO then said that there were five million home pregnancy tests sold every year, only to women, but that both men and women were concerned about heart health and cholesterol, so therefore sales would exceed five million per year.
Fearon couldn’t believe his ears, especially since the man “was not only an accomplished executive, he also had a PhD in … biochemistry. His IQ was almost certainly a few touchdowns higher than mine.” Nonetheless, he called it “one of the dumbest things I have ever heard.”
He wrote, “People buy pregnancy kits because they absolutely have to know the results,” whereas someone who just ate a Big Mac feels nowhere near the same sense of urgency. “There’s no way someone’s going to rush off to Walgreens or CVS, plunk down twenty bucks, and then stab themselves in the finger just so they can feel guilty for overindulging.”
Fearon sent a gofer to 20 nearby drugstores to put a small nick on the packaging of the first five Chemtrak tests on the shelf. After several months, they were all still sitting there. Fearon shorted the stock, which before long fell from more than $20 to under a buck.
“Lots of very smart people make this mistake,” he wrote. “They fixate on some given set of data or analysis instead of the most important data set of all: how people in the real world behave.”
Learning Only from the Recent Past
Another potentially devastating business mistake, according to Fearon, is assuming that the recent past is a more accurate predictor of the future than the more distant past. Certainly there are cyclical industries, but that doesn’t mean that larger, less-frequent “supercycles” aren’t just as regular as the shorter ones.
In mid-2008, he wrote, almost everyone in the U.S. real estate and financial industries was optimistically predicting that the housing market would rebound following an enormous rise in foreclosures that began in 2006. Of course, what actually happened is that the real estate crash of the late 2000s “almost brought down the entire global economy.” The market failed to realize that the downturn from 2006-2008 was only the leading edge of a collapse that was larger than any seen since before most observers had been born.
That summer Fearon went to visit a company called California Coastal Communities, which he had targeted as a potential short investment, not because it was a real estate company per se but because it was suffering from rapidly shrinking revenues and quickly rising debt. The company had a 110-acre development in which it planned to build 300 houses but had sold only 40 of them.
A minor car accident blew out Fearon’s schedule that day, so he didn’t make it to California Coastal’s offices. He did, though, drive in a rental car to take a look at the development for himself. “The place was an unmitigated disaster,” he wrote. “The company was slapping up chintzy McMansions cheek-by-jowl and charging $800,000 for the smallest, cheapest units.”
Fearon had a hunch that the housing market wasn’t actually going to recover soon. “But it wasn’t until I physically set foot on the pale red soil … and saw the debacle-in-progress that I fully understood the magnitude of the downturn we were facing…. I got on the phone right then with my office and told my trader to short 200,000 shares of Cal Coastal.”
Relying Too Heavily on a Formula for Success
While Fearon told some tales about companies that got too hung up on formulas for their own good, the most vivid illustrations of the principle pertained to investment mistakes he’s made. The following anecdote is not about shorting stocks, but rather about not going long on stocks when he should have.
A couple years after he started his hedge fund, on a single day he met with the CFOs of two up-and-coming young companies in Seattle called Costco and Starbucks. He was skeptical of both.
He worried about Costco’s profit margins, calculating that what the company cleared on merchandise sales was so little that most of its profits came from the membership dues it charged to customers. That begged the question: Was it really a good idea to limit the number of customers?
The CFO acknowledged that margins were thin and that the membership fees allowed Costco to turn a profit. The thin margins also were why the company didn’t let customers use credit cards, ensuring that payments would be in cash or in checks that, as a result of the membership application process, didn’t bounce.
As for Starbucks, Fearon was concerned about the price of coffee beans, a volatile commodity whose prices can fluctuate wildly even within a single trading day. The CFO told him that the company had surveyed customers as they were leaving as to how much they had just paid for their coffee or latte. Most of them couldn’t remember.
“What we give people is a little luxury,” he said. “They’re willing to pay a small premium for it.” While people were very conscious of the price of big items like cars and televisions, when it came to premium coffee they didn’t care because it was only a couple of bucks and it made them happy.
Fearon bought the CFOs’ arguments and abandoned his pessimism. “There was no doubt in my mind that both of these companies were going to prosper,” he wrote. But he did not buy their stocks.
Why? He was too attached to a formula behind what’s known as GARP, or growth-at-a-reasonable-price investing. GARP investors calculate a company’s multiple — the ratio of its share price to its earnings per share — and compare the result to the company’s growth rate. When the former is larger than the latter, the stock is overpriced and not a good investment. And that applied to both Costco and Starbucks.
“My rigid adherence to the GARP philosophy kept me from recognizing something important” about the two companies, he wrote. “There was a good reason their stock prices were so high. They were, and remain today, once-in-a-lifetime companies…. This fallacy happens all the time in management as well as investing. Corporate managers bind themselves tightly to what seems like a winning approach, only to discover after the fact that it was really a noose.”
Falling Victim to a Mania
During his career Fearon has experienced several historic asset bubbles, “otherwise known as manias,” he wrote. They included an oil boom in East Texas in the 1980s, before he started his hedge fund, and the mid-2000s housing craze. “But nothing compared to the dotcom delirium of the late 1990s.”
In March of 2000, at a time when he was growing ever-more skeptical of the claims of new dotcoms, he met with executives of a web company called Women.com. It had sites that dealt with pregnancy, parenting, fashion, cooking, careers, and dozens of others that might appeal to web-surfing females. The CEO described how women were the fastest-growing population of Internet users, followed by “the usual preposterously optimistic revenue projections and the mandatory talk of scaling.”
Fearon asked her, “If I buy 100,000 of your shares tomorrow, and a year from now it’s lost half it’s value, why would that have happened?” She replied, “Quite frankly, we’ve looked at all the data, and we’ve discussed this very issue at the board level and we all agree: there’s just no way we can lose.”
At the time, the company shares were around $15. Then the bubble burst, and by early 2001 the stock was at 70 cents and Women.com was sold to another company that was “circling the drain,” as Fearon put it.
In manias, he wrote, “People willfully forget inconvenient facts like arithmetic.” He was scared away from buying Costco because its multiple was in the 30s, but dotcoms like Women.com had infinitely higher multiples because they had no earnings. “But investors were so hot to believe in these companies — and the great new internet age — that they started valuing them based on page views, or ‘eyeballs,’ as they put it. No, I am not kidding.”
Failing to Adapt to Tectonic Industry Shifts
The demise of Blockbuster Entertainment, which clung to its physical-location model for years after Netflix started beating its brains out with online ordering for home-delivered movies, is a classic example of this failure.
When Fearon visited Blockbuster in December 2007, it was already in deep trouble, on its way to a fourth straight money-losing quarter. “It wasn’t hard to figure out why,” he wrote. “The company was saddled with over nine thousand brick-and-mortar store locations and tens of thousands of employees, at the same time that Netflix — a web-based, ruthlessly efficient competitor with a fraction of its overhead — was pilfering millions of its customers.”
Blockbuster’s investment relations director, though, stated the company believed its stores were its greatest asset. She acknowledged they were losing money, but said plans were afoot to use them to generate new revenue streams. The plans included selling (rather than renting) children’s movies and video games, and also selling movie posters, movie memorabilia — and theater-style concession items.
“You mean you’re going to sell popcorn and Junior Mints?” Fearon said, noting that “she mistook my incredulity for approval.” She replied, “Yes, and we’re going to carry the large novelty sizes you can only get in theaters!”
He wrote, “There was no use discussing matters any further…. Blockbuster’s leaders were seriously pitching candy sales as the thing that would keep the company from the ash heap.”
Although Fearon shorted the stocks of three other publicly held video rental chains, he did not short Blockbuster’s, because Carl Icahn was the company’s biggest shareholder, and he “didn’t want to be on the wrong side of such a powerful figure.”
Icahn later declared his investment in Blockbuster to be the worst of his career. “Icahn and his allies at Blockbuster made a classic blunder. Old Wall Street hands call it the buggy whip syndrome: they failed to recognize that their industry had fundamentally and permanently changed,” Fearon wrote.
A Serious Rant
The last two chapters of “Dead Companies Walking” take a different, darker turn, firing a quiver full of poison arrows at the investment industry and the government. Some choice comments:
- “After almost three decades in this business, I can say one thing without reservation: people on Wall Street are not looking out for anybody’s interest but their own, and they often take care of those interests by screwing someone else. Many are, by and large, very bad people.”
- “Buying stocks on the word of so-called experts is the biggest mistake an investor can make. If somebody tries to tell you that they know something special about a given stock or the wider financial markets, they’re probably either (a) doing something illegal or (b) trying to scam you.”
- “Deep down, everybody in my industry knows that Wall Street brokerages routinely push bad investments to maximize their profits.”
- On the roles played by the government and Wall Street in the corporate bailouts during the financial crisis: “Instead of letting the stocks and bonds of almost every major investment bank, and many other debt-laden companies, go to zero, they protected themselves from the consequences of their own ineptitude by turning our stock market into the financial equivalent of professional wrestling.”
- Yanking interest rates to near zero “punished the prudent to help the profligate. People who had done the right thing and put their money into savings lost out so that poorly managed corporations could refinance what should have been fatal debt loads.”
- “Capital increasingly flows to politically favored businesses instead of innovative and well-managed concerns. That’s not a free market; it’s crony capitalism — a surefire way to hamper growth, job creation, and economic vitality.”