Dead Companies Walking Read online

  Dead Companies Walking

  How a Hedge Fund Manager Finds Opportunity in Unexpected Places

  Scott Fearon

  with

  Jesse Powell

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  Dedicated to everyone who loves, educates, worries about, and cares for intellectually and physically disabled children and adults. You are selfless, unsung heroes.

  Contents

  Cover

  Title Page

  Copyright Notice

  Introduction: Forged in Failure

  One: Historical Myopia

  Two: The Fallacy of Formulas

  Three: A Minor Oversight: Your Customers

  Four: Madness and Manias

  Five: Deck Chairs on a Sinking Ship

  Six: The Buck Stops . . . There

  Seven: Short to Long: Rescuing Failing Companies

  Eight: Losing Money without Even Trying: Welcome to Wall Street

  Conclusion: Learning to Love Failure All Over Again

  Acknowledgments

  Index

  About the Author

  Copyright

  Introduction

  Forged in Failure

  If you want to increase your success rate, double your failure rate.

  —Thomas J. Watson

  If you don’t know who you are, the stock market is an expensive place to find out.

  —George Goodman, aka Adam Smith

  Like a lot of quintessentially American stories, my career in money management began with a road trip. It was the summer of 1983. I’d just graduated from business school in leafy Evanston, Illinois, and landed my first job at the largest bank in Texas. On a clear, breezy summer morning, I piled three suitcases’ worth of my belongings into the trunk of my powder blue Oldsmobile Delta 88 and headed for the bank’s headquarters in Houston. I was eager to start my new life as a financial executive. The economy of Texas was riding a ten-year boom. A barrel of light sweet crude was going for over thirty bucks, three times more than in the mid-1970s, and just about everyone expected it to go a whole lot higher.

  Little did I know, as I tooled down Highway 57, I was actually driving toward a catastrophe. A Category Five economic hurricane was brewing off the coast of Houston, and it hit shortly after I arrived in town. The price of oil began to fall. Then, in January 1986, Saudi Arabia opened the spigots and swamped the market with cheap crude. In a single day, oil crashed below $10 a barrel, and the entire economy of Texas imploded. Scores of energy companies went bankrupt. Unemployment shot up. “For Sale” signs swung in the yards of abandoned houses. Vast asphalt parking lots sat vacant in front of shuttered department stores. Entire neighborhoods turned into ghost towns.

  Just like that, my budding career seemed to be over before it started. The bank immediately froze my $30,000-a-year salary, and every morning I came in to work expecting to find a pink slip pinned to the wall of my cubicle.

  If this sounds familiar, it should. It was a small, regional preview of the global meltdown that came in the wake of the 2008 financial crisis. But for those of us who were in East Texas in the 1980s, it didn’t seem small or regional. It was cataclysmic—and it shaped me as an individual, a businessperson, and an investor. What I didn’t realize at the time was that living through that bust was the luckiest thing that would ever happen to me. It taught me perhaps the single most important lesson about business and about life: Things go wrong more often than they go right. Failure is actually a natural—even crucial—element of a healthy economy. And the people who are willing to acknowledge that fact can make a hell of a lot of money.

  The Business of Failure

  Shortly after the collapse, I left Houston for the San Francisco Bay Area. From 1987 to 1990, I managed a mutual fund in downtown San Francisco. Since 1991, I’ve run a hedge fund from a modest Marin County office park in the shadow of Mount Tamalpais. I’ve lived through several more booms and busts since then, but I’ve almost always managed to make a profit, even in the worst of times. Over twenty-three years, my fund rose roughly 1,100 percent after all fees—significantly higher than the S&P 500’s total return during that same period. I credit one thing above all for this success. Long ago, I learned to appreciate one of the most enduring and important American business traditions: failure.

  While most of my fund’s investments are in the stocks of companies I believe are undervalued, I also look for stocks that are overvalued by the markets. My specialty is identifying what I call “dead companies walking”—businesses on their way to bankruptcy and a zeroed-out share price. To the noninvestor, earning money on losing stocks might sound counterintuitive. But short selling is a routine, if widely misunderstood, investment strategy. And while it may seem macabre to profit on the misfortunes of others, investors like me make our markets stronger and more efficient.

  We Americans like to think we have the greatest economy in the history of the world. And we do. But most people don’t really understand why. It’s not just because of our plentiful natural resources or our global dominance or our business-friendly politics. It’s because, until recently anyway, we have allowed ourselves and our markets an unprecedented amount of freedom—not only the freedom to grow and make obscenely large profits, but also the freedom to fall flat on our faces.

  As paradoxical as it seems, thriving, dynamic market economies—like ours has been for most of its history—embrace failure. In contrast, economies that try to manage failure by propping up slumping businesses lag behind because they don’t grow or innovate. Japan is probably the best recent example of this phenomenon. The country is notorious for keeping moribund but politically favored corporations alive, and the results of that strategy are plain. It has been mired in a zero-growth economy since I first tried sushi in the late 1980s.

  I spend a good deal of time visiting and studying companies in Silicon Valley. That place has taken on an almost mythical status in the business world, and deservedly so. It’s chock-full of smart, creative people. Without all the high-tech innovations they’ve come up with in the last half century, the global economy would be dead in the water. But no one talks about the real reason the Valley is such fertile ground: failure. It’s the biggest, most volatile petri dish of raw capitalism on the planet. New ideas and companies are put to the test rapidly and ruthlessly. The good ones survive. The bad ones don’t. Sure, they might get some buzz and even some big initial funding. But if they don’t have what it takes, they die a quick death. Even when the region is doing well, dozens of unheralded companies come on the scene every year, only to fade away.

  The Austrian economist Joseph Schumpeter called this process “creative destruction.” It’s a harsh but vital process. It weeds out subpar ideas and gives good ones like Google the nourishment they need to grow. Short-sellers help make this happen. We identify the duds, which is good not only for the larger economy but also for the people involved in those ventures. Even the smartest people can get caught up in bad ideas or bad ways of doing business. The sooner they are disabused of these flawed practices, the better for everyone.

  Nothing Special

  The money manager David Rocker identified three types of businesses that falter and go under: “frauds, fads, and failures.”* The frauds—like WorldCom and Enron—get
most of the attention, because their stories are usually dramatic, full of intrigue and greed and deception. But frauds are an infinitesimal fraction of the number of companies that fail every year. Fads—companies or products that explode onto the scene before fizzling out, like Pac-Man and the Hula Hoop—are also relatively rare. Most companies that enter bankruptcy fall into the third category. They’re just plain old failures, the result of bad ideas, bad management, or a combination of the two.

  As the manager of my hedge fund, I’ve shorted the stocks of over two hundred companies that have eventually gone bankrupt. Many of these businesses started out with promising, even inspired ideas: natural cures for common diseases, for example, or a cool new kind of sporting goods product. Others were once-thriving organizations trying to rebound from hard times. Despite their differences, they all failed because their leaders made one or more of six common mistakes that I look for:

  They learned from only the recent past.

  They relied too heavily on a formula for success.

  They misread or alienated their customers.

  They fell victim to a mania.

  They failed to adapt to tectonic shifts in their industries.

  They were physically or emotionally removed from their companies’ operations.

  I will describe each of these six deadly business sins in the following chapters and give several examples of each from my three decades of observing both failing and successful companies. As you’ll see, I’ve committed a number of these sins myself as both an investor and a businessperson. In addition to running my fund, I’ve opened two restaurants. My second attempt in that notoriously failure-prone industry has been very successful; my first closed in less than three years. That’s right—I have personally run a dead company walking.

  I’d like to think my recollections can help corporate leaders and investors avoid these same mistakes. However, I didn’t set out to write a simple how-to, or maybe how-not-to, guide for management and investing. I hope this book can accomplish something more. It might sound strange, but I want to celebrate failure, or at least take away some of its stigma.

  In my experience, the vast majority of people who fail in business are neither idiots for believing in their companies nor swindlers looking to dupe their customers and investors. All of the executives I am going to describe, even the ones who suffered the worst disasters, were intelligent, honest, and hard-working individuals. I have a great deal of respect for anyone who tries and fails in business, and I hope that when you finish this book, you will recognize just how ordinary, and important, failure is. It’s a critical part of what makes a healthy market economy—and it happens every day to some of the smartest people in the world.

  Notes

  *David Rocker, “The Short Perspective in Today’s Markets,” CFA Institute Conference Proceedings Quarterly, June 2005.

  One

  Historical Myopia

  “How did you go bankrupt?” Bill asked.

  “Two ways,” Mike said. “Gradually and then suddenly.”

  —Ernest Hemingway, The Sun Also Rises

  A man named Geoff Raymond taught me the basics of money management. He ran the investment division at Texas Commerce Bank in Houston. But Geoff was far from your average straight-laced banker. He wore his flowing blond hair down past his ears. He favored pastel shirts with white collars and gold or silver collar bars. And he was the fastest walker I’ve ever seen. Anytime we went anywhere by foot, I almost had to jog to keep up with him. He told me he’d learned to speed walk like that during his days working at Citibank in Lower Manhattan. He’d figured out that if you walked like Carl Lewis ran, you could make every green light heading uptown. But when it came to picking stocks, Geoff was never in a hurry. He was very deliberate. And he believed in something extremely unusual in those days—actual research.

  More than anything—more than projections and book values and price-to-earnings ratios—Geoff believed human-to-human contact was the best way to gauge a company’s future performance. He valued numbers and raw data, but he knew that numbers were easy to fudge or misread. You had to study the people behind the numbers to get the full story. And reading secondhand profiles about a company’s executives didn’t count. Neither did pressing their flesh and swapping a few jokes with them at an investor conference. You had to go see them where they lived and worked—their own offices.

  The very first company I brought to Geoff as a potential investment for Texas Commerce’s trust accounts was called Global Marine (stock symbol: GLM). The company owned a fleet of offshore drilling rigs and ships that it would lease out to oil companies. Ten years before I came to Houston, it also got into a funny side business when its former owner, Howard Hughes, built a giant ship named the Glomar Explorer and leased it to the CIA to help salvage a wrecked Soviet submarine out in the middle of the Pacific Ocean. Like just about every other energy-related outfit in Texas, Global Marine had gotten very rich during the oil boom. And even though its stock price was at a multiyear low in 1984, around $5, the company still had a lot of assets. Its book value—assets minus liabilities divided by total shares outstanding—was around $10. That meant, by classic value investment standards, GLM was a potential winner. I grabbed my handmade earnings models and proudly strolled into Geoff’s office.

  “This looks good, Scott,” he said. “Let’s go pay them a visit and see what they have to say.”

  I made a call to Global Marine’s corporate office and arranged a meeting with the company’s chief financial officer, a man named Jerry.* The next morning I found myself jogging through the bank’s parking garage, trying to keep up with Geoff. We took my Oldsmobile about twenty miles west on the Katy Freeway, as I-10 is known in Houston, until we reached Global Marine’s six-story, glass-fronted headquarters off Memorial Drive. It was late in the summer, the hottest, stickiest time of year in East Texas. The temperature was pushing a hundred, and the humidity wasn’t far behind. By the time I chased Geoff from the parking lot to the front door of the place, I was gushing sweat.

  It wasn’t just the heat that was making me perspire. This was the first company visit of my life. I was nervous as hell. And you know what? Even though I’ve gone on more than 1,400 office visits since then, I still get a little amped up as I head in to meet management teams. It’s exciting. You never know what you’re going to hear.

  Jerry was a polite, friendly, unpretentious guy. He wore a polo shirt and slacks and drank his coffee from a Styrofoam cup. He was also very bullish on Global Marine’s future. I wouldn’t go so far as to call him cocky. He was too reserved and soft-spoken for that. But he didn’t seem the least bit concerned about the fact that the company’s stock had taken a virtual nosedive. He had a ready answer for that, and for why we should snap up every GLM share we could find for the bank’s accounts.

  “The oil business is cyclical by its nature,” he said as he sipped at his coffee. “We’re down for a little while and then we’re up again. Seventy percent. That’s the magic number.”

  “Seventy percent of what?” I asked, mopping my still-moist brow.

  “Seventy percent utilization, the number of our drilling rigs currently leased out worldwide,” he explained. “Right now, we’re just below seventy. And that means one thing as far as you guys are concerned: buy, buy, and buy some more. I’ve been in this business for decades, and 70 percent is always the bottom. It never fails. Look, I’ll show you.”

  He pulled a chart out for me and traced the up-and-down cycle of Global Marine’s “rig utilization rate” over the previous few decades. Sure enough, every time the rate slipped below seventy, it turned around and shot up shortly thereafter.

  Jerry gave me a self-assured smile. “I’m telling you, Scott. Now’s the time to get in.”

  As we drove back on the Katy Freeway toward Texas Commerce’s gleaming headquarters in th
e distance, Geoff turned to me and said, “Well, what do you think?”

  I watched the road for a little while, trying to figure out why I was so reluctant to pull the trigger on GLM. It was a classic winner according to the rules of value investing. The share price was half the company’s book value. And Jerry’s presentation had been very persuasive. I’m sure most twenty-five-year-old financial rookies—and even a lot of seasoned money managers—would have left Global Marine’s offices eager to buy into the company. But I just couldn’t.

  First, even back then, I knew how risky it was to predict the bottom of a downturn. On Wall Street, they call it “trying to catch a falling knife.” Second, I recognized that as accomplished, intelligent, and sincere as Jerry was, he couldn’t help but suffer from an unconscious bias in favor of Global Marine. His financial security depended on the company turning around as he was predicting. If he allowed himself to believe that Global Marine was at risk, he wouldn’t have been sitting in his office sipping coffee and showing me charts. He would have been out looking for another job.

  Given these two concerns, I did the same thing I’ve done countless times since that humid morning in Houston when confronted with a difficult call on a stock: nothing. Over the years, I’ve found that doing nothing is often the soundest investment strategy.

  “I can’t recommend that we buy it,” I said to Geoff. “Not yet. I’d rather hold off and get it on the way up, at $7 or even $10. It might cost us a few bucks in profit, but at least we’ll be sure that they’re going in the right direction.”

  I expected Geoff to test me more or at least to question my reasoning a little bit. What I was suggesting didn’t really mean just “a few bucks in profit.” If Jerry’s predictions came true and Global Marine’s stock took off, the difference between buying in at $5 and $7 or $10 would mean leaving millions on the table. But to my surprise, Geoff just shrugged and said, “Okay. What do you want for lunch?”