Dead Companies Walking Page 7

  The business media loves to laud idiosyncratic visionaries who disrupt their industries by introducing unconventional new products or services. Steve Jobs famously eschewed market research and claimed that he and his team built the first Mac computers for themselves, not their customers. Jobs was also famous for bragging that consumers didn’t know what they wanted until he showed it to them. This self-centered approach worked out for him and a few other uniquely gifted innovators. But for every Steve Jobs, there are countless corporate leaders who have lost everything trying to remake their customers’ habits.

  In 2012, JCPenney’s (stock symbol: JCP) management team famously “fired its customers” by eliminating coupons and stocking more expensive brand-name merchandise. The problem was that the people who shopped at JCPenney liked using coupons. They enjoyed the feeling that they had discovered bargains, even on no-name or knockoff brands. For many of them, that experience was the main reason they went to JCPenney in the first place, and they stopped coming to the stores after it was taken away from them. These disastrous changes wound up losing the company more than a billion dollars in a single year. They also got the CEO who instituted them, Ron Johnson, unceremoniously canned after only eighteen months on the job. I’ll talk about Johnson’s absentee management style later on, but his doomed upscale strategy shows the dangers of confusing your own tastes with the tastes of your customers. Shortly after Johnson’s ouster, I visited the retailer’s offices in Plano, Texas. A longtime executive there gave a simple reason for his former CEO’s failure: “He wanted to make JCPenney into a place where he and his friends would shop.”

  Johnson had previously overseen Apple’s retail stores, and just like I did with Cajun food in Marin County, he tried to foist his personal preference for luxury retail onto the people who patronized JCPenney. According to the executive I met with, not only did Johnson get rid of coupons and bring in more upscale brands, he also curtailed advertising in Spanish and reduced the company’s “Big and Tall” inventory, which had once accounted for a significant portion of JCPenney’s revenue. These actions practically hung a sign on the front of every JCPenney with Ron Johnson’s face on it and the caption, “If you aren’t a fit, affluent yuppie like me, don’t bother coming in here. We don’t want your money.”

  Of course, there are plenty of profitable businesses that cater primarily to higher-earning customers. Johnson’s old employer Apple is a prime example. But JCPenney was never going to transform itself into a luxury brand like Apple or Saks or Lexus. Most of its thousand-plus locations are in middle- and working-class areas, and nearly one hundred of them are in its home state of Texas. You know who lives in Texas in huge numbers? People who speak Spanish! You know who else? People who could use a little extra room in the waistline of their pants. Both of these groups had been loyal JCPenney patrons. If Johnson had gotten past his own class biases, he would have recognized that both groups represented major future opportunities for the company too. Any demographer will tell you that Spanish speakers are one of the fastest-growing populations in the country, and lord knows Americans aren’t getting any skinnier. Yet Johnson was so eager to remake JCPenney in his own image, he purposely alienated these fast-growing customer bases, perhaps permanently.

  Incredibly, getting rid of coupons, stocking prohibitively expensive brands, and turning off Hispanic and big and tall patrons might not have been the worst ways Johnson “fired” JCPenney’s core customers. He also removed most of the cash registers in the company’s stores and gave salespeople handheld iPads to conduct credit card–only transactions instead. Shoppers who wanted to use cash for their purchases had to schlep their items to special areas, often in remote parts of the stores. That’s right—JCPenney made cash-paying customers work to spend their money. And since a good number of those customers were “unbanked,” without traditional bank accounts or credit cards, this disastrous strategy only made them feel even more unwelcome. The executive I met with estimated that roughly a quarter of all transactions at JCPenney’s checkouts were in cash. Take a wild guess how much same-store sales dropped in Johnson’s first and only full year as CEO. That’s right—25 percent, or $4 billion.*

  Not to pile on, but I can’t help but share one more of Johnson’s follies. The executive I spoke with also told me that Johnson personally disliked the look of antitheft sensors. He thought they made the clothing on sale look cheap—his kind of people would never shop in stores with ugly plastic sensors clipped to the merchandise!—so he ordered them removed. “Our ‘shrink’ doubled overnight,” the executive recounted with a sigh, using the retail industry term for the amount of items stolen or misplaced.

  Ron Johnson might go down in history as the poster child of alienating a business’s core customers, but he was far from the first CEO to make this mistake. In the 1980s, Cadillac did the same thing as JCPenney, but in reverse. Instead of trying to sell upscale items to downscale buyers, Cadillac tried to market cheaper, more compact models like the Cimarron. But no one buys a Cadillac to demonstrate thrift or to save money on gas. People buy Cadillacs to show the world that they can afford to buy a Cadillac. They want them big, powerful, and as ostentatious as possible. They sure as hell don’t want something that looks like a glorified Chevy. This misreading of its customers almost brought the venerable brand to ruin. It took Cadillac decades to recover.

  Of course, established companies shift strategies all the time. Many succeed in doing so. But just as many, if not more, forget the basic buying habits of their customers in the process. Sometimes managements get so emotionally attached to their creations, or so convinced that they’ve discovered a unique market need, that they wind up being the last people on Earth to realize that nobody else shares their opinion. Investors are also susceptible to this overconfidence. They buy into a company that they themselves patronize, or that they are convinced creates an indispensable product or service, and they often ignore very compelling evidence that the rest of the market does not share their tastes. It’s called confirmation bias—believing what you want to believe and discounting contrary information—and it has destroyed countless portfolios and businesses alike.

  Fad on Wheels

  You may remember that, for a little while, inline skates, known popularly as Rollerblades, were the must-have sporting goods item in this country. My son wanted some so badly, I couldn’t even get him to wait for Christmas to get them. He was about ten at the time, and every time he turned on the TV, he saw ads with ecstatic kids flying down the street. It drove him crazy. Finally, I broke down and took him to the store to get a pair.

  The first letdown happened right after he took his new toys out of the box. They had so many straps and laces and hooks, it took the two of us fifteen minutes to get them on his feet. It was like donning moon boots or gearing up for a scuba dive. After we finally managed to get him in the things, he took off down the driveway, fell on his rear end, and promptly decided he wasn’t so thrilled with inline skates after all. He never wore them again.

  Around that time, I was at a Hambrecht & Quist conference in San Francisco, and I saw the two guys running First Team Sports Inc. (stock symbol: FTSP), one of the biggest makers of inline skates, give a presentation. Their stock, like their product, was a hot item at the time. Now, most corporate presentations at stock conferences are absurdly optimistic, but this speech was downright silly. They had charts with sales projections literally turning vertical and flying up off the top of the page. I didn’t stay for the whole thing. But I did call an analyst handling the stock at Hambrecht & Quist a couple days later.

  “Is this Rollerblade thing for real or is it going to go the way of the Slinky and the Hula Hoop?” I asked her.

  “Oh, no,” she answered breathlessly. “Rollerblades are here to stay. They’re huge and they’re only going to get more popular as time goes on.”

  After I expressed skepticism about this claim, she came back with the most preposte
rous prediction I have heard in thirty years of listening to preposterously optimistic predictions from analysts, executives, and entrepreneurs: “Mark my words, Scott,” she pronounced. “In ten years’ time, for every one bike you see in Golden Gate Park on a sunny day, you’re going to see ten people on Rollerblades.”

  “Let me ask you a question,” I said. “Do you Rollerblade?”

  “Absolutely!” she exclaimed. “So do all my friends. I do it every morning before work. It’s the best workout you can get!”

  I thanked her for her time, hung up the phone, and promptly shorted the stock of First Team Sports. At the time, it was around $6, and to hear people in the business talk, it was quickly heading higher. But when sales stopped growing, the stock made a sharp U-turn. I didn’t wait for it to go all the way to zero. I covered my position when it hit $2, shortly before the company was bought out with its stock still clinging to life at $1 a share.

  Betting against First Team Sports was not a sure thing. Shorting a company selling a fad product is a very tricky game. Even if you’re convinced that their popularity isn’t going to last, you still can’t tell when it’s going to fade. It could take years. But my conversation with the Hambrecht & Quist analyst convinced me that inline skates were going to wipe out sooner than later.

  The average Wall Street analyst or institutional salesperson is three things: young, affluent, and hypercompetitive. In other words, people like that analyst I spoke with are the prime demographic for a fad fitness product like inline skates. But most Americans are not like your average person on Wall Street. Sure, for a couple years, the skates sold well, mainly because everybody’s kids harangued them into buying a pair. But I was pretty sure most of those buyers had the same letdown as my son did once they actually tried the things. They were simply too awkward to wear and too difficult to master.

  First Team’s stock was trading at thirty times the company’s earnings when I shorted it. That big of a multiple is a major red flag. But the Hambrecht & Quist analyst and the rest of her Rollerblading friends in the industry failed to recognize that clear danger sign. All they knew was that they loved inline skating and so did everyone in their social circle, and they made the crucial error of assuming that the rest of the country would follow their lead.

  Off Track

  Inline skates were far from the first exercise product to get overhyped in the money management world. There have been many of them over the years. Remember NordicTrack? It was a big, heavy, expensive contraption built to simulate the workout you got from cross-country skiing. In the late 1980s, two Harvard MBAs bought out the little mom-and-pop company in Minnesota that had invented it. They both loved the thing, and just like that analyst I spoke with about Rollerblades, they assumed that average Americans would, too.

  NordicTrack was especially popular in the investment community. No surprise there. Like I said, the industry is full of young, rich strivers with plenty of money to burn on the latest gear for self-improvement. But, as it turned out, most consumers weren’t interested in paying hundreds of dollars for something that would take up half their living room and looked like a prop from the movie Robocop. It took a few years, but NordicTrack, like inline skates, went off the rails. Its parent company, CML Group, declared bankruptcy in 1998.

  In my opinion, the ultracompetitiveness that makes many money managers fall for fad fitness gear is a terrible trait for any investor. Yet most brokerage firms actively seek out competitive people to work for them. Montgomery Securities in San Francisco used to recruit, almost exclusively, former college athletes. They liked the fire and the discipline that the ex-jocks brought to the job. To be sure, those are good attributes for salespeople. But the real reason Montgomery coveted jocks was for their competitiveness, their obsession with winning at all costs. And that, in my opinion, is a very destructive quality. It’s actually the last thing you should want in someone handling your money. Why? Because quitting is very important when you’re buying and selling stocks.

  I’m not perfect at what I do, by any stretch, but I am a very good quitter. I’d say I’m one of the better quitters I know. And that skill has helped me a lot over the years.

  Take my experience with Advanced Marketing in chapter 2. I blew my chance to profit on that stock when it was still trading at its peak. And I was so enamored with my GARP formula that I exacerbated my mistake by waiting too long to get out. But as soon as I recognized my misreading of the company, I sold right away. I didn’t even wait to find out why the stock was going down. I just pulled the rip cord and parachuted out. And while I wound up losing all of the profits I would have made if I’d been more perceptive and sold earlier, I didn’t make excuses and hold on as the stock crashed. That’s usually the way it goes for me. I might sacrifice some profits, or miss out on chances to make more, but aside from running restaurants in Marin County, I rarely give up large sums of money. And there’s one reason for that: I’m a great quitter—and proud of it.

  The fact that more companies fail than succeed means, as an investor, you’re going to have to deal with losing investments. Excessively competitive people have a hard time accepting this reality. They overestimate their own abilities and their own chances of success. Worst of all, they are reluctant to give up when things turn bad. That’s the real danger of competitiveness. Remember the old saying: “It’s okay to be wrong; it’s not okay to stay wrong.” Too often, investors break this rule. They think they can will their stocks to victory somehow, that things will come out well in the end if they just try hard enough. And that’s just not how it works.

  Businesspeople make the mistake of thinking they can will their ventures to success as well, but in a slightly different way. Rather than getting too emotionally attached to their creations—as I did with my first restaurant—they take a more cerebral, but no less flawed, approach. Most entrepreneurs and corporate executives are, understandably, confident people. They have an unshakable faith in their instincts, their intelligence, and the products or services their companies offer. But, over the years, I’ve seen this self-assurance blind even the sharpest, most capable managers to a fatal problem: their target customers simply don’t want what they’re selling.

  Clogged Thinking

  One of the smartest people I have ever met said one of the dumbest things I have ever heard.

  He was the CEO of Chemtrak (stock symbol: CMTR), which specialized in take-home medical tests. I drove down to visit the company’s headquarters in an office park outside of Palo Alto soon after Chemtrak went public. Chemtrak’s only product was an over-the-counter blood test for cholesterol levels. It had just received FDA approval, and Wall Street was all aflutter. CMTR had shot up from $10 to $20 on the news.

  The company’s chief executive was a lean, dignified-looking man with a graying beard and a beautiful red silk turban wrapped around his head. To demonstrate the ease and usability of Chemtrak’s newly approved test, he had his secretary bring one into the office for me to try. She opened the packaging and removed a small plastic lancet, then showed me how to prick my finger with it. I don’t normally expect to shed blood at business meetings, but I went ahead and did as she directed.

  “It is painless,” the CEO reassured me in his lilting Indian accent. “Just a little pinch.”

  His secretary helped me squeeze a small drop of my blood into a plastic vial that contained a test strip.

  “In twelve minutes we will have the results,” her boss announced with a proud smile. “It’s that easy.”

  As I placed a small bandage on my finger, I told him that, as easy as the test was to administer, I was skeptical about the hype surrounding the product. It just didn’t seem like something American consumers would buy in big numbers. His response shocked me. After giving me a brief but authoritative report on the epidemic levels of heart disease in our country, and how lowering cholesterol levels was a crucial preventive measure, he de
livered an astoundingly dense analogy: “Our research indicates that there are five million home pregnancy tests sold every year. Nearly all of those tests are purchased by women. But both men and women in America are concerned about heart health and cholesterol. Therefore, we are confident our sales will exceed five million units per year.”

  I had to take a moment to process his words. I thought I must have misheard him. This man was not only an accomplished executive, he also had a PhD in, I believe, biochemistry. His IQ was almost certainly a few touchdowns higher than mine. And yet I couldn’t deny it: he was making the single most idiotic argument I had ever heard. People buy pregnancy kits because they absolutely have to know the results. They’re extremely invested in the outcome, to say the least. Somebody who just ate a Big Mac at McDonald’s or a Double-Double at In-N-Out Burger does not feel anywhere near that same sense of urgency when it comes to their cholesterol. If anything, cholesterol is the last thing on their mind. They don’t want to ruin the pleasure of the meal they’ve just had by thinking about how bad it was for them. That’s just not how American consumers behave. Throw in the fact that Chemtrak’s product was a blood test, and the comparison gets even more untenable. 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.

  The CEO looked a little mystified by my reaction. I’m sure he had delivered this speech to numerous potential investors, and apparently I was the first person to balk at it. Thankfully, my test results were ready by that point, so we could change the subject. As usual, despite my generally atrocious diet, my cholesterol was superbly low. (My wife is always shocked at this, and a little bit jealous.) The CEO congratulated me on my good health and I quickly departed his office.