Monday, February 23, 2015

Book Review: "Dead Companies Walking" by Scott Fearon

"Dead Companies Walking" is an excellent investing book that focuses on individual company shorts that hedge fund manager Mr. Fearon had encountered during his investing career going back to the 1980s. This is NOT a how-to book as there is relatively little in terms of process. The value of the book to an investor today is in the numerous "mini-cases" primarily of shorting situations, with some longs, misses and short-to-long along the way.

The key conclusions from the book are:
(1) Nothing new under the sun: business failure is a feature, not a bug, of capitalism. Names and faces change but there will also be plenty of stocks that go to zero regardless of what the story was that was sold to investors.

(2) Big investing career misses can come from being too rigid: the author balked at paying a high multiple for SBUX and COST when they came out despite knowing, visiting and liking both companies. The two would go on to become two of the biggest winners in the market.

(3) There are six traps that management teams fall into: extrapolating the recent past, being formulaic, not understanding the customers, falling for a mania, not seeing tectonic shifts in the industry, and being aloof from the company operations. He builds on David Rocker's famous "frauds, fads and failures"

(4) He is really big on in-person visits (has done thousands) to really gauge what's going on. He also praises doing nothing as a good strategy: investing might well be the only business where doing nothing is actually doing something.

(5) He's wary of "infallible" and/or competitive characters: individuals from brand-name schools, from brand-name companies, running marathons, etc. Mr. Fearon's view is that both management teams and investors have to be able to walk ("The best money managers are also the best quitters. They quit early and they quit often"). I could not agree more.

Biographically, Mr Fearon starts his career in the trust department of a bank in Houston in the early 1980s just as the oil boom implodes. He then goes on to manage a mutual fund, gets disgusted with the industry at the time (incl. hiring boiler room operators to push the shares and not closing to inflows). He starts his own fund in 1990. The mini-cases in the book are not in chronological order but this serves to illustrate the various topics.

Mini-case one:
Off-shore driller that looked cheap as the boom ended (sounds familiar to 2014 investors). The CFO is bullish: utilization rates are low and they always bounce back. They pass. The company eventually goes under: the CFO's utilization data did not go far enough to capture a similar collapse in the industry.

Mini-case two:
The TXU LBO in 2007, the largest LBO ever, and one of Buffett's "unforced errors." Extrapolations for the recent past (increasing electricity prices in TX) and heavy debt load led to the current restructuring, in addition to a bet on coal. Shale gas abundance resulted in lower electricity prices.

Mini-case three:
TGI Fridays in the 1980s: hot and growing restaurant chain IPOs hits an air pocket as growth slows and the valuation gets cut down. We have seen some of that with the 2013-14 JOBS Act IPO restaurants over the last few months.

Mini-case four:
January 2008, Orange County, California, single-family developer Cal Coastal. A small car accident at the airport means that Mr. Fearon cannot meet management that day, so he heads to the company's only development. The place is a disaster. He shorts that day. The company files for bankruptcy in 2009. Mr. Fearon admits to not seeing the "big" bubble the way some other managers did.

Mini-case five:
Mr. Fearon's own bank employer in Texas as oil fell. The management team is confident, says they "did not lend on iron" (loans backed by oil rigs), etc. His colleagues buy the stock as it goes down. Eventually the ten largest banks in TX are acquired or go under. Also, it turned out that his own bank did "lend on iron." This is eerily reminiscent to Lehman's internal propaganda and various management team members buying stock in 2008.

Mini-case six:
A friend of Mr. Fearon's offers his a special investment in a slightly mysterious manager generating steady, double-digit returns. He takes a look, sees a lot of red flags, and passes. Turns out it was Madoff, and the friend was a feeder fund. Plenty has been written on Madoff: affinity fraud, very generous, board service, industry leadership, etc.

Mini-cases seven and eight:
Passing on Costco and Starbucks in 1992 on the same day: visit with the down-to-earth COST CFO is great, the business is straight forward, clear growth path, quality merchandise, membership fee is both gravy and a screen for better customers, multiple too high. Similar experience with the SBUX CFO who lays it out: affordable luxury, consistent everywhere, people have no idea how much they just paid, etc. Also high multiple. He passes on both. By 2014, SBUX is a 100x, and COST is 20x. Could have been career-defining investments yet he was too rigid on not paying a high P/E.

Mini-case nine:
Dollar retail chain Value Merchants. Very competitive marathon runner CEO with outlandish growth plans (double every year). Mr. Fearon visits a local store, and it is a disaster. Unsold merchandise gets trucked to another location. Earnings were already faltering, and the company goes bankrupt within a year.

Mini-case ten:
QSR chain Krispy Kreme, an early 2000's darling also expands too aggressively (using area master-franchisees) but several of these area developers blow up. KKD was on the brink of filing for bankruptcy protection when its expansion plans collapsed.

Mini-case eleven:
Book distributor to big box retailers in the early 2000s has been growing sales nicely. Mr. Fearon buys the stock after a visit, Eventually, the stock round-trips on him (after a famous Fidelity manager who also happened to be the CEO's cousin warns Mr. Fearon that the business is just too low margin). It turns out that there was some fraud involved by lower level employees that would have been hard to detect from the outside. The numbers were just looking  too good.

Mini-case twelve:
Idearc (a Yellow Pages publisher). The company looked very cheap on EBITDA basis with a very optimistic CEO. Eventually, its debt load and declining business does it in. The company then re-emerges as Supermedia and is a hot stock in 2011. It also goes bankrupt. Then it merges with the only other public (US) yellow pages company, and is now known as Dex Media (trades at about 1/3rd of its 2013 high now in Feb 2015).

Mini-case thirteen:
This one is good: Mr. Fearon's own restaurant failure. He fell in love with cajun cuisine during his time in Texas so he decided to open a cajun place in Marin County, CA, where he lives. (Barbi Cap pro tip: 99% of normal people and 100% of foodies should not even think about opening a restaurant) He has all kinds of problems, loses over a million dollars over the years, and eventually relocates it to Berkley, where it thrives. His conclusion is that he did not understand the Marin Country customers: aging hippies who are more heavily in typical CA fusion cuisine rather than cajun.

Mini-case fourteen:
Along the lines of misunderstanding customers, Mr. Fearon covers the grandiose failure of Apple's retail chief Ron Johnson to turn around JC Penney in 2012. Under his leadership, JCP "fired its customer": stopped coupons, went with upscale merchandise, reduced "big and tall", reduced Spanish language ads, made it hard to pay with cash, removed anti-theft tags, etc. Typical moves for someone who is so isolated from the operations that commutes by airplane to "work" and stays at the Ritz for the week (instead of the hotel across from the offices). Same store sales in aggregate drop $4 billion or 25%, shrink doubles, and so on.

Mini-case fifteen:
Cadillac tries to market smaller, cheaper models and fails. Cadillac buyers want a Cadillac, not a rebadged Chevy.

Mini-case sixteen:
Fad product Rollerblades by First Team Sports (also mentioned Hula hoop and Slinky). Pushed very hard by younger competitive analysts, often former athletes, who loved in-line skating. Wider conclusion is that competitive, confident investment managers AND entrepreneurs are often blindsided by their own persistence.

Mini-case seventeen:
Chemtrak, a maker of take at home medical tests. Its only product was an OTC blood test that was approved by the FDA. Indian PhD CEO at the meeting says obesity is a huge problem, and pregnancy tests sell by the millions every year. Obvious logical fallacy: people don't really want to cut themselves on a regular basis to check cholesterol. Also marking boxes in local pharmacies showed that the product was not moving. It takes five years for the stock to go to zero.

Mini-cases eighteen/nineteen:
Internet bubble stock PlanetRX. Mr. Fearon takes his father to the CEO meeting. The father asks a few skeptical questions (ie older people have not adopted the internet, the pharmacy has the prescriptions filled fast) PLRX eventually goes from 40 to under a dollar. The company did not understand the customer (at the time). Webvan was another one with a similar problem at the time: people, especially mothers shopping, need to see and select the food they are buying for their families.

Mini-cases twenty and twenty-one:
WOMN, woman dot com, online information portal selling banner ads. Goes from $15 to under $1. Eventually bought by iVillage, which crashed from 100 to 2. CEO confidently assures him that there is no way her business fails. A VC friend of the author at the time said "none of these companies are ever going to make any money...but people just keep pouring capital into them." (this is pretty applicable to some of the tech darlings today). Quokka, ticker QKKA- Australian sailing enthusiast wants to stream live sailboat races with many cameras on the boats. Falls into the trap of thinking he can change human behavior: watching sailing will catch on with mainstream US. Company goes under less than a year later.

Mini-case twenty two:
Buffet restaurant chain Fresh Choice (ticker SALD), hot restaurant IPO with focus on healthy food for families. This one could have done well now: at the time, in Mr Fearon's view, Bay Area customers were into sit-down dining while buffet-style customers did not care about healthy options or cleanliness (big focus of SALD which he attributed to the Mormon faith of the founders). The company expands rapidly and goes bankrupt.

Mini-case twenty-three:
"Always around the corner" type company developing a non-invasive blood glucose monitor, called Cygnus, ticker CYGN. It was a watch that was supposed to read blood glucose from skin sweat. It did not work, nor did the second version. Reminds me a bit of of my experience with Fitbit.

Mini-case twenty-four:
Shaman Pharmaceuticals (LOL). Focused on developing drugs from traditional healing plants from the Amazon. Eventually fails after many years of burning cash and not coming up with a product. This will probably be the case with the majority of the small biotechs now.

Mini-case twenty-five:
Blockbuster in 2007: well-known story by now. Did not move fast enough to offset the retail decline (instead, wanted to sell more candy and popcorn), too much debt. Merged with Hollywood Video, tried to merge with Circuit City.

Mini-case twenty-six:
PageNet, a pager company, does not think that cell phones are a threat in 1999 (too bulky, expensive, bad coverage, interruption). You know how that story ends.

Mini-case twenty-seven:
Ultimate Electronics high end electronics retail chain with a new CFO from The Good Guys electronics retail chain. Gets killed in 2005 by the big boxes despite their belief in how differentiated they are.

Mini-case twenty-eight:
Texas Air/Continental in the 1980s: it was taken over by a famous raider called Frank Lorenzo. He met with young Fearon (who had figured out they had the lowest cost per mile), and lectured him on going through chapter 11 with Continental to reduce costs. Fearon buys the stock for the bank and it eventually goes up 10x. Fearon, like Buffett, does not like airlines but comments on how the industry has struggled with costs over time.

Mini-case twenty-nine:
Building Materials Holding Corp (BMHC), debt-fueled roll-up of commodity building supply companies with expensive HQ office in San Francisco. You can tell what happens when the housing market crashed in 2008.

Mini-case thirty:
MiniScribe disk drives get dropped by IBM hires a Mr. Fixit who does not want to move from LA to Colorado. However the pressure he exerts on the local management via unrealistic goals leads to a massive internal fraud which pumps up the stock price prior to detection.

Mini-case thirty-one:
Consilium, a robotics software company, is seeing revenues flatline while debt is climbing up in 1991. The CFO blames it on M-1 (the money supply) being constrained by the Fed, leading to slower factory spending. Mr. Fearon finds the blame absurd and shorts the stock immediately at 17, and covers at 10 about a year the later. The company is ultimately sold at $7/share. More recent example was Cisco blaming the NSA in 2013 when they were already losing business to Huawei.

Mini-cast thirty-two:
Discount retailer 50-Off Stores blames the weather for its poor results for two years in a row, using the *exact* same language in its filings. Mr. Fearon does some further analysts and shorts the stock. Ultimately, the company goes bankrupt.

Mini-case thirty-three:
Dendreon in 2013: while the stock shot up after its main drug approval, there were two competitors that followed suit with similar but substantially cheaper drugs. DNDN had issued convertible debt to expand just as their revenues started to decline. The company recently filed for bankruptcy.

Mini-case thirty-four:
Management that cares too much about the stock price (Bill Gates vs. Enron). The case is Silk Greenhouse which had had a good run leasing closed supermarket locations and selling fake plants in it. Site visit in the office reveals a tell: there is a big board with the company stock price. The CEO of this relatively new business talks a lot about expansion instead of fine-tuning the model. The company is bankrupt two years later.

Mini-case thirty-five:
Mr. Fearon shorts Palm after it becomes abundantly clear that the company has lost any advantage it had previously had. Yet somehow HP acquires them, leading to a big write-off later illustrating the problems of growth by acquisition. Often acquired employees "rest and vest", in other words, hang around just long enough to have their new options vested before bolting. Similar thing happened with the SF tech banks that were bought out by the big players.

Mini-case thirty-six:
This is going short to long. Cost Plus World Market, a retailer of various of imported goods with an ever-changing assortment. In 2003 the company embarks on a fast unit growth trajectory and changes the assortment from the quirky products to high end furniture. Going upscale alienates the core customer and same-store sales decelerate while traffic declines (with the check up). Inventory turns slow due to higher ticket items. In 2005, the comps go negative but the CFO blames Walmart. Mr. Fearon waits for the stock price to decline further before shorting, which he ultimately does in 2007. The stock hits 50 cents in 2009 but begins to creep up later in the year. A new CFO explains that they are going back to the old product assortment. The metrics recover, he covers and late buys, and BBBY buys them for $22/share at the end.

Mini-case thirty-seven:
Another short to long, ZLC Zale Corp, the jewelry retailer. It has a steady business selling diamonds and other "nice" pieces to middle class customers in malls. In the mid-2000s, it starts selling "fashion jewelry" (aka junk) alienating its core customer, while, at the same time, expanding locations aggressively. Comps and margins start dropping into the 2008 crisis. The stock loses about 90%, down to $3, by the time new management come in January 2010. New CEO gets some fresh capital, closes locations, gets rid of the fashion jewelry, bring quality back in (ie Vera Wang brand). Comps start to turn around, and the stock eventually follows. Signet acquires Zale in 2014 at $21/share.

Mini-case thirty-eight:
Early 1990s, International Game technology (IGT), maker of slot machines against a backdrop of increasing number of casinos (Indian gaming expansion). While most expensive of the bunch, they also spend 5x in R&D to escape competing on price, and come up with progressive jackpot and leasing machines with revenue upside. The stock outperforms the competition by far.

Mini-case thirty-nine:
As the oil business implodes in the 1980s, an Oklahoma bank spins its data-processing unit in order to leverage the know-how by selling services to other banks (the parent will likely stay on as the largest customer for a while). Speaking to professionals in the space, the separation appeared to make no sense until one guy suggests that the bank needs cash since its loans are probably going bad, and you will hold a de-facto captive service provider to a bank that might go under. Two years later the bank is gone and the processors is acquired for a fraction of the IPO price.

The book ends with an extensive discussion of many unsavory sell-side and buy-side practices, a parade of charlatans going back to the 1980s, the crooked bailouts during the GFC and how the bailouts have created substantial moral hazard; the cluelessness (or worse) of SEC regarding outright frauds.

Overall recommendation: "must-read" for buy-side professionals. "Good to read" for general financial professionals and active individual investors.

Disclosures: none. I bought my own Kindle copy and I do not know Mr. Fearon or his writer-helper Jesse Powell.

Addendum: reviewers of the review on Twitter (@BrattleStCap and @TheCreditBubble) suggest the following inclusions:
"investing might well be the only business where doing nothing is actually doing something"
few more generalities; 1. He doesn't short as much now 2. 'Synergies' are garbage 3. Zombie stocks can hang on for a long time
re; process, he waits for stocks to be down 50% from 52-wk high; no 'momo'
Brattle also recommends the review of The Art of Short Selling by Walrus value

















Wednesday, January 7, 2015

CEO Names on Bill Ackman's Desk

Bloomberg has an extensive article on Bill Ackman of Pershing Sqare who has had a truly spectacular year (and, if anyone from Pershing Square is reading this, thank you for ZTS). The article is a good read though I personally find their decks a lot more interesting. The opportunity to learn also extends to studying Mr. Ackman's work environment.

In any case, a close inspection of the hi-res photo of Mr. Ackman's office revealed a short list of CEOs on a hand-written pad.

They appear to be:
Juan Ramon Alaix (of Zoetis, recent activist long)
Paul Fribourg (CEO of Continental Grain, Board Member BKW WYN L EL APOL etc.)
David Sokol (formerly of Berkshire Hathaway)
Dennis Reilley (Praxair, DuPont, Covidien, Dow, Marathon Oil) [spelled as Reilly]
Mike Pearson (of Valeant)
Unreadable to me (tweet at me if you can figure it out) (Update: Joseph/Joe Shenker, Chairman of Sullivan & Cromwell; thank you @drchik23)

A less interesting piece is a handwritten note under the Polycom unit from (I think) Steven Wood of Greenwood Investors. The note is largely unintelligible to me.

There are several other notepads that I cannot read (barely making out George somebody... 1982-2000 on the one under the phone), nor can I figure out the book behind Mr. Ackman.

(h/t to Maoxian for tweeting the link to the hi-res pic)

Update 1: Twitter discussion whether Ackman *wanted* people to see it... given how the memos on his desk are flipped. We won't probably know.

Update 2: The story has taken a life on its own now: Wall Street Journal, BloombergBusiness Insider and even BuzzFeed.


Monday, December 15, 2014

The 2014 Global Rejects for 2015

Based on the positive feedback from the imaginary "2013 Global Rejects Portfolio: Only For People Who Hate Money" (posted here), I have decided to do a quick imaginary "2014 Global Rejects Portfolio: Money To Burn"

There is a challenge however: going solely off YTD and loss from 52-week high would present a gigantic bet on commodities/USD weakness, be it producers or whole countries. The 2013 rejects were a more diversified bunch. So I am still sticking with Rejects (down 5% to 52% down from the 52-week high as of Friday Dec 12 2014) but not everything is from the very bottom. I am also going with 5% picks only.

Here it is by broad category:

Commodity-driven industry sector ETFs (7): FCG nat gas equities, OIH oil services, GDX gold miners, SLX steel producers, SIL silver miners, KOL coal miners, AMLP MLPs

Weak US sector ETFs (3): SOCL social media, ITB homebuilders, KBE regional banks

International ETFs (3): ELD EM local debt, EMCB EM corporate debt, IPS international consumer staples

US fixed income ETF (1): JNK high yield

Country ETFs (6): RXSJ Russia small caps, GREK Greece, BRF Brazil small caps, EWI Italy, EWP Spain, ARGT Argentina

(The imaginary nemesis, call it the "2014 Global All Stars: The Mo Bro" could be something like 10% each: TLT LT Treasury, PFF US Preferreds, XLU US Utilities, VNQ US REITs, LQD US IG Corporates, XLY US Discretionary, IBB Biotechs, EPHE Philippines, ENZL New Zealand, EPI India)


Saturday, December 13, 2014

The Imaginary "Barbarian Capital All-Star Global Rejects 2013" Portfolio

About a year ago, bond manager, herbal tea enthusiast*, Boston** sports fanatic and occasional blogger @DavidSchawel emailed me (and several other people) to crowdsource portfolio ideas for a blog post. The blog post never came but I had already saved the portfolio that I submitted: The Barbarian Capital All-Star Global Rejects 2013: ONLY for people who hate money.

The simplistic portfolio approach was to buy the worst performing global assets in 2013 via ETFs available in the US. If you remember, interest rates were rising in the US so US fixed income and real estate had not done well. Internationally, we had weakness in several markets, some commodity driven. We also had weakness in precious metals and coal.

So the portfolio was 15% each GDX gold miners, KOL global coal, TLT long US bonds, IYR US Real Estate, and 5% each ECH Chile, BRF Brazil Small Cap, IDX Indonesia, TUR Turkey, EPI India, THD Thailand, REM Mortgage REITs and PFF US Preferred Stocks.

How did it do? Not bad actually: up a little over 8% after 365 days even with train wrecks likea Coal and Brazil. Most of the performance was driven by declining US rates (helped TLT IYR REM and PFF), as well as a breakout in India. An equally weighted portfolio would have done a little better, at 9.8%.

What can you learn from it? Nothing: it shows momentum, mean-reversion and luck. May be a case for diversification.

Screenshot of the portfolio and the original email below.

*,**- Schawel actually likes coffee and Chicago sports

Thursday, May 8, 2014

Did Walmart Kill the Organic Food Names?

For a number of years, stocks along the entire organic/natural chain have commanded premium valuations versus conventional food peers, as organic foods in general have had higher price points and stronger sales growth.

On April 10th, 2014, Walmart announced a new partnership with privately held Wild Oats that will drive organic food product pricing to about parity with branded conventional food counterparts.

This may have resulted in understandable market pessimism for the players in the space (with the exception of SunOpta STKL, an ingredient supplier). Some were already trending down because of individual problems (ie BNNY) but it seems that in the last month or so since the announcement, every stock- producers and grocers- has weakened in the face of new highs in the staples ETF XLP.