Wednesday, April 6, 2016

Book review: "Dead Companies Walking" by Scott Fearon

Scott Fearon is a successful investor from California. Dead Companies Walking chronicles his thirty-year career as a stock analyst, manager of a mutual fund, and finally manager of a long/short hedge fund. The book's message is that failure is an inevitable feature of business and investing, and to illustrate this, Fearon includes case studies of 34 companies he researched that either failed or experienced significant problems. (There are also five case studies of successful businesses, including one that almost failed but later recovered.)

According to Fearon, the six typical reasons why companies fail are:
1. They learned only from the recent past.
2. They relied too heavily on a formula for success.
3. They misread or alienated their customers.
4. They fell victim to a mania.
5. They failed to adapt to tectonic shifts in their industries.
6. They were physically or emotionally removed from their companies' operations.

When Fearon researches a company's stock, he likes to meet with its managers. The book mentions that he's visited 1,400 corporate offices since 1984--nearly one visit per week. He also employs more creative forms of research: once, to gauge how well a cholesterol test was selling, he went to local pharmacies and left tiny marks on boxes of the test. When he returned to the pharmacies months later and saw that the marked boxes were still there, he knew the test had sold poorly.

If Fearon becomes convinced a company will fail, he doesn't short its stock right away. Instead, he waits until the company has begun reporting bad news and its stock has fallen significantly from its highs. He wants clear evidence that the company is failing and that the market is starting to recognize it's failing. I would describe this strategy as a mix of value and momentum: he looks for situations where the market underreacts to bad news, so that while a stock has already dropped, it's still above fair value and he can expect it to drop further.

Although Walter Resources isn't one of Fearon's case studies, it's a good example of this dynamic. Walter's stock peaked at 140 in early 2011 amid booming demand for metallurgical coal. By 2014, met coal prices were down 50% and the stock was down 90%. At that point Walter, encumbered by billions of dollars debt, was almost certain to go bankrupt, yet the stock still traded above 10 and the company still had a billion-dollar market cap.

Some investors didn't sell Walter stock because they were averse to taking a loss and desperately hoped it would rebound. Others didn't appreciate how oversupplied the met-coal market had become. Whatever their reasons for holding on, the stock was overvalued despite being down 90%, and it soon went to zero.

Dead Companies Walking seems to be a popular book. Many of the investors whom I follow online have praised it. I have a less favorable opinion: I think Fearon's strategy has become crowded and that it has several inherent drawbacks.

A crowded strategy

When a stock falls, its short interest usually rises. I've seen this happen to nearly every stock I follow as a short-sale candidate.

I think this happens because many hedge funds have risk-control strategies that force them to act like momentum investors: these funds reduce their gross exposure when they lose money, which forces them to cover shorts that go against them. Conversely, the funds allow themselves to raise exposure when they make money, adding to their shorts as they fall.

Whatever the reason for this dynamic, it's made Fearon's strategy very crowded. Shorting a stock that's low and headed lower now entails paying a negative rebate, possibly a large rebate. It also entails the risk of a ferocious dead-cat bounce, and the bounce may involve a buy-in that makes the short seller's losses permanent.

Ironically, while crowdedness makes Fearon's strategy worse, it also explains why Dead Companies Walking is popular. Long/short fund managers like the book because Fearon's experiences and investing principles are the same as theirs.

Drwaback #1: It doesn't scale

On his website, Fearon argues that hedge funds' returns plummet as their assets grow. I don't think that's true universally, but it's definitely true for his strategy. There's a low limit to the amount of money that can be put to work shorting small, failing companies. If a stock goes to 0, a short seller will earn a 100% return regardless of his entry price, but his absolute gain is much larger if he shorts a million shares at 50 than if he shorts it at 5.

Drawback #2: The tail risk is huge

Every so often, a failing company finds a way to beat the odds and its stock surges. In 2009, many companies that would have gone bankrupt in a typical crisis not only stayed alive but swiftly recovered. Not coincidentally, 2009 was Fearon's first losing year as a fund manager.

Weight Watchers' contract with Oprah is a more recent example of a bankruptcy-bound company getting a new lease on life. I think Weight Watches is still likely to go bankrupt, but that didn't stop its stock from going from a low of $4 to a high of $26 after the contract was announced.

Drawback 3: It isn't universally applicable

Fearon's research is mostly qualitative: he meets with management, he judges the logic of their business plan, he looks for anecdotes that suggest a product will succeed or fail, etc. His research also tends to emphasize how a company is doing at the moment and how it will do in the near future.

While this tack is valuable for some companies, it's useless for others. A year ago, Fearon wrote a bullish article on Trinity Industries, which makes railcars. He argued that investors had overreacted to bad headlines and pushed Trinity's stock down to an irrationally low multiple of only 8x next year's earnings.

When Fearon wrote his article, Trinity was earning lots of money because of strong demand for tank cars that are used to ship oil. The problem is that shipping by rail is vastly inferior to shipping by pipeline, so unless no major pipelines are built in the next 8 years, an 8x multiple isn't cheap.

Even worse, tank cars have decades-long lives. If/when new pipelines are built, all the tank cars that are currently used to ship oil will no longer be needed, and they'll be dumped on the market.

"Business is strong right now, and it's cheap on next year's earnings" may be a good reason to buy a consumer-products company, but it isn't for a cyclical business like Trinity. Artificially high demand for long-lived goods just pulls orders forward, so it doesn't deserve a multiple.


I'll end this review on a positive note. Despite the foregoing criticism, I think Fearon's strategy can be very successful in some instances.

Here's a prominent one: in January, Valeant was trading at $90-100, 60% below its all-time high. Despite that, the stock wasn't cheap, and it's fallen by another 60% since then. When the existence of Valeant's specialty pharmacies was revealed and the company had to shut them down, investors realized the company was in trouble and the stock tanked. Nonetheless, few investors understood just how essential the specialty pharmacies were for selling drugs that otherwise would be uncompetitive.

As with many of companies in Fearon's case studies, Valeant investors underreacted to bad news, and this created an opportunity to short the stock even though it had already dropped significantly.