Dead Companies Walking

How a Hedge Fund Manager Finds Opportunity in Unexpected Places

Book by Scott Fearon

Review & Article by GlobalMacroForex

Author Scott Fearon’s hedge fund has averaged an 11.4% return per year after fees, beating the S&P500 benchmark every year since 1991 (except in 2009, when he shorted Citigroup but it got bailed out by the government despite being bankrupt.)

With an impressive track record, Mr. Fearon gives us some great insight into his short selling decisions and what makes a great business.  In this article (which just skims the surface of this book), we will discuss:

·      A lot of businesses fail

·      Products that don’t sell in the real world

·      Managers that don’t know when to quit

·      Don’t go with the flow

·      And the real money is on going long

Let’s dig right in…

A lot of businesses fail

A major message of Scott Fearon is that a lot of businesses fail.  Most tiny companies with a brand new product, don’t sell that many of its new ideas; they usually don’t work.  But that’s okay because capitalism is all about creative destruction.

Mr. Fearon searches for companies that have already fallen significantly and are essentially walking zombies by the time he arrives to short them.  He looks for companies in a dying business (for example Blockbuster, which he shorted long after Netflix was driving Blockbuster out of the business).  Or he looks for companies that have lost touch with their consumers’ core needs or a product that, while it sounds nice, won’t actually sell in the real world.  (See the Chemtrak example below.)

Doesn’t Sell in the Real World

Scott Fearon looks to short businesses that have a fundamentally flawed business model.  He gives one type of flawed business where the product is not something people actually want, such as Chemtrak who made a home cholesterol test.  The test required pricking one’s finger to work, and Mr. Fearon just didn’t think most American consumers were interested in stabbing themselves after a meal to feel guilty for overindulging.

“Even though heart disease is a major problem inn this country, American consumers were simply not going to buy what Chemtrak was selling.  Lots and lots of very smart people make this mistake.  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.”

To test his hypothesis, Fearon sent his intern to put a nick on the corners of the products at 5 stores to see if they sold.  After a few months, his intern went back and found not a single one sold.   That gave Scott Fearon all the information he needed to short the stock.

Don’t know when to quit

“The average Wall St analyst or institutional salesperson is three things: young, affluent, and hypercompetitive.”

So Mr. Fearon points out how the average Wall Street analyst isn’t like the average American consumer.  By being out to touch with the consumer’s real world wants, the analyst isn’t able to figure out if the core business model works.

Also by being so hypercompetitive — typically a jock from an Ivy League school – the analyst doesn’t ever want to acknowledge failure.

“Quitting is very important when you’re buying and selling stocks”

Fearon repeats that a lot of businesses don’t work out and fail.  You have to acknowledge it and move on.  You can’t hold on to a business that has a flawed core product and falling shares just because your high school coach taught you to never give in.

“It’s okay to be wrong, it’s not okay to stay wrong”

Don’t go with the flow

Scott Fearon stresses the need for money managers to be intellectually curious.  He gives the example of some of his colleagues that didn’t know what the taxes were in their own state.  He stresses that you have to figure things out for yourself and not automatically trust your colleagues, who may not be as intellectually curious.

 “Effective money managers do not go with the flow”

Fearon explains how contrarian investing can lead to significant gains and that there’s a certain character about successful money managers that they avoid the herd.

“They don’t automatically trust that what the majority of people-especially the experts-are doing is necessarily correct or wise.  If anything, they move in the opposite direction of the majority, or they at least seek out their own course.”

Real money isn’t on short

Although the theme of Scott Fearon’s book is looking for walking zombie businesses one can short, he says the real money to be made is on the upside.

“Going long on successful businesses will always be the best way to earn outsized returns.”

Fearon notes how a great stock can double, triple, or even go up multiple times its original investment.  On the other hand, shorts only go to zero, and they aren’t going to infinitely generate profits.

Conclusion

Mr. Fearon goes into great depth with this book that I’m merely skimming the surface of, including in-depth examples of multiple businesses he shorted or went long and what were the deciding factors in his decision.  This book is filled with practical direct real world advise with stories of his interaction with the corporate management and what made Fearon decide that these businesses would ultimately fail or succeed.  I highly recommend this book to anyone looking to invest, even if you have no intention of short selling because it’s important to know what to avoid.