Dead Companies Walking

by Scott Fearon

  I realized something else, too, there on the coast of Orange County: my grandparents probably would have laughed at me for taking so long to figure out how bad things were. People in their generation were very attuned to the pitfalls of the real estate market. They’d lived through the Depression, and because of that they did everything they could to avoid big debts, or at least to minimize their exposure. They used to hold mortgage-burning parties with all of their neighbors when they’d finished paying off their loans. It was a huge relief for them to be clear of the frightening burden of their home loans. I considered how far we’d gotten from that. At the height of the housing bubble, people gladly loaded themselves down with enormous mortgages (and other debts) that they couldn’t possibly afford. Then they went on to take out second, third, even fourth mortgages on top of it.

  I got on the phone right then with my office and told my trader to short 200,000 shares of Cal Coastal. The company was bankrupt by the end of the following year, and its stock went to zero. I also shorted several other real estate–related companies. But that’s not the interesting part of the Brightwater story. I’m not claiming that I was a genius for profiting from the hubris of a badly indebted housing developer hawking vastly overpriced houses on the site of an old Indian burial ground. No. What’s interesting is how many people refused to face this reality.

  Two weeks before Cal Coastal filed for bankruptcy in October 2009, a well-known analyst at San Francisco–based JMP Securities put out a research report on the company. The stock cost was $1.50 at the time, and the analyst strongly advised his firm’s clients to buy it. He predicted that it would hit $5 again in the near future. I couldn’t believe what I was reading. Was he talking about the same California Coastal Communities? I had to check twice to make sure.

  Fourteen days later, the company officially petitioned for bankruptcy protection. Oops!

  Even after Cal Coastal went into Chapter 11, people continued to hope against hope that it would make a comeback. One prominent money manager started to buy Cal Coastal like it was a hot new start-up. There were roughly eleven million common shares of the company. By the time his spree came to an end, this guy had acquired more than two million of them—just in time for the final bankruptcy settlement to wipe out every cent of value they had.

  How I Make Money on Falling Stocks

  The mechanics of short selling are relatively simple. My prime broker borrows a certain number of shares in a company on my behalf. My fund then sells these borrowed shares at the current market price. Normally, at some point in the future, I would be obligated to purchase that number of shares so that I can “cover” my position.

  If the stock in question goes down in value, as I’m expecting, I will be able to buy those shares at a lower price than I sold them for. That’s how I make my profit. If the stock goes up, however, covering my position will cost me more than the original price, and I’ll have to eat the difference. This is what makes the process more risky than your average investment. Theoretically, there is an infinite amount of risk. If you buy a stock selling at $10, the most you can possibly lose is $10. If you short that same stock, however, and it winds up being the next Apple or Exxon or Berkshire Hathaway, you stand to lose a whole lot more if you don’t cover in time.

  Ideally, I don’t have to worry about covering my positions at all. That’s because, unlike most other short-selling investors out there, I don’t seek out stocks I think are just going to dip a little bit in the near term (as I did with my very first short of TGI Fridays). I look for genuine failures, companies like Cal Coastal, that seem destined for one outcome: bankruptcy and a zeroed-out stock price.

  Neither the analyst nor the fund manager was up to anything underhanded or crooked. They were just catastrophically wrong. And they were far from alone. Almost nobody wanted to face how bad things were in the real estate market. There was a monolithic, if hugely irrational, belief that things would turn around and that prices would start going up again.

  I was never heavily invested in real estate stocks. Even at the height of the bubble, I avoided home building and mortgage companies. I knew the real estate market was overheated and that housing had always been a cyclical industry. But even I didn’t fully comprehend the enormity of the supercycle disaster we were facing until I set foot on Bolsa Chica Mesa that day and saw all those empty, half-built houses.

  In other words, I wasn’t like those guys in Michael Lewis’s book The Big Short. I didn’t see the crash coming before the fact. If I had, I’d probably be living on my own private island somewhere. But there’s an old saying in the investment game: “It’s okay to be wrong; it’s not okay to stay wrong.” As soon as I figured out just how historically massive the downturn was, I adjusted to that reality and began shorting companies in the real estate sector. Pretending that things were going to work out for the best and that the market was going to turn around would have been disastrous. And yet that’s exactly what most people did. They stayed in denial right up until they went broke.

  Unfortunately, this is how the majority of people in business and investing behave when they’re facing hard times and hard choices.

  The Lone Star State of Denial

  I got to witness my first full-blown corporate implosion from the inside. Texas Commerce Bank, or TCB as we affectionately called it, started off as an obscure regional bank catering mainly to Houston’s wealthy elite. But it grew exponentially during the oil boom of the 1970s. By the time I got there in ’83, it was the largest bank in Texas. The Texas Commerce Tower, our headquarters, was the eighth-tallest high-rise on the planet at the time, and everyone who worked there was brimming with enthusiasm.

  Then the oil market collapsed, and quite literally overnight, everything changed. I still remember the bleak mood that fell over the staff after our chief financial officer announced that we’d had our first quarterly profit decline in more than sixteen years. The room was tomb silent. No one could believe it. But our CFO, a smart, fast-thinking Harvard- and Stanford-educated Houston native, was quick to reassure us with a clever analogy. “Listen. Everybody remembers when Joe DiMaggio’s fifty-six-game hitting streak ended,” he said. “But did you know he started another streak the very next day that went on for sixteen more games? We’re going to be like DiMaggio, guys. Don’t worry. This is just a temporary setback.”

  He went on to explain why we were going to be like DiMaggio. Unlike most other banks in Texas, he said, TCB hadn’t been “lending on iron”—that is, it hadn’t allowed energy companies to use their drilling equipment for collateral on loans. He stressed this repeatedly to us. It was very comforting to hear, because after the price of oil cratered, there was a whole lot of idle drilling equipment sitting around reaping nothing but rust. Before the crash, the Hughes Tool Report counted almost five thousand land rigs operating in North America. By the time our CFO stood up in that meeting, the number was down to a thousand.

  After the meeting, a couple of friends approached me as I was crossing the street to get some coffee. The bank’s stock was down six bucks that morning alone. After our CFO’s pep talk, they were ready to pool their money and buy a big chunk of shares. I was tempted, but I politely declined. As with Global Marine, I was wary of trying to “catch a falling knife” by calling the bottom of our company’s downturn. I was also beginning to suspect that things were considerably worse than anyone was admitting. My boss and I talked regularly with management teams in the energy industry, and a lot of those guys were spouting their own we’re-down-but-not-out stories. Nobody offered anything quite as inspired as the tale of Joe DiMaggio’s hitting streaks, but they were all equally convinced their firms would bounce back.

  My circumspection saved me money. It turned out that Texas Commerce, like just about every other bank in the region, had actually been “lending on iron” in a big way. And like just about every other bank in the region, we went downhill fast because of i
t. By the end of the 1980s, the ten largest banks in Texas had all either gone under or been gobbled up by larger institutions. Texas Commerce was one of the “lucky” ones that got bought out. Chemical Bank, itself soon to be devoured by Chase Manhattan, took us over shortly before I left. We used to joke ruefully that TCB was now “Chemically dependent.”

  I’m not saying I foresaw Texas Commerce’s demise that morning when my friends tried to get me to go in with them on those shares. But even if I didn’t quite realize it at the time, I was learning an important and fascinating lesson about business and human nature: Failure terrifies people. They’ll do whatever they have to do to downplay it, wish it away, and just plain pretend it doesn’t exist. Most of the time, they’ll go on living in denial long after the truth of their predicament becomes obvious. Americans are especially prone to this kind of mental contortionism. We have a pathological “can do” faith in our abilities. “Failure is not an option” is one of our favorite sayings. The idea of quitting or giving up is almost unpatriotic. This attitude benefits us in many ways as a nation. But when it comes to business, and also investing, this kind of excessive optimism can do more harm than good.

  Shortly before our CFO’s pep talk, another high-level executive at the bank stopped me in the hall to give me what he considered some critical advice. “A lot of smart kids like you come through the bank, and they use it for a stepping stone,” he said. “They stay for a year or two and then they leave. I think that’s a huge mistake. Look at me: I’ve been here forever and I’m happier than anyone I know. This place rewards loyalty, and I’m good at my job because I’ve got my finger right on the pulse of the company. I know everything that’s going on.”

  A week later, I saw two workmen hauling boxes out of his office. He was a victim of the bank’s first-ever round of layoffs. I’m not trying to put this man down for his faith in the bank or make light of his unemployment. I want to use his story to make another point about failure in business. That chat reinforced something else I was beginning to learn: people in management positions, even very senior management positions, are often completely wrong about the fortunes of their own companies. More important, in making these misjudgments, they almost always err on the side of excessive optimism. They think their businesses are in much better shape than they actually are. Jerry’s rig utilization chart at Global Marine and our own CFO’s boasts about Joe DiMaggio only underscored this lesson for me at the time. And, three decades and over 1,400 meetings with other executives later, I can say this tendency is as pronounced as ever.

  As I explained in the introduction, the companies I describe in this book failed because their managements committed one or more of six common mistakes. But to a person, those leaders all made an additional error: they allowed their optimism to blind them to the reality of their troubles. We could call this the original sin that led to all of their other miscues. Instead of adjusting their strategies, they chose to believe things would naturally work out for the best and they made up all sorts of comforting rationalizations to prove their rosy predictions.

  The Doctrine of Elite Infallibility

  One of the primary causes of this unrealistic optimism in the corporate and investing worlds is an almost slavish faith in the capabilities of our country’s elite. People seem to think that a degree from a top university inoculates its holder from failure. I can’t tell you how many times stock analysts and fellow money managers have tried to convince me that a clearly troubled company would turn around simply because its CEO was a graduate of some distinguished school. “He’s a Harvard MBA,” they’ll say in almost reverential tones, or, “He graduated cum laude from Princeton”—as if those facts alone would be enough to offset overwhelming evidence that, despite their impressive backgrounds, they were running their businesses straight into the ground.

  Whenever I hear this special pleading, I think of a guy named Robert Jaedicke. He was an accounting professor at Stanford when I was an undergraduate there. Shortly after I graduated, he became the dean of the business school. He parlayed that prestigious position into a number of lucrative seats on corporate boards, including the chairmanship of the audit committee for Enron. Jaedicke began that job in 1985, around the time I saw Ken Lay speak in the Transco Tower. Jaedicke held the job all the way until the company blew apart in 2001 in the biggest accounting scandal in American corporate history. In retrospect, it’s obvious that the only thing the board of Enron managed to audit in all that time were the buffet tables at their meetings. But right up to the end, the impression that such a distinguished figure from a top school like Stanford was overseeing the company’s books gave an awful lot of Enron investors a dangerously false sense of security.**

  The doctrine of elite infallibility almost cost me a great deal of money, too. In 2007, one of my social friends pitched me on investing some of my own money in a large and exclusive New York hedge fund. He showed me an impressive prospectus and boasted of the fund’s steady, double-digit annual returns. I was intrigued but declined his invitation. For one thing, when I asked to have a cup of coffee with the fund’s manager the next time I was in New York, my friend said the man never met with potential clients. On top of that, the fund was audited by an obscure accounting firm in New Jersey. That might be all right for a small concern, but this was a multibillion-dollar operation. Finally, the fund’s manager didn’t keep the performance fee he charged. Instead, he kicked the money back to a worldwide army of asset gatherers, people like my friend, who recruited new investors. All of these facts struck me as more than a little fishy. But after I said no to my friend’s offer, I didn’t think much about it—until a year later when I turned on the news and saw hedge fund manager Bernard Madoff being perp-walked into a Manhattan courthouse. I dug up the prospectus my friend had given me and discovered that I had narrowly avoided becoming one of the victims of the largest financial fraud in history.

  When my friend tried to sell me on investing in one of Madoff’s “feeder” funds, it took me less than an hour to spot three very troubling issues with his operation. But most people failed to investigate Madoff’s business at all before investing. They assumed that someone so prestigious had to be aboveboard. He was friends with senators. He was the former chairman of NASDAQ. The idea that a man of his stature was running a $50 billion Ponzi scheme was unthinkable, so investors gave him fortunes without a second thought. If they’d only taken a few moments to study his business practices, they could have easily identified the same potential problems I saw. These red flags weren’t hidden from view. In fact, several years before Madoff’s arrest, a whistleblower sent the Securities and Exchange Commission a fifty-page report detailing the obvious fraud. But even the regulatory authorities refused to believe that such a prominent figure was a crook.

  It wasn’t just elitism that led investors to trust Madoff with their money. Two other factors contributed to their faith. The first was plain old greed. Madoff’s phony returns were phenomenal, and phenomenally consistent. Everybody was too busy basking in the money he was supposedly making them to realize that his fund’s performance was almost certainly too good to be true. The second factor had to do with identity. For a large number of his investors, Bernie Madoff was “one of us.” He was a respected, even revered figure in the Jewish community—and many of his victims came from that world because of it. This is an age-old problem in both business and investing. Call it the country club effect. Even the sharpest, most astute professionals tend to perform less due diligence when they’re dealing with someone with whom they have an affinity. Whether these ties are based on ethnic, class, or family background is immaterial. The affinity fallacy happens across all groups.

  Fraudsters often play on affinities to avoid scrutiny. Madoff was a master at this. He donated millions to Jewish charities to build up his reputation and strengthen people’s trust. Unfortunately, many of those same charities and nonprofits wound up losing huge amounts of money when his s
cam was uncovered.††

  For all the publicity they generate, pure con artists like Madoff are actually quite rare. Most financial and business elites who fail aren’t frauds or criminals. Like Robert Jaedicke at Enron, they simply do a poor job. Just about every executive I’ve ever met boasted impressive, even world-class credentials. You don’t get hired for senior management or directorship positions at publicly traded corporations without being well educated, accomplished, and capable. But those positive qualities create negative results when they lead people—and their followers—into overconfidence or hubris. I’m not saying that a successful track record and a degree from a good school are bad things. But they can create a kind of personal historical myopia, a mistaken belief that one’s past successes guarantee similar results in the future.

  Self-delusion is a powerfully democratic force. It cuts across all social classes. You can be richer, smarter, and more successful than anyone else. But if you’re not brutally honest with yourself about your own potential for failure, you’re going to have a problem—and you’re going to lose money, maybe a lot of money. I should know. Not all my trades have worked out as well as my experience with California Coastal Communities. I’ve made plenty of losing investments and blown plenty of major opportunities. One of my biggest blunders came only two years after I started my hedge fund. I missed out on a chance to buy in early on a couple of small but promising companies in the Pacific Northwest. You might have heard of them.

  Do the names Costco and Starbucks ring any bells?