by Scott Fearon
At one of these meetings, the company’s chief operating officer, a Stanford MBA named Craig, strapped a prototype watch to my wrist. While Craig was giving me the latest rundown about why the watch wasn’t quite ready for mass production yet, I waited to find out what my glucose levels were—and waited and waited some more. After fifteen minutes, the prototype was still blinking double zeroes at me. I figured my wrist wasn’t sweaty enough for it to get a reading, so I started shaking my arm around to get it to perspire. That was not a good plan. I accidentally rapped the edge of the conference table and cracked the face of the watch. For a second, I was terrified that I had ruined the company’s one and only model. I could see the headlines in my mind: “Hedge Fund Manager Destroys Million-Dollar Prototype!” But Craig was a good sport about it. He assured me they had dozens of others. He even offered to get another one for me to try, but I declined. I didn’t want to take the risk. I sat very still for the rest of his presentation.
Looking back, that incident was definitely an omen. The whole idea of the GlucoWatch was, well, cracked. As it turned out, there was a very good reason it took Cygnus so long to develop the watch: getting accurate blood sugar levels out of perspiration is incredibly hard, maybe even impossible (though some companies are still working on it today). After years and years of development, Cygnus finally managed to get FDA approval for their first version of the product in 2001. But it didn’t come close to living up to expectations. The first GlucoWatch quickly earned a bad reputation for producing faulty readings. Not only that, it gave a lot of people nasty rashes on their wrists. As a result, sales were sluggish. That didn’t deter Cygnus, though. It put out a second-generation watch the following year, and it was just as flawed as the first. By then, the company’s stock was trading in the pennies. The rest of the world had figured out what Craig and the other guys at Cygnus still couldn’t face: that the story they had been telling themselves and others simply wasn’t true. As hopeful as the GlucoWatch was, it just plain didn’t work. And since they had sold the rights to other products they had been working on, Cygnus was nothing but a one-trick pony—and that pony was dead.
I was sad to see Cygnus fail, and not just because I wanted to buy truckloads of its stock and make a fortune when it succeeded. I don’t normally get emotionally involved in the companies I research. And it’s not like I shed any tears over Cygnus’s demise. But I could definitely understand why the people working there believed so fervently in the dream of the GlucoWatch. It was the complete opposite of Chemtrak’s cholesterol test. That was a case of businessmen pushing an invasive product that consumers didn’t want, let alone need. The GlucoWatch, on the other hand, could have been a lifesaving device that actually spared millions of people from the invasive procedure of drawing blood. But the fact remains: the thing was a dud—and so Cygnus, for all its promise, crashed just as hard as Chemtrak.
The whole concept of reading glucose levels in perspiration was probably doomed from the start. But rather than face this disappointing reality, Cygnus’s executives tried even harder to make it work. They even sold off other assets so that they could continue to squander their money on it. This behavior reminds me of a common mistake investors make: buying a stock as it drops. It’s called averaging down. You see it all the time, even from seasoned pros. They believe in a certain company. They think it is destined for greatness. And they get so infatuated with that positive narrative that when things don’t work out the way they expected and the company’s stock starts to fall, they actually buy more of it. Perversely, they convince themselves that it’s a good thing that the stock is dropping because that means they can get more shares for a better price. They keep reassuring themselves with this flawed reasoning right up until the day they go broke.
This is such a common mistake, there’s even a Wall Street saying for it: “Double-up, triple-up, belly-up.” Short-sellers do it, too, but in reverse. They short more of a company’s stock as it rises, all the while telling themselves that they’ll wind up making more when it drops. But they rarely survive long enough to see that happen.
Like I’ve said, the best money managers are also the best quitters. They quit early and they quit often. As soon as they see things turning for the worse, they don’t wait around, they bail. This same quality is just as important in business. That’s not to say that tenaciousness isn’t important or that faith in your abilities and your ideas is a bad thing somehow. But you have to separate faith from blind faith. Cygnus’s leaders put years and years, not to mention every cent they had, into what was almost certainly a lost cause. Instead of adapting their approach to deal with that very strong possibility, they doubled and tripled up. The result was all too predictable.
Speaking of blind faith, for more than a decade, a company called Shaman Pharmaceuticals (stock symbol: SHMN) managed to get by on little else. In all that time, it never produced a single revenue-generating medicine. But the power of its story was enough to bring in hundreds of millions of dollars in stock offerings and private investments.
The founder and CEO of Shaman, a woman named Lisa, could certainly cast a spell. She had long cinnamon-colored hair and striking brown eyes. I went to visit her in Shaman’s offices down by the San Francisco airport in 1998. Even though she’d been running the company for nine years by then, she was still quite young. I don’t think she was even forty yet. And she brimmed with positive energy as she dimmed the lights and gave me a presentation on Shaman’s work. She showed me slide after slide of herself and other Shaman employees trekking through the jungles of Brazil, speaking with indigenous people, and collecting samples of plants and trees.
“The rainforests of Brazil contain tens of thousands of undiscovered medicinal compounds,” Lisa explained. “We consult with traditional healers from remote tribes to learn how they treat illnesses. Then we bring the plants and herbs they use back to our labs and create pharmaceutical-grade drugs out of them. It’s the perfect blend of East and West, old and new.”
I must admit, I was quite intrigued by the story and by Lisa’s charismatic way of presenting it. There was something about her that made you root for her to succeed. Then I remembered reality: Lisa and the rest of Shaman’s executives were well on their way to bankruptcy. They had started out in 1989 with plans to cure major diseases like cancer and HIV. But by the time I visited their offices, they had managed to produce exactly one potential product—an antidiarrheal medication derived from the gooey red secretions of a certain tree in the Amazon—and even that hadn’t cleared clinical trials.§ As a result, the company’s debt was mounting at the same time its stock price was starting to drop. In other words, despite Shaman’s hopeful premise, it was just another failing company. The year after I met with Lisa, Shaman filed for bankruptcy and SHMN officially went to zero.
The reason why Lisa and Shaman were able to survive for so long and raise so much money without any results is that she was telling a great story, a story that a lot of investors wanted to believe in. Most people don’t want to accept corporate-driven solutions to our problems. They don’t like the fact that we need Big Oil to find our gas for us or that we need Big Government to run our country. And they are reluctant to acknowledge that Western medicine and Big Pharma, for all of their faults, have lengthened our lifespans and vastly improved the quality of our lives. Lisa offered people an alternative vision. She gave them the (probably false) hope that we could heal ourselves by listening to smaller, simpler societies and rediscovering their forgotten wisdom. It was a nice idea. But in the end, it was little more than a pipe dream.
I want to make one thing clear: Lisa is not a scam artist. She genuinely believed (and still believes) in what she was doing, and she backed up that belief by hiring some of the best biologists and chemists in the country to try to make Shaman’s story come true. Amazingly, her dream did not die when the company went into bankruptcy. Lisa started Shaman Botanicals and raised millions more in investments to m
arket its antidiarrheal medicine as a dietary supplement. (This allowed the company to bypass the FDA approval process.) Even when this failed, she was not deterred. She formed another company based on the same premise. She even brought it public in London. In 2010, Forbes published a feature on her then twenty-year quest to make drugs out of rainforest plants. All told, according to that article, she had raised and spent more than $200 million on the effort.¶
From my meeting with Lisa, I know she’s a great saleswoman. But after two decades and almost a quarter billion dollars, it’s incredible to me that investors are still willing to fund her work. And yet the power of her vision and her story seems to blind them to reality. That’s what I mean when I say that manias happen all the time, even on very small scales. Whether it’s a massive, society-wide bubble like the dotcom boom or individual ventures like Shaman or Cygnus, this same maniacal faith is at work. People get so caught up in an enchanting narrative, they block out any evidence that it might not be true. They refuse to believe that it can fail—sometimes even after it has already failed multiple times.
Running the Option
Luckily for me, I learned very early on how destructive maniacal thinking can be. Living through the Great Texas Oil Bust wasn’t my first experience with a financial meltdown. I had a much smaller and much more personal experience with failure a few years earlier, and it helped shape me almost as much as my time in Houston.
Snake Oil
As I just said, I do not believe that Lisa is a fraud. When you get down to it, Shaman and her subsequent ventures were just plain old failures, like the vast majority of the other companies I write about in this book. But when it comes to the wider alternative health products industry, I’m afraid Lisa is one of the few honest—if misguided—brokers.
In 1993, I paid a visit to Herbalife (stock symbol: HLF), the granddaddy of multilevel marketing, or MLM, companies. Most MLM outfits, like Herbalife, are in the vitamin or natural remedy business. A large amount of them are based in Utah, which has led some people to offer a new meaning for the MLM acronym: Mormons Losing Money. Herbalife’s headquarters are not in Utah, though. At the time of my visit, they were in a shiny glass high-rise off the 405 freeway in Los Angeles, directly beneath the flight path of LAX. The COO, a man named Norm, led me into his office and regaled me with the company’s plans to expand aggressively into Asia and eastern Europe. Every three minutes or so, the whole building would shake as a jumbo jet thundered past overhead, forcing him to shout.
When he had finished his presentation, I abruptly changed the subject from the company’s business plans to something much more important to me—what Herbalife actually put in its products. It was notoriously secretive about how it made its nutrition and weight-loss pills and elixirs. It had also been the subject of multiple investigations by state and federal authorities for false claims and potentially harmful side effects. I didn’t bring it up at the time, but to me its new emphasis on foreign markets didn’t look so much like an expansion as an evasion, a search for less restrictive regulatory environments and fresh suckers to buy its dubious wares.
“Norm, will Herbalife ever release the ingredients for your products?”
You would have thought I had asked Norm to release naked pictures of his wife. His back stiffened and he gave me a very sour look. The formulas, he declared, were “proprietary.”
“But if nobody knows what’s in your products, how can investors like me be sure they work?”
The question seemed to take Norm by surprise. I honestly don’t think he had ever thought about this issue or at least been asked about it in meetings with potential investors. The only thing he expected me to be interested in was how the company planned to grow revenues. The idea that a money manager would care whether Herbalife’s products actually did what they said they did was a shock to him. After a short moment of throat clearing and awkward silence, he came up with a response.
“The best proof that our products work is our founder, Mark Hughes,” Norm said. “Before he started this company, he was terribly overweight. Now look at him. He’s lean and muscular, the picture of health, all thanks to Herbalife.”
I left Herbalife HQ convinced they were nothing but a global, modern-day snake oil business. I didn’t short its stock, though, because I knew the alternative health-care mania wasn’t going to die anytime soon. Over twenty years later, it still hasn’t. A few years ago, hedge fund manager Bill Ackman shorted $1 billion of Herbalife’s stock. He accused the company of running a pyramid scheme and mounted an aggressive public relations campaign to bring it down. But, as of this writing, it’s still very much alive. Unfortunately, the same can’t be said for the company’s founder, Mr. Hughes, the man Norm held up as living proof of the benefits of Herbalife’s product line. He died in 2000 at the ripe old age of forty-four. His fourth wife found him unconscious after a party in his palatial Malibu mansion. Turns out, he was a tad less health-conscious than he had led his employees to believe. His blood alcohol level was just shy of moonshine. The much advertised mood-enhancing properties of his products obviously didn’t help Mark much, either. His autopsy revealed large amounts of prescription antidepressants in his system.*
*“Binge Led to Death of Herbalife Founder,” New York Times, August 12, 2000.
Sometime during my freshman year at Stanford, I read a magazine article about options trading. I don’t remember where I read it, or why exactly it got me so fired up, but I came back to my hometown of Tempe, Arizona, that summer hot to try my hand at the options game. The lure of it probably had something to do with the fact that, using options, you can invest in companies for a fraction of the cost of actually buying shares in them. That was quite attractive to my eighteen-year-old mind.
My first week of summer vacation, my father agreed to loan me $500, and I opened an account at a Merrill Lynch office in a strip mall on the corner of North Scottsdale and Camelback roads. I had a job working nights as a bellhop at the Tempe Holiday Inn, which was down the street from the brokerage. I would stop in on my way to the hotel a few times a week, watch the ticker for a little while, and make some trades. I was buying and selling “calls,” options to buy stocks at certain prices. It was a lot of fun, but I didn’t take it too seriously that first summer. It was just something to do. I especially liked hanging out and talking shop with my broker, a good-natured, middle-aged divorcé named Mike.
Once a week or so when I had a day off, Mike and I would go down to a nearby pizza place after the markets closed. We’d each order a large pizza and pitcher of beer (the drinking age in Arizona was only eighteen). We’d munch on our pizza, drink our beer straight from our pitchers, and converse endlessly about the markets—the hottest stocks, the latest earnings forecasts, trends, rumors, anything and everything having to do with “The Street.” I loved those pizza- and beer-fueled gab sessions. They made me feel like a real-live money man. Not only that, it seemed like I had a talent for options trading. By the end of that first summer I had managed to double my dad’s initial loan. I flew back for my sophomore year at Stanford with a cool thousand bucks sitting in my brokerage account.
The following summer, things started out great. I returned to Arizona from Palo Alto, and my father not only let me keep the money he’d loaned me the summer before, he matched the amount already in my account. That meant I had a whopping $2,000 to play with, a princely sum to me at the time. My first day in Tempe, I drove up to the Merrill Lynch branch on Camelback Road and started swapping calls again. Mike was pleased to see me and excited to help me continue my winning streak. For the rest of the summer, I stopped in every day on my way to work to confer with him and make my trades. We also resumed our once-a-week pizza-and-beer strategy sessions. I was far more active that second summer. This was not a mere hobby anymore or a summer diversion. This was bordering on an obsession. I hung on every tidbit and rumor Mike passed along. I put everything I ha
d into the effort.
And it was all in vain.
By the end of that second summer, my Merrill Lynch account had exactly zero dollars in it. I’d lost everything—not only the money I’d made the summer before, but the original $500 my father had loaned me and the additional thousand he’d given me, too.
You’d think this experience would have soured me on playing the markets. But it actually made me more interested in them. I never traded options again, but my own personal boom-and-bust left me fascinated by the size, complexity, and dynamism of the financial world. When I got back to Stanford for my junior year, I took more classes on investing and finance, and I decided that I would get an MBA immediately after I graduated. In many ways, losing all that money actually wound up directing me toward my career in money management. I was determined to figure out why I had failed and how I could do better in the future. And I gleaned a few very important lessons from my short and disastrous stint as an options trader:
First: Stockbrokers are useless. Nothing against my old pal Mike, but like most of his colleagues in the business, he had very little to offer besides the same old conventional wisdom that everyone else was reading in Barron’s or the Wall Street Journal.
This kind of groupthink is rampant in the financial world. After the fact, I learned that all the hot tips Mike the “Financial Executive” (as his business card described him) had passed along to me were drawn from stuff he was reading in the mass media and hearing from his pals in the industry, who were only parroting other stuff they had read in the mass media and heard from their pals in the industry. None of them were sharing anything new or especially insightful. They were just repeating the same stale news that everyone else already knew. You can imagine just how stale Mike’s so-called expert advice was by the time it traveled all the way out to Tempe, Arizona. This was long before the internet, so I was trading on information that might as well have arrived by Pony Express.