Dead Companies Walking

by Scott Fearon

  Second: Trading on trends is a fool’s game. That second summer, with Mike’s help, I studied every chart I could find looking for things like “pivots” and “indicators.” I might as well have been trying to glean stock tips from my optometrist’s eye chart, because it was about as useful as any graph put out by the most prominent Wall Street trend analysts.

  Third: Stocks tend to go up gradually but often go down rapidly. Traders have a less delicate way of expressing this: “Stocks,” they say, “eat like a bird but crap like a bear.” I was mainly trading so-called out-of-the-money calls during those summers. By buying these types of options, I was betting on certain stocks to go up in value before the option expiration date. Many did, but not by very much. The stocks that fell were often a much different story. A good number dropped like cartoon anvils, plummeting 10, 20, 30 percent or more in a single trading day. Those experiences left a strong impression on me. There’s nothing quite like seeing a stock you’re hoping will rise puke up a third of its value right in front of your eyes.

  At the time, if someone had asked me to explain what shorts were, I would have held up a pair of swimming trunks. But a few years later, when I learned that you could make money on falling stocks, those hot summer days in the Merrill Lynch office came back to me and helped me realize just how profitable short selling could be.

  The fourth and final lesson I took from my options washout was the most important one of all, because it’s helped keep me from getting caught up in all the maniacal asset bubbles I’ve lived through since those early days in Tempe: effective money managers do not go with the flow. They are loners, by and large. They’re not joiners; they’re skeptics, cynics even. Whatever label you want to put on them, the trait they all share is that 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.

  Warren Buffett is the best example of this contrarian impulse. In the 1960s, when Buffett started out, most money managers were investing in highly cyclical, heavily indebted and capital-intensive industrial giants like U.S. Steel. As a consequence, stocks in those kinds of companies were extremely overpriced in Buffett’s view, especially when compared to their earnings. Instead of following the majority and buying into that minibubble, he consciously sought out companies on the other end of the spectrum—businesses with lower capital expenditures and higher profit margins—and he wound up buying relatively cheap stocks in ad agencies and regional media companies like Capital Cities, Gannett, and the Washington Post. This was a complete departure from the consensus of the time, and it made Buffett a ridiculous amount of money.

  My investment focus on dead companies walking also started out as a contrarian idea. When I first came back to California and was running mutual funds for GT Capital, I joined a dinner group with a bunch of other money managers. Every month, we’d all go out for a meal and talk shop. One night, about ten of us went to Il Fornaio down on the Embarcadero in San Francisco. A man named Gary Smith stood up after our plates were cleared and handed around some papers he’d copied for us. He was a former basketball player, at least six foot three, so when he got up from his chair, it was hard not to notice. We all quit talking and listened.

  “These are some numbers for Prime Motor Inns,” he announced. “They’re going broke, boys. Their stock is going to flat-line. And I’m going to make a killing when it does.”

  The way the rest of the guys reacted, you’d think Gary had just told them the chef had stuffed their raviolis with horse meat. There was a long silence. Nobody knew what to say. Back in those days, what Gary was proposing—shorting a company and hoping it went bankrupt—was very radical. Traders shorted stocks, sure. But most did so infrequently, and when they did, they almost always followed a formula called valuation-based shorting. They’d find a stock with a big price-earnings ratio and go against it until its share price dropped a couple of bucks, then they’d quickly take their profits. What Gary was talking about was a major departure from that strategy. And while everyone else around the table looked perplexed, even horrified, by the idea, I immediately saw the genius of it.

  Incurious

  There’s no one method or approach that makes for a successful investor. But there is one common trait that I believe all great investors share: intellectual curiosity. Good money managers are broad-minded and intellectually curious. They don’t, no, they can’t just accept conventional wisdom. They are vociferous readers. They crave new ideas and when they hear them, they’re willing to try them out. They’re not afraid of something just because it’s novel or disruptive. In fact, the more iconoclastic an idea is, the more curious they are about it. Unfortunately, this attitude is exceedingly rare on Wall Street.

  I used to play a stock-picking game with about twenty different brokerage salesmen and Wall Street analysts. Most of them worked at well-known firms—Merrill Lynch, Alex Brown, Goldman Sachs, Bear Stearns. The rules of the game were simple: pick two longs and one short. You could only swap out picks at the end of each quarter. At the end of one year I mailed a gift to all the participants, a short but insightful book titled In the Shadows of Wall Street. Written by Cornell professor Paul Strebel, it analyzed how smaller-company stocks neglected by Wall Street often outperformed those rated as buys. Over the next few months, I asked each of my fellow game participants, one by one, what they’d thought of the book. Not a single one had read beyond the first page.

  Prime Motor Inns owned most of the Howard Johnson motel and restaurant chain, as well as other hospitality companies. The night of that dinner, its stock was still trading for around $17 a share, and I think it’s safe to say that nobody except Gary Smith expected it to go anywhere near zero. I myself had a soft spot for Howard Johnson. When I was a kid, my dad would take my brother and me out to eat at one of their locations across the street from Arizona State University. He and my brother would always order the fried clams. I would get a hot dog. But by the late 1980s, the brand was definitely looking musty. The company had bought up a bunch of competitors to try to get some of its mojo back, but, as Gary explained that night, those new companies only wound up adding to Prime Motor Inns’ problems. It was well over $500 million in debt. At the same time, its revenues were shrinking. Put those two factors together—growing debt and dwindling cash—and you almost always get one result: bankruptcy, exactly what Gary Smith was predicting.

  “Think about it,” he said to his uncomfortably quiet audience around the table. “Pretty soon they won’t be able to service all that debt. They’ll go into default and all their equity will be—”

  I finished the sentence with him: “Wiped out.”

  “That’s right,” he said. “The stock will go to zero and I’ll never have to cover my short.”

  Hearing Gary’s strategy was a seminal event for me. It jived with all of my experiences to that point—the Texas oil bust, Black Monday, my options trading washout, and my growing realization that corporate failure is more prevalent than people like to acknowledge. But I was the only one who appreciated Gary’s idea. The rest of our buddies were still giving him confused looks. His strategy was too new for them, too unfamiliar. They couldn’t get their minds around it.

  A year after that dinner, Prime Motor Inns declared bankruptcy.

  Notes

  *Betsy Schiffman, “iVillage Swallows Women.com,” Forbes, February 6, 2001.

  †David Shabelman, “Net Stocks Treading Water Along with Broader Market,” The Street.com, September 13, 1999.

  ‡“Cygnus Sells Drug-Delivery Assets,” Silicon Valley Business Journal, November 19, 1999.

  §Amazingly, the drug eventually did gain FDA approval—in 2013, well over a decade after the initial incarnation of Shaman went bankrupt.

  ¶H
elen Coster, “One Pharma Entrepreneur’s Never Ending Quest,” Forbes, December 30, 2010.

  Five

  Deck Chairs on a Sinking Ship

  If the rate of change on the outside exceeds the rate of change on the inside, the end is near.

  —Jack Welch

  For a brief moment in December 2007, I thought the video rental chain Blockbuster had hired a movie star to be its director of investor relations. The woman who came out to greet me in the lobby of the company’s Dallas headquarters could have easily walked right off the cover of a DVD in one of its stores. She was tall and slender, with silky dark hair and a matinee idol’s radiant smile. Her name was Angelika, and her slight eastern European accent made her sound like a femme fatale in a James Bond flick.

  “Good morning, Mr. Fearon,” she said, extending her hand. “Why don’t we speak in my office?”

  After I managed to quit stammering, I accepted her offer. You have to understand, I spend almost all of my time meeting with people who look more or less like me—middle-aged guys with boring haircuts in sport coats or oxford shirts. Seeing Angelika that morning was a memorable surprise. Unfortunately for Angelika and everyone else at the company, though, Blockbuster (stock symbol: BBI) was in trouble at the time. It had had three straight money-losing quarters and was on its way to a fourth. It wasn’t hard to figure out why. The company was saddled with over nine thousand brick-and-mortar store locations and tens of thousands of employees, at the same time that Netflix—a web-based, ruthlessly efficient competitor with a fraction of its overhead—was pilfering millions of its customers. By the time I flew into Dallas and met with Angelika, the “bust” in the company’s name was starting to sound more and more like a foregone conclusion. Its stock price had slid below $4, and it didn’t look like it was going to recover.

  Despite this bad news, Angelika was upbeat. She enthusiastically predicted a comeback for Blockbuster. I expected her to tell me that the company’s managers planned to accomplish this by expanding the online service they had launched to compete with Netflix. But, to my surprise, she said they were actually scaling that effort back.

  “We believe our greatest assets are our stores,” she stated.

  “Your stores? But your stores have been losing money ever since Netflix started.”

  “That’s true, but we plan to use them to generate new revenue streams.”

  “How?”

  “Retail,” Angelika announced.

  She seemed to think that single word would make me rush out and buy as many shares of BBI as I could find. The frown I was wearing must have informed her that I required a little more convincing, so she cleared her throat and went on.

  “We’ve found that particular products will generate more revenue as sale items rather than rentals,” she explained. “Children’s movies, for instance. Kids like to watch movies repeatedly, so parents are more inclined to purchase them as opposed to renting them. Video games are also items consumers generally want to own instead of rent.”

  She presented me with a glossy report detailing the company’s plans. “I see,” I said with a polite smile as I turned the pages. I was doing my best not to seem rude or dismissive, even though I was highly skeptical.

  “We’re not just going to sell movies and video games. We plan to offer a whole host of ancillary products as well: movie posters, movie memorabilia, magazines and books about Hollywood. And at the point of purchase, all of our stores will feature theater-style concession items.”

  “You mean you’re going to sell popcorn and Junior Mints, things like that?”

  “Yes,” Angelika replied happily. She mistook my incredulity for approval. “And we’re going to carry the large novelty sizes you can only get in theaters!”

  Again, I held my tongue and thanked Angelika for her time. There was no use discussing matters any further. I had heard enough. Angelika escorted me back into the lobby and we exchanged friendly good-byes.

  I walked out into the chilly North Texas winter morning with one word playing over and over in my head: candy. I just couldn’t get past it. Blockbuster’s leaders were seriously pitching candy sales as the thing that would keep the company from the ash heap. It was almost sad. For a quarter century, Blockbuster had been a massively successful business. Even with all of its recent troubles, it had still had almost $6 billion in revenues the year before my visit. And yet things had gotten so bad so quickly that its executives had been reduced to hoping that selling oversized boxes of Jujyfruits could save it.

  Can You Hear Me Now?

  Misguided attempts to preserve an outmoded business model are quite common, and not just at dead companies walking. Starting in the late 2000s, cable television providers began steadily losing subscribers as more and more young consumers in particular “cut the cord” and watched their entertainment online. Big Cable managed to maintain its margins by raising prices. But charging a shrinking pool of customers more for the same product is probably not a sustainable long-term model. In 2013, the cable company in my area briefly pursued what seemed like a Blockbuster-esque strategy: it started aggressively marketing cable-based home phone service. That’s right—its salespeople were pushing . . . landline telephones. “Hello, cable providers? Ma Bell called and she wants her business model back.” All kidding aside, it’s hard to believe that in the age of mobile communication and content delivery that the company’s management believed something as old-fashioned as home phones would reverse its slide. Candy sales almost seemed more promising by comparison.

  Even though I shorted the stocks of three other public video rental chains that wound up going bankrupt, I never shorted Blockbuster. You could say I got “cahned.” A few years before my visit with Angelika, renowned investor Carl Icahn had become the biggest shareholder in Blockbuster and had won a proxy war to control its board of directors. I respected Icahn’s acumen, or at least his clout, enough to stay away from shorting Blockbuster while he was so deeply involved. Even if the new retail scheme was as doomed as I thought, I didn’t want to be on the wrong side of such a powerful figure. For all I knew, he was prepared to sink a fortune into the company to keep its stock price elevated—and his pockets are a lot deeper than mine.

  As it turned out, I completely misread the situation. Icahn wound up being one of the main reasons Blockbuster went broke sooner than later. When he and his allies took over the board in 2005, the CEO at the time was pushing for the company to focus more on the internet. But Icahn got into a feud with him over compensation and eventually brought in a new CEO who implemented the retail strategy.* In other words, Icahn and his handpicked leadership of the company doubled up and tripled up on the very thing that was killing Blockbuster to begin with—the enormous cost burdens of all those locations and employees. Predictably, the company went belly-up as a result. Blockbuster declared bankruptcy in 2010, right after Icahn unloaded all of his shares for pennies on the dollar.

  Icahn and his allies at Blockbuster made a classic blunder. Old Wall Street hands call it the buggy whip syndrome: they failed to recognize that their industry had fundamentally and permanently changed.

  The executives at Cygnus Therapeutics and Shaman Pharmaceuticals, and even Women.com and Quokka Sports, were driven by inspiring ideas. Sure, those companies all failed. But all were developing new, innovative products or services. I had a lot of respect for their efforts and even admiration for their passion. I can’t say the same for the leadership of Blockbuster. They didn’t have the excuse of being caught up in the mania of a captivating story. They were just holding out because they couldn’t accept the unpleasant truth that their industry—and the rest of the world—had left them behind.

  By the time I got to Dallas, Blockbuster and its storefront model were clearly the horse-drawn carriages of the movie rental business. Netflix and its web-based format were the equivalents of Model A cars. Unlike groceries o
r prescription pills, consumers liked picking out their DVD rentals online and receiving them in the mail. And they especially liked paying a flat monthly price instead of the exorbitant late fees Blockbuster had been getting fat on for decades. There was no getting around these truths. Netflix already had millions of subscribers in 2007. Just about every other major movie rental chain had already gone broke as a result or was on the brink of it. And yet everyone at Blockbuster did their best to come up with new ways to pretend that things hadn’t changed.

  At one point, the buzz around the industry was that Blockbuster would save itself by merging with its biggest competitor, Hollywood Video. Here you’ve got two money-losing companies with identical obsolete business models—and yet somehow, by merging into one giant money-losing company with an obsolete business model, they were magically supposed to become profitable again. When that flawed idea fell through, Blockbuster’s brass still did not begin the necessary process of closing stores and investing in their web-based service. Instead, they came up with yet another cockamamie plan to make those stores profitable again, this time by acquiring the nearly bankrupt electronics chain Circuit City. It’s hard to believe, but Icahn and the others at Blockbuster seriously thought hawking low-margin gadgets alongside video games and Raisinettes was going to reverse their slide.

  The Circuit City deal never happened. But the end was already near. By early 2009, shares of BBI were trading below a buck. A year later, they officially went to zero. Even after the company’s bankruptcy, it still took until early 2014 for the last of Blockbuster’s stores to close.