by Scott Fearon
Big companies play the blame game as much as smaller firms like Consilium. In 2013, tech behemoth Cisco blamed a sizable dip in its offshore sales on revelations that several Silicon Valley companies had helped the US government spy on foreign governments and companies.§ This excuse would have seemed a whole lot more plausible if Cisco’s main Chinese competitor, a company called Huawei, hadn’t been eating into its overseas market share long before news of the spying scandal broke.
Just about every industry has its pet excuse for bad results. Companies in the apparel sector routinely blame the weather for any dip in sales. Winter-focused clothing companies will bemoan unseasonably warm weather while sporting and outdoor clothing companies will cite cold snaps for disappointing results. I remember studying the numbers of one discount retailer in San Antonio called 50-Off Stores and finding the same weather excuse in its financial filings for two straight years. Its managers didn’t just blame the weather for the company’s poor performance, they used the exact same wording to do so. That was a red flag for me, and after crunching the numbers a bit more, I shorted its stock. The repetition of the wording showed me that 50-Off’s management team wasn’t just refusing to take responsibility for its internal problems, they were too lazy to come up with a new scapegoat. Within a few years, 50-Off was 100 percent bankrupt.
Grounded
The unluckiest dead company walking I’ve ever shorted was Minnesota-based Wilsons Leather (stock symbol: WLSN). Unlike Consilium, 50-Off Stores, and so many other troubled companies I’ve encountered, it had every right to blame external events for its failure.
For most of its long history, Wilsons was a profitable, well-managed concern. Shortly before the terrorist attacks of September 11, 2001, it acquired dozens of airport kiosks selling leather luggage and other travel gear. It wasn’t a bad business move, unless you count the horrendous timing, which no one could have foreseen. After several months of virtually no air travel following the attacks, and no revenues coming in from the kiosks, Wilsons had no choice but to file for bankruptcy.
Another excuse I see is our country’s “sluggish economy.” That precise phrase is frequently employed in press releases and corporate disclosures. Having lived through a number of genuine economic collapses in my career—the 1980s Texas oil bust, the bursting of the dotcom bubble, and the 2008 financial crisis—I usually find this explanation for disappointing results less than convincing. The US churns out more than $17 trillion in economic output every year. We have the most dynamic and sophisticated economy in the history of the world. Blaming an individual company’s lackluster performance on slight variations in that ocean-sized system is like saying a typhoon in Japan caused flooding in Mazatlán. Sure, it’s remotely possible, but there are a whole lot of other factors at play, and what’s happening inside a company almost always trumps what’s going on outside of it. Also, if you study our GDP numbers, growth in the United States has been consistently sluggish for a long while. And yet plenty of companies have done just fine. In fact, whenever I see the “sluggish economy” chestnut in a disappointing earnings report, I make sure to check how the company’s competitors are faring. More often than not, they aren’t doing very sluggishly at all.
Long and Wrong
As it turned out, Consilium’s CFO wasn’t the only one refusing to see the writing on the wall when it came to his company’s problems. A few months after that meeting in San Jose, I was in the buffet line at the American Electronics Association Conference and got an earful from someone else who thought Consilium was bound to recover. They used to hold the conference at the Hyatt in Monterey every year back then. I was scooping mashed potatoes onto my plate and looking out at the beautiful view of the Pacific when a brash money manager shouldered his way through the crowd and started giving me all kinds of grief for shorting Consilium.
“I’ve done hundreds of hours of research on that company,” he said. “The CEO is a top engineer in Silicon Valley. Consilium is going up, and if you stay short, you’re going to lose big. I promise you.”
I was more than a little worried that this guy might be right. I only had three million bucks in my hedge fund at that point, and a good chunk of that belonged to me and members of my family. I couldn’t afford to be wrong. But I stood my ground and I told him I was going to stick with my decision. Then I went back to my food.
“We’ll see,” he said ominously. “We’ll just see.”
We did see, of course. Despite his confidence and his “hundreds of hours” of research, that money manager was wrong. Looking back, the fundamentals of Consilium were obviously flawed. They were a troubled business in a very dynamic, fast-changing sector. And yet I was one of the only people in the investment game to see it. I’m pretty sure the reason for that was the same reason the company’s CFO was content to blame M-1: people cannot face their own bad decisions, in business or in investing. The guy who chewed me out in the buffet line wasn’t the only money manager who was “long and wrong” in Consilium. Practically everyone misread the company. But no one could bring themselves to reverse course. They forgot that cardinal rule: it’s okay to be wrong; it’s not okay to stay wrong.
Even sophisticated, accomplished investors often hold on to money-losing stocks long past when they should have cut their losses. Many of them even double up and triple up on their stakes by averaging down as stocks fall. They justify these actions by convincing themselves—like Mark at Consilium or Rob at Building Materials Holding Corporation—that external rather than internal factors are causing the companies to struggle. In 2013, I shorted a troubled company called Dendreon (stock symbol: DNDN). The firm produces one of only three viable nonsurgical prostate cancer treatments on the market. Its drug, Provenge, was the first of the three treatments to receive approval from the FDA back in 2010. Dendreon’s stock shot up close to $50 on the news, as excited analysts predicted billions in future revenues from the drug. As it turned out, though, the competing treatments—which gained approval shortly after Provenge—were not only comparably effective but much less expensive to administer. Not surprisingly, they vastly outsold Provenge. Making matters worse, when the company was riding high, Dendreon issued over $600 million in bonds to expand its manufacturing and marketing capabilities. By 2013, its earnings were anemic, and all that debt was like a parasite sucking the life out of the company. Remember, falling revenues and mounting debt almost always lead to one fatal outcome: bankruptcy. DNDN was below $10 when I shorted it; I couldn’t imagine a scenario where it didn’t drop all the way to zero.
In late 2013, I predicted Dendreon’s demise in an article for the popular investing site Seeking Alpha. The backlash on the site from the company’s proponents was severe and severely misinformed. Some indignant respondents disputed my conclusions by touting the news that Provenge had recently been approved for sale in Europe. Of course, they didn’t mention that its two better-performing competitors were also fast on their way to gaining the same approval. Others repeated rumors of an imminent Dendreon buyout by a larger competitor. This line of argument was even less convincing. I am fully aware that approved cancer treatments are rare and thus immensely valuable commodities. But what company in its right mind would take on more than $600 million in debt, on top of retiring hundreds of millions in shareholder equity, for the rights to a poorly selling drug, especially one competing with two cheaper and more popular alternatives? Moreover, as I pointed out in the article, the patent on Provenge would likely be sold during bankruptcy proceedings for a fraction of the cost of buying out the whole company.
The litany of excuses, rationalizations, and hopeful predictions of Dendreon’s recovery didn’t stop there. People claimed that its treatment would soon be prescribed for numerous new off-label indications. They bashed its competitors as less effective. Most dispiritingly, they blamed contrary investors like me for dragging down the price of the stock. One spelling-challenged commenter even declared th
at all short-sellers should be “ivicerated.” This is a tried-and-true tradition on Wall Street. When things go wrong, investors and corporate executives alike love to blame that old bogeyman, short-sellers. It’s a convenient way to justify unwise investments and deflect attention from the real reason companies lose value: the poor decisions of the people running them. Instead of looking inward and redirecting a business’s strategy, this scapegoating allows leaders and shareholders the illusion of shedding their own responsibility for the condition of their firms. It’s another hollow excuse, like Mark blaming a contraction in monetary policy for Consilium’s struggles.
If anything, smart managements should welcome short-sellers, because when someone shorts a stock, they are committing themselves to buying it in the future. Unless a company goes bankrupt and its stock price goes to zero, short-sellers have to cover their positions at some point, and if that stock rises in the meantime, their purchases will only push the price higher. Also, as I discussed earlier, short-selling carries an infinite amount of risk. The most you can lose from buying a stock is its share price. Shorting a stock has no such floor. For that reason, short-sellers are almost always the smartest, the most savvy, and also the most cautious investors out there. If we weren’t, we’d all be broke. And contrary to popular opinion, we don’t target companies based on malice, and we don’t delight in the near ubiquity of failure in the business world. We simply acknowledge how common failure is and invest accordingly.
Ticker Shock
Ironically, I’ve found that one of the main ways corporate leaders can harm their business is by worrying about its stock too much, either by blaming external factors like short-sellers for its underperformance or by basing strategic decisions on how Wall Street will react to them. Seeing as I make my money almost exclusively on equities, you might think I would want the CEOs of the companies I own to concentrate on nothing but their share prices, but the opposite is true.
Bill Gates is famously disinterested in the performance of Microsoft’s stock. He even delayed bringing the company public for several years because he worried that doing so would create a distraction for himself and his employees. “People get confused because the stock price doesn’t reflect your financial performance,” he told Fortune magazine after the company’s IPO. “And to have a stock trader call up the chief executive and ask him questions is uneconomic—the ball bearings shouldn’t be asking the driver about the grease.”¶
Most successful executives I’ve met have been like Gates. They’ve been too wrapped up in driving the operations of their businesses to pay much attention to the ball bearings and the grease of the stock market. In contrast, the brilliant documentary Enron: The Smartest Guys in the Room showed that “ticker shock” infected the highest reaches of that doomed company’s management. Its stock quotes were even displayed in the elevators of the corporate headquarters. Enron’s executives became so focused on its share price, they were willing to do whatever it took to boost it higher, even if it meant risking ruin. Many of the leaders of the dead companies walking I’ve met with have been similarly preoccupied.
Way back before I started my hedge fund, I paid a visit to a strange and short-lived retailer based in Tampa, Florida, called Silk Greenhouse. The company specialized in leasing out bankrupt grocery store locations and stocking their aisles with thousands of fake flowers. Believe it or not, it made a lot of money hawking those imitation roses and carnations. For a little while, its stock shot up past $20. I’ll never forget my trip to Silk Greenhouse’s corporate headquarters. For one thing, I got hopelessly lost trying to find it. They were so far out in the sticks, I don’t think the street they were on was even marked, and after driving in circles for the better part of an hour, I finally figured out why—the industrial park where Silk Greenhouse kept its offices was at the end of a dirt road! But that isn’t why I’m talking about the company, even though it makes me laugh to think back on that day (and how flabbergasted I was to discover that this hot company that all of Wall Street was buzzing about was housed at the end of an unpaved street).
Silk Greenhouse was my first experience with a management team that seemed to care about its share price to the exclusion of everything else. I was confronted with evidence of this fixation right away. In the lobby of its offices, I was shocked to see a sign with my name on it: “Welcome to Silk Greenhouse, Scott Fearon!” Underneath that pleasant, if unexpected, greeting was a single piece of information: the company’s most recent stock quote. The only thing I remember about my meeting with Silk Greenhouse’s CFO was that he spent the whole time talking excitedly about how fast the business was expanding. He pulled out a map of all the locations they had opened around the Southeast since going public and all the new locations they were already in the process of opening. To him, this rapid expansion was the cure-all for everything.
“You’re a relatively new business,” I pointed out. “Don’t you think you should fine-tune your existing locations to make sure they’re profitable before buying up as many new ones as you can?”
He dismissed my question with a friendly wave of his hand and confidently predicted that the company’s earnings per share would continue to blossom as new Silk Greenhouse outlets sprouted up throughout the region. He also made sure to emphasize the positive effects this aggressive growth would have on its stock price. In the short term, he was right. The stock continued to do well. But hypergrowth—as I later saw with Value Merchants, Building Materials Holding Corporation, and dozens of other companies—can be deadly. Silk Greenhouse’s management went too fast, too soon. They tried to open over two dozen new locations virtually at the same time.
It takes time and effort to build out, stock, and staff one large new store, let alone more than twenty of them. Anybody who’s ever remodeled a single room in their house knows that construction projects can be full of unexpected delays and cost overruns. Multiply that exponentially, and you’ve got a good idea of what caused Silk Greenhouse’s demise. Planned openings were pushed back repeatedly, new inventory had to be warehoused, and the costs of the expansion kept going up while revenue growth slowed and then finally collapsed.** Eventually, investors got wise and Silk Greenhouse’s stock slipped, too. As so often happens, it went down a lot faster than it had gone up. The company was bankrupt less than two years after my trip to Tampa.
Building Materials Holding Corporation also raised revenues in large part through mergers and acquisitions. In the late 1990s and early 2000s, BMHC steadily bought out smaller competing companies. But as I said earlier, this process also fattened up another part of its balance sheet, its debt load. By the time the housing market turned, Rob and the other BMHC executives had saddled the company with hundreds of millions in liabilities to fund these constant acquisitions. Without that onerous debt load, BMHC might have been able to weather the downturn. But, instead, the company was like someone with a massive credit card bill who suddenly loses their job. With fewer and fewer revenues coming in, it couldn’t even afford the minimum payments on its debts and wound up with no better option than bankruptcy.
Growth through acquisitions can be a successful strategy if it is carefully conducted. Airlines, for example, have fairly stable administrative costs, so gaining new routes by buying up competing firms often boosts revenues without adding much more overhead. In many cases, though, growth through acquisitions can be just as dangerous as the kind of expansion-on-steroids that killed off Silk Greenhouse or Value Merchants. While building out and opening a number of new facilities in a short period of time is risky, at least it’s an internally managed endeavor. A business’s existing employees can, in theory, oversee the process and ensure that it’s running smoothly. But integrating a separate business into your own is, by its nature, an outside-in process. For that reason, it’s bound to be a crapshoot. No matter how many lawyers and auditors an acquiring company hires, no matter how much due diligence it performs beforehand, the seller almost always g
ets a better deal than the buyer. Sellers know where the bodies are buried in their businesses, and there’s usually a good reason why they’re willing to give up ownership.
During the 2000s, Hewlett Packard went on a prolonged acquisition spree. One of its most infamous acquisitions was the mobile device firm Palm. HP wanted to get into the smartphone business and was willing to pay good money to do it—the Palm buyout cost the tech giant $1.2 billion. What did they get for all that cash? A dead company walking whose industry had long left it behind. After multiple visits to Palm’s Silicon Valley headquarters, I had shorted its stock, and I was stunned when HP bought such a clearly troubled company. Back in the late 1990s and early 2000s, Palm products, especially its Pilot, were ubiquitous. But HP didn’t acquire Palm until 2010, several years after the iPhone and other competitors like Android had crushed Palm’s market share. Barely a year after the deal went through, HP shuttered the company and wrote off almost its entire investment.††
The thing that gets lost in all the hype over growth through acquisitions is the effect it can have on morale. People are always a business’s most valuable assets, and one of the surest ways to kill that value is to tick employees off by disrupting their lives or making them feel unappreciated. I once played golf with an executive whose previous employer, a large tech company, had gone through a major merger. I asked him how he and his colleagues had handled the transition. He shrugged and said, “We rested and vested.” When I asked him to explain what that meant, he told me that almost all of the original employees at his firm felt alienated by the new corporate culture and planned on quitting, but not until their stock options in the newly merged company vested.