by Scott Fearon
ZLC tripled in price in the first six months I owned it, but I never considered selling it. In fact, I bought another large chunk and considered buying more. Why? Because, as Stephen Mandel said, managements matter. I never got a chance to purchase more shares of ZLC, though. In early 2014, the largest jewelry company in the country, Signet (stock symbol: SIG), acquired Zale for $21 a share.
Jackpot
Zale’s commitment to finding new ways to boost its profit margins brought it back from the abyss. By the time the new management team took over, just holding down the fort wasn’t going to cut it. The company was in a shambles, and it had to figure out how to build the proverbial airplane in midflight. As I said, innovating is hard enough for successful businesses. Doing it on a shoestring budget while trying to stave off bankruptcy is a Herculean task—but I’ve seen the best corporate managers pull it off, and not just in retail.
When I first visited the management of the Reno-based slot machine company International Gaming Technology (stock symbol: IGT) in the early 1990s, its headquarters made Cost Plus’s modest Oakland offices look like the Taj Majal. The company would eventually move into a gleaming new facility on Prototype Road, but at the time IGT was still housed out among a cluster of low-slung warehouses on a parched strip of land at the edge of Reno-Tahoe International Airport. It didn’t seem like a fitting home for a business that was making record profits, thanks to a boom in legalized gambling. Over the previous half decade, Indian casinos had been opening all over the country, and the entire gaming industry was flush because of it. But then again, IGT’s stock had been down as low as 11 cents only a few years earlier in the mid-1980s, so I assumed that its employees were happy to have any offices at all.
The company’s CFO was a linebacker-sized guy named Tom. He had thinning brown hair and a soothing, resonant baritone. After he nearly crimped my palm in half with his handshake, he offered to show me some of the latest machines. I gladly accepted, but before we stepped out of his office, I made the mistake of commenting on one of the numerous framed photos of Harley-Davidsons hanging on the walls. Tom spent a good while regaling me with tales of riding his bikes up into the Sierras. To be honest, it got a little dull. But eventually, he remembered that I was there to talk about slots, not choppers, and he took me out to the lobby of the building, where several dozen of the newest models were on display. He let me try my luck at some Hollywood-themed machines, which featured the characters of old television shows and movies. I gave the Gilligan’s Island one a spin, but I can’t say it did much for me. I’ve never been a big gambler.
“With all those new Indian casinos being built, your orders must be way up,” I said over the electronic chirps and whistles of the slots.
“Absolutely,” he agreed. “We’re struggling to keep up. But it’s a good problem to have.”
“You guys must be thanking your lucky stars for legalized gambling. It came just in time for you.”
I thought I was making an obvious point, but Tom gave me a perplexed frown.
“What do you mean?” he asked.
“The company was on the brink of bankruptcy in 1986,” I recounted. “Your competition was eating up your market share, and your stock was selling for pennies. Then the Supreme Court said that Native Americans could run casinos on their reservations. It saved your business.”
Tom visibly bristled at my version of events.
“Respectfully, Scott,” he said, “that’s not quite accurate. You make it sound like we just got lucky or something. But luck had nothing to do with it. Don’t get me wrong; we’re happy about all the new casinos opening, and we’re making way more money than we would have without them. But that’s not what saved us.”
“What did?”
“We did,” he said with a smile. “We spend five times more on research and development than our competitors. That’s our edge. We knew there was no way we could compete by cutting costs or trying to make the same machines for less money—we had to come up with something new. So even though we were losing tons of money at the time, we kept investing in R&D and it paid off.” He swept his big hand around the room of colorful, jangling consoles. “It used to be that every one of these machines was an isolated unit, with its own odds and payouts. The customer put a coin in, and if they hit, they might win twenty or fifty bucks or maybe even a couple hundred on some of the higher-end models. But now, all of these machines and hundreds of others are linked up electronically so that their jackpots are pooled together. That same customer can put a quarter into one of these slots and win fifty or a hundred thousand dollars, maybe even a million. It’s called a progressive jackpot. We put out the first version of it before Indian gaming was officially legalized. People were already crazy for it and we had orders pouring in.”
Tom led me back to his office again and showed me some numbers to illustrate his point. It was true; IGT’s revenues had started growing again before the legalization boom. But I was still dubious about his reasoning.
“How can you say that without legalization you would still be doing well?” I asked. “Sure, you invented progressive slots, and I can see that they were selling well, but there are only so many casinos in Nevada and Atlantic City. Once they all bought the new machines, where would your growth have come from? You’re a manufacturer. You need to make new sales and new markets to make money.”
Tom didn’t answer right away. Instead, he showed me one of the company’s balance sheets and jabbed a meaty finger at an item labeled “Casino Operations.” I saw that it made up nearly a third of all of IGT’s earnings.
“What’s this?” I asked.
“The real innovation of progressive slots isn’t the machines themselves,” Tom asserted. “It’s how we distribute them. We don’t sell the units outright anymore and take a one-time profit. We lease them to the casinos. That way we get a healthy cut of every coin that goes into them. So even if the boom starts to taper off, which is not going to happen anytime soon, we’ve still got a major revenue stream coming in.”
Tom sat back contentedly in his chair and watched me as I studied IGT’s numbers. He could tell that his arguments were sinking in.
I bought my first tranche of IGT shortly after that meeting. The stock had just spilt and risen back up into the mid-thirties. But I wound up buying a lot of more it, and I was glad I did. A couple of years after my meeting with Tom, I was down in Las Vegas talking to the CFO of Mirage Resorts. They had just opened the Treasure Island casino on the Strip, and one of the main selling points the executive used to try to convince me to invest in their company was the fact that they had gone “100 percent IGT” in the slots at the new resort.
“Normally, you want a mix of different machines from different manufacturers,” he said. “But our research shows that customers love IGT’s products. They go crazy for them, so we decided to give them what they want.”
I went home and bought another chunk of shares. Then, a year later, IGT debuted what would become the most popular slot of all time—the Wheel of Fortune game—and I bought yet another batch.
It didn’t take a stroke of genius to realize that buying stock in a slot machine company in 1993 was probably a good investment. The gaming sector was undergoing an unprecedented expansion. It wasn’t just Native Americans fueling the boom, either. Riverboat gambling was growing all over the Midwest and South, and cities like Detroit were preparing to legalize gambling outright. At the same time, slot machines had become hugely popular and were now responsible for as much as 70 percent of most casinos’ revenues. Finally, the general public had become much more accepting of gambling as a pastime. It wasn’t viewed as something sinful or unsavory anymore.
Silicon Valley East
In many ways, the executives of IGT ran the company more like a Silicon Valley tech firm than an old-fashioned slot machine manufacturer. They recognized that their creatives—the designer
s who dreamed up new kinds of slot machines—were their biggest assets, and they spoiled them as much as Google spoils its employees.
On one of my later trips to Reno, I was walking through the parking lot of IGT’s giant new campus with Tom, and we passed a brand-new red Ferrari Spider.
“Who’s car is that?” I asked.
“That’s Steve’s,” he said. “He’s one of our best developers. I’m shocked to see it here, to be honest. I don’t think he’s come into the office for a month or so.”
Given these factors, it might have seemed like I could have thrown a dart at a list of publicly traded slot machine makers and expected to make good returns. But that wasn’t the case. IGT’s two largest competitors in the slots industry, Williams Gaming (WMS) and Bally Technologies (BYI), had much lower valuations in the early 1990s. On paper, they might have appeared to have been better investments at the time. But after visiting Reno and speaking with Tom, I decided to bet on IGT, and it was the right play. BYI and WMS wound up not being nearly as lucrative, and the reasons why were familiar.
In the mid-2000s, in the midst of an absolute orgy of housing bubble–driven consumer spending, Cost Plus managed to post poor earnings even as just about every other player in the retail world soaked up massive profits. Despite what its CFO tried to tell me, this didn’t happen because of the Walmart effect or some misguided marketing campaigns. It happened for one simple reason: the people in charge of the company made lousy decisions. They screwed up, and even a stampeding bull market couldn’t save them. The same was true to a lesser extent for Williams and Bally during the 1990s and early 2000s. Neither of them came close to developing products as popular as IGT’s, so even as gambling boomed and IGT’s stock rose steadily, their share prices lagged behind. BYI even dipped precipitously toward the end of the 1990s, and the company was forced to engineer a reverse stock split.
The thing that separated IGT from Bally and Williams is the same thing that saved Cost Plus and Zale: people—smart, adaptable management teams making good decisions. As Tom proudly said, luck had nothing to do with IGT’s success. The company’s leaders created their own good fortune. In the mid-1980s, they were getting creamed by cheaper competitors. They could have gone the Yellow Pages route and cut costs drastically to try to wring a few drops of profit from an ever-shrinking pot of revenues. Or they could have pulled a Blockbuster and made a few cosmetic changes to their business model. But instead, they spent more on their products and aggressively sought out large, game-changing innovations. Like Zale with its Vera Wang collection and other initiatives, IGT’s return from the brink of bankruptcy was due to this emphasis on finding creative new ways to boost earnings. That wound up not only saving the business, but making it the dominant player in its industry.
Cost Plus’s new management team didn’t come up with a novel new concept or product like IGT and Zale. They didn’t have to—the company already had a novel approach that had been proven successful. Nonetheless, going back to its original treasure hunt formula was almost as bold as spending more money on research and development in the midst of a major crisis, as IGT did. During Cost Plus’s low ebb, its new managers could have behaved like the people in the paging industry and invented new justifications for why their focus on high-end furniture was eventually going to pay off. But they recognized that the new luxury strategy had failed and did the incredibly strenuous work of reversing the damage. I can’t emphasize how rare that willingness to change, and admit error, is in business.
Flower Power
Peter Lynch estimated that for every ten stocks he studied (and he studied just about every stock out there), he usually identified one worth buying. He also said that he only found a handful of truly great stocks in his entire career. Once he located those “five baggers” or “ten baggers,” as he called his big winners, he held on to them. Unfortunately, not many investors follow this model. They see a stock they own start to go up and they panic that it might have hit its peak, so they unload it.
I’ve already talked about the terrible habit of averaging down—buying a stock as it drops. That comes directly from an allergic reaction to the idea of failure. Investors don’t want to admit they made a losing decision, so instead of cutting their losses and getting out, they actually double up and triple up on it. Selling a great stock too quickly is the opposite of averaging down, but it is also rooted in people’s fear of failure; they’d rather take a small profit on an investment than risk it going down again. Lynch called these two mistakes, which often go together, “watering the weeds and cutting out the flowers.”*
*Peter Lynch interview.
Most executives are very smart people. In thirty years of visiting corporate headquarters, I don’t think I’ve ever met a single dumb person who had risen to helm a publicly traded company. But very few leaders, despite their intelligence, are willing to face hard facts and revise their thinking. That’s one of the main reasons more businesses fail than succeed. The same thing is true in money management. You don’t wind up running hundreds of millions or even billions of dollars of other peoples’ money without being intelligent. But intelligence doesn’t guarantee success. Peter Lynch, probably the most successful money manager in history, said the best you can hope for is to be right six times out of ten when it comes to picking winning companies.* Think about that for a second. The man most people credit as being one of the greatest, if not the greatest, investor we’ve ever seen readily admitted that he was wrong almost as much as he was right!
I’ve said it once, I’ll say it again: if you want to be a good investor, learn to be a good quitter. Quit early and quit often. And you might as well make friends with the feeling of disappointment, because it’s certainly going to make friends with you. No matter how smart or savvy you are, if you play the markets, you’re going to spend some up-close-and-personal time with your own fallibility, because failure in the stock market happens all the time—even to the most accomplished professional money managers in the financial industry. And yet, just like in the corporate world, most investors refuse to acknowledge this inescapable reality. That denial leads to some all-too-common mistakes.
Notes
*Interview with Peter Lynch, PBS Frontline, January 14, 1997.
Eight
Losing Money Without Even Trying
Welcome to Wall Street
It is difficult to get a man to understand something when his salary depends upon his not understanding it.
—Upton Sinclair
The only trouble with capitalism is the capitalists—they’re too damn greedy.
—Herbert Hoover
My immediate supervisor at my first job in finance at Texas Commerce Bank was the trust department’s senior portfolio manager, a tall, lanky Michigan native who answered directly to Geoff Raymond. He was and still is one of the most trusting and warm-hearted people I have ever met. Unfortunately, those qualities are not terribly helpful in the money management game. If anything, they can get you into trouble. They certainly did in his case.
One morning early in my time in Houston, he strolled over to my cubicle and told me he was strongly considering buying large stakes in two stock offerings. One was a secondary offering for a restaurant management company that owned a bunch of Shoney’s restaurant franchises. The other was an initial offering for a new subsidiary of the First National Bank and Trust Company of Oklahoma City. The bank planned to spin off its data-processing unit into a separate entity called First Data Management Company (stock symbol: FDMC) so that it could, theoretically, sell its services to smaller banks in the region. My boss asked me to look through the prospectuses of the two companies, do some due diligence, and write up a standard, two-page report on each of them, as required by our bank’s compliance department.
The restaurant company took almost no time to vet. Shoney’s restaurants were hugely popular at the ti
me all over the South, so I could see no reason not to recommend that stock. First Data Management was another story. When I looked through its projections, it was obvious that most of its revenue was going to come from the First National Bank and Trust of Oklahoma City—the same company that was making it into a separate entity. It just seemed weird. Why go through the trouble of spinning off one of your units when all it was going to do was turn around and perform the same services for you it had always performed? Since I was no expert on the world of interbank data processing, I called the executive who ran Texas Commerce’s own data-processing section and put the question to him. He was as perplexed as I was.
“I don’t get it either, Scott,” he said. “I wish I could help you. Good luck.”
I spent the next couple of hours trying to make the numbers make sense, but I simply couldn’t see a good reason why the bank was forming this subsidiary. It wasn’t until I called the executive in charge of data processing for my bank’s biggest competitor in Houston, a bank called First City, that I started to get an inkling of what the bank in Oklahoma was up to.
“It definitely seems fishy,” the man said. “It’s not like there’s a huge market for other banks to pay for that service. And you know, a lot of people don’t think First National is going to last much longer. They made all kinds of bad loans during the oil boom.”