Dead Companies Walking

by Scott Fearon

  Weighted Up

  The way stock indexes are calculated feeds investors’ excessive optimism by masking how common failure is in the business world. Just about all of them are weighted by market capitalization. That means they’re not based purely on the average performance of the companies listed in them. The size of those companies is also a major factor. The larger a company’s market capitalization, the bigger effect its stock has on the index’s value. The S&P 500, the NASDAQ, all the Russell indexes, they’re all weighted this way, and most investors have no clue how this distorts their view of the corporate world.

  Here’s what I mean: a single company with a massive market cap and a rapidly rising stock price often drives an entire index higher even as dozens or hundreds of smaller companies in that same index drop or disappear altogether. From 2005 to 2012, Apple’s stock shot up from $40 a share to $700. As it approached its peak, Apple made up more than a fifth of the NASDAQ 100 and almost 12 percent of the entire index. For significant periods of time its growth was responsible for much of the index’s gains. That kind of outsized weighting conceals the plain fact that more stocks in that index went down rather than up over the course of Apple’s incredible rally.

  Notes

  *I don’t think it would be helpful to give Jerry’s full name. The same is true for most of the executives I describe in the book. Also, the conversations I recount are based on recollections and notes from my meetings with them.

  †Before the price of oil collapsed, there were plans afoot to build the world’s tallest building twenty miles west of downtown.

  ‡Steven Mufson and David Cho, “Energy Firm Accepts $45 Billion Takeover Bid,” Washington Post, February 26, 2007.

  §Mark Chediak, “Oncor Lower Earnings Forecast Cuts Valuation,” Bloomberg News, October 16, 2013.

  ¶Stephen Grocer, “Warren Buffett Likely Not Going to Like This TXU News,” Wall Street Journal, February 7, 2013.

  **Kathleen Pender, “Ex-Dean of Stanford Business School Led Enron Audit Panel,” San Francisco Chronicle, February 7, 2002.

  ††Robin Pogrebin, “In Madoff Scandal, Jews Feel an Acute Betrayal,” New York Times, December 24, 2008.

  Two

  The Fallacy of Formulas

  Figures lie and liars figure.

  —Anonymous

  Jerry, the Global Marine executive, didn’t just make the mistake of learning only from the recent past when he told me to buy the company’s stock. He also put way too much faith in his magic rig utilization formula. For Jerry, buying stock in Global Marine at 70 percent utilization was what they call, in sports betting, a “lock.” That’s why he was so relaxed and confident when Geoff Raymond and I met him. But of course, there’s no such thing as a true lock, in sports or in business, and confusing formulas with good decision making can be disastrous—not only because formulas can be wrong, but also because if you get too fixated on a set of numbers or a particular way of doing things, you can easily miss out on other critical information. I’ve fallen into that trap repeatedly over the years. But one particular instance still stings, even after more than two decades.

  Blowing a chance to make millions of dollars is hard to forget.

  In August 1992, I took a trip up to Seattle to visit the managements of a few up-and-coming companies at the time. My first meeting was with the chief financial officer of Costco (stock symbol: COST), a fellow named Richard. I took a morning flight out of San Francisco and drove across Lake Washington from Sea-Tac airport to the company’s corporate headquarters, which were still in Kirkland at the time. On the way, I stopped for my third cup of coffee of the day from, of all places, Starbucks. They’d opened a few stores in the Bay Area by then and I was a fan of their java. OK, fan is an understatement. Hopeless addict would be a better description.

  When Richard came out of his office and extended his hand to me, it took me a minute to realize he was the executive I was scheduled to meet. He looked like he should have been driving a forklift around a Costco warehouse instead of running the company’s finances. He was a husky guy with a receding hairline and a dark, bushy mustache. But what really threw me was his outfit. He was wearing baggy blue jeans and a flannel shirt. That was my introduction to the relaxed corporate culture of the Pacific Northwest. A guy dressed like that wouldn’t have been allowed in the door of Texas Commerce Bank. But in Seattle, he was the number three man in one of the region’s most promising companies.

  After recovering from my initial confusion, I shook Richard’s hand and he escorted me into his office. That third Starbucks coffee had gotten me pretty revved up. I tend to talk fast anyway, but that morning I was really rolling. Before Richard could say anything, I rattled off all of my reservations about his company. First, I brought up its profit margins. By my calculations, the money Costco cleared on merchandise was so minuscule, most of its profits actually came from the membership dues it charged customers. That led straight into my second issue: What was the deal with charging people to shop in its stores anyway? Was it really a good idea to limit the number of customers it had? Finally, I said I was worried about its biggest competitor at the time, a company called Price Club.

  Richard took a moment to make sure I was done and then calmly answered my questions. He may have been dressed like the rhythm guitarist in a grunge band, but he was very, very smart. And to his credit, he didn’t try to sell me or spin the truth.

  “You’re right,” he said. “Our margins are quite thin. They’re less than 2 percent on most items after overhead. That’s why we don’t accept credit cards. The banks charge 2 percent for each transaction, so if we took cards, we’d actually be losing money on most sales. That’s why we charge a nominal membership fee. It helps ensure that our customers have the means to pay with cash or to write us checks that won’t bounce.”

  “And what about Price Club?” I asked. “How are you going to fend them off?”

  “They’re a good company, but we’re better,” he answered confidently. “We’re growing faster and we’re opening more stores.”

  I shook Richard’s hand again and drove back into Seattle for my next meeting with Orin, the CFO of Starbucks (stock symbol: SBUX). Later on, Starbucks would move into some very plush corporate offices on Utah Avenue. But back then, its executives were still working out of a drab warehouse space near Boeing Field.

  Orin was the polar opposite of Richard, at least appearance-wise. He was tall and lean. He wore the typical CFO uniform—khakis and a crisply tucked blue oxford shirt—and the part in his neatly combed blond hair was as straight as a rifle barrel. We had a good chat, very cordial but also to the point. I rarely spend more than an hour in these kinds of meetings. I lay out my concerns and I listen to peoples’ answers, then I let them get back to work. That morning, I told Orin I was concerned about spikes in the price of coffee and how those would affect Starbucks’ bottom line. Coffee is a volatile commodity. Prices can fluctuate wildly, even in a single trading day. Orin was surprisingly blasé about that fact.

  “We’ve done surveys of our customers as they’re leaving our stores,” he told me. “We ask them, ‘How much did you just pay for that cup of coffee or that latte?’ And the majority of them can’t remember. They have no idea what they just paid, even though it was only minutes earlier!”

  “That’s interesting,” I said. “But how does that answer my question about coffee prices?”

  “What we give people is a little luxury,” Orin replied. “They’re willing to pay a small premium for it. Big luxuries, like a new car or a new television, those are different. People are very conscious of what they’re spending on those kinds of things. But when it comes to our products, they don’t care because it’s only a couple bucks and it makes them happy. So if the price of coffee beans goes up, we just add a few cents to what we charge. Trust me,
nobody notices.”

  As I drove back to Sea-Tac and considered whether to buy stock in Starbucks and Costco, I thought about the three cups of coffee I’d bought that day—one from a Starbucks location near my house in Mill Valley, one from a kiosk at San Francisco airport, and one on the way to Kirkland. Orin was right. I had absolutely no idea what any of them had cost. I’d plunked down my money and pocketed my change without glancing at it. I was too excited to take that first sip to care whether I’d paid a buck-fifty or two or even three dollars.

  The beauty of Starbucks, especially back then, was its consistency. You knew that no matter where you were, the coffee was going taste the same as it did anywhere else, whether it was from a location near the boardwalk in Newport Beach, California, or at the company’s original cafe in Seattle’s Pike Place Market. That might not sound like much of a big deal now, but this was an extremely novel concept in the early 1990s. Up to that point, it had been hard to find anything better than Folgers in most of America. Sure, there were upscale cafes in cities like Los Angeles, New York, and Seattle, but until Starbucks came around, there was no way to get comparable coffee in most other places.

  Costco had a similarly unique business model. It offered cheap prices, just like Kmart, Sears, and the other classic big-box retailers of that era. Unlike those places, however, it sold quality merchandise instead of discount junk. Costco’s leaders recognized that people who bought higher-end stuff liked a bargain as much as anyone else. And of course, the company also sold food and beverages—good food and beverages, in bulk, at more or less wholesale rates. It might seem normal nowadays for suburbanites to stock up on cases of fine wine and mayonnaise jars the size of oil drums. But back in 1992, it was downright revolutionary. People went wild for the concept and the company took off. Like Starbucks, Costco was building all over the country, with more stores opening seemingly every day.

  There was no doubt in my mind that both of these companies were going to prosper. My gut was telling me to jump in and buy thousands of shares of each. But my head just wouldn’t let me. In the end, I talked myself out of investing—and that wound up being an expensive conversation.

  In August 1992, a share of Costco was running around $34. Less than a year later, Costco merged with Price Club and its stock split 2–1. It then went on a steady rally until it split again at over $90 per share in 2000. By the beginning of 2014, COST was trading for roughly $120. Adjusted for splits and dividends, if I’d bought the stock back then and held on to it until 2014, my investment would have gone up over twenty times. But that missed opportunity is actually small compared to my other colossal could-have-been from that trip, Starbucks. If I had bought SBUX after chatting with Orin at the company’s old headquarters that morning, it would have been worth over one hundred times what I’d put in twenty-two years earlier.

  So what went wrong that day in 1992? Why didn’t I pull the trigger on the stocks? After all, I thought both companies were winners. I was (and still am) literally addicted to the products one of them offered. And as I found out in person on that trip, they were run by extremely bright, competent managements. So what in the world was my problem?

  Put simply, I was too attached to my formula. For one, I am very wary of stocks that have recently gone public. I never buy into initial public offerings. Unless you are one of the insiders who gets awarded sharply discounted shares, they are almost always terrible investments. But that wasn’t the main reason I shied away from Costco and Starbucks. The biggest rationale was that neither of them added up to a good buy according to my chosen method for picking stocks, something called growth at a reasonable price (GARP) investing.

  Back then, there were basically two schools of money management: GARP and value investing. As I discussed in the last chapter, Geoff Raymond was primarily a value investor. He would calculate a company’s book value and compare that to its share price to determine if it was undervalued or overvalued. I practiced this method with him at Texas Commerce, but after I left the bank, I came to rely more on GARP to guide me. Despite what happened in Seattle in 1992, I still do.

  A GARP investor looks for companies that are growing. Starbucks and Costco certainly were doing that in big ways. But the acronym contains a caveat: at a reasonable price. If a company’s earnings are growing fast but its share price is growing faster, the GARP school says to stay away. The way you figure out whether this is the case is by calculating something called the multiple—the ratio of a company’s share price to its earnings per share—and comparing it to its rate of growth. When a company’s multiple is larger than its rate of growth, the stock is overpriced and thus not a good investment.

  At the time of my visit, Costco’s stock was actually down from a high of almost $65 a year before. But even at its newly discounted price, by the GARP formula Costco’s past and projected earnings were not enough to make the investment worthwhile. Its earnings multiple was quite high, in the thirties. The idea of investing in a company with those kinds of numbers was a big stretch for me, no matter how promising it seemed. Unfortunately, I got the same results when I crunched the numbers on Starbucks. Its price-earnings multiple was also well over thirty. Compared with its recent and projected future earnings, that valuation was simply too high to make it a worthwhile investment. Or so I figured. By which I mean I figured wrong.

  One of the main reasons I favor the GARP investing approach is that it helps prevent me from falling prey to manias and groupthink. If a company’s stock price is too high compared to its earnings, that generally means one of two things: either its earnings growth has slowed but investors have been reluctant to sell off their holdings, or its stock has been bid up beyond what the company’s performance merits. In both of these scenarios, the GARP formula keeps an investor from following the herd. You don’t stay invested in overvalued companies, and you don’t get caught up in popular, overhyped stocks that are rising too fast.

  But here’s the catch: sometimes the herd is right.

  My rigid adherence to the GARP philosophy kept me from recognizing something important about Starbucks and Costco. There was a good reason their stock prices were so high. They were, and they remain today, once-in-a-lifetime companies. Since that visit to Seattle, they have each reinvented their respective industries. They are two of the greatest corporate success stories in the last century. Starbucks in particular has built the greatest American brand since Coca-Cola. Most investors are lucky to get in early on one opportunity like that. And I was gift-wrapped the chance to buy into two of them—in one day—and I passed on both.

  This is what I mean when I say that fixating on a formula can be disastrous. All real-life rules have exceptions to them. When it came to Costco and Starbucks, I almost recognized this. I strongly suspected that they were both unique companies that defied the usual formulas. But, in the end, I just couldn’t pry myself away from my formula, and it cost me an enormous amount of money.

  This fallacy happens all the time in management as well as investing. Corporate managers frequently bind themselves tightly to what seems like a winning approach, only to discover after the fact that it was really a noose.

  Double Jeopardy

  One of the first companies I shorted on its way to bankruptcy failed because, just like I did with Starbucks and Costco, the executives in charge wed themselves too strictly to a formula. Soon after my trip to Seattle, I was chatting on the phone with a stock analyst at Chicago-based William Blair, and he mentioned a dollar-store company from Milwaukee called Value Merchants (stock symbol: VLMR). It had started out as a toy retailer, but by the time I learned about it, most of its revenue came from its ubiquitous Everything’s a Dollar stores.

  “These guys are growing like crazy,” the analyst said. “The new CEO has pledged to double the number of locations every single year.”

  “Double?” I asked incredulously.

  “That’s right,” he replied. “
When he took over, they only had sixty Everything’s a Dollar stores. They were up to two hundred by the end of the next year. Now, there’s over five hundred.”

  “That’s insane,” I said.

  “Maybe, maybe not. But they say they’re going to keep it up and double again this year.”

  I hung up the phone and took a short drive to the nearest Everything’s a Dollar outlet in the Northgate Mall in San Rafael, California, a few miles from my office. I’d never been in one of those stores before, and it was a strange experience. The smell of cheap vinyl permeated the place, and the merchandising choices were haphazard, to say the least. Bins of rubber rats and other cheap toys lined the floors beneath plastic sunglasses, costume jewelry, novelty bumper stickers, and shelves of weird generic cereals and toothpaste brands I’d never heard of. After I walked the aisles for a little while, I approached the store manager, a harried-looking woman restocking a table of “I’m with Stupid” T-shirts.

  “Excuse me,” I said. “How do you decide what items you sell here?”

  “I don’t decide anything,” she answered with a bashful smile. “Every week a truck backs up behind the store, and we offload boxes of merchandise. Then we take all the things that haven’t sold in the past week, and we put them in those same boxes and they go back onto the truck.”

  “Where does that stuff go?”

  The woman shrugged, “To the next store, I guess.”

  Normally, I follow Geoff Raymond’s formula for investing: I study a company’s fundamentals, and I visit its management before I make a decision on whether or how to invest in it. But I broke that formula in the case of Value Merchants. I didn’t bother flying to Milwaukee to meet with its executives. I shorted sixty thousand shares right after I got back to my office. I knew the formula of doubling stores every year was going to be the death of the company. There was simply no way it could manage that kind of hypergrowth.