Dead Companies Walking

by Scott Fearon

  The company’s earnings were already starting to go sour at the time. Even though all those new stores had boosted top-line revenues, profit margins were down. That was hardly surprising. Opening all those stores required major capital outlays. But more important, it kept the company’s management from focusing on the most important task retailers—even junk retailers—have to perform: finding things that people actually want to purchase. Just because the stuff on your shelves is cheap doesn’t mean consumers will automatically buy it. Even the least-discriminating shoppers out there have to like what you’re selling.

  Marathon Man

  Shortly after my visit to the Everything’s a Dollar store in San Rafael, I was chatting on the phone with another stock analyst from Robert Baird, a brokerage that, like Value Merchants, was based in Milwaukee. I happened to mention that I was short Value Merchants. The analyst gasped audibly.

  “I know the CEO personally,” he said. “He gets up every morning at 4 a.m. He ran a three-hour marathon last year. I’m telling you, he’s a competitive beast, Scott. He eats steel for breakfast.”

  “So what?” I countered.

  “So I wouldn’t bet against a guy like that.”

  After I got off the phone, I felt even better about my decision to short VLMR. I was even tempted to increase my position. As I’ll discuss later on, people in the investment and business worlds mistakenly overvalue competitiveness. I think it’s actually one of the worst qualities you can have, not only because it leads people to put too much faith in their own abilities, but also because it makes them less likely to recognize their mistakes and change course. Competitive types think they can will their way to success, no matter what. But no amount of will can counter a doomed formula—like doubling your number of stores every year.

  The store manager’s story of weekly deliveries confirmed that the company was headed for disaster. It clearly sourced all of its merchandise from overruns, remainders, or fire sales. There was no way it could return goods that didn’t sell to the manufacturers. So where did it all go? Back onto the truck and straight to the next store on its delivery schedule. That next store would then stock this rejected junk and pass its poor-selling goods on to the subsequent one and so on and so on. It was a kind of inventory Ponzi scheme. The company was relying solely on new store growth to boost its revenues. But because of that excessive growth, it couldn’t possibly bring in enough desirable new merchandise for all those locations, so it was reduced to rotating an increasingly unsellable backlog of crap among its outlets.

  Less than twelve months after my trip to Northgate Mall, Value Merchants filed for bankruptcy.

  Failed business formulas usually aren’t as mathematically precise as Value Merchants’ commitment to double in size every twelve months. More generalized “growth for growth’s sake” formulas can be just as dangerous, especially when they rely on debt. The airline industry is notorious for debt-fueled expansion, and that’s one of the main reasons nearly every major airline has filed for bankruptcy at one time or another.

  Another sector that has seen numerous companies fall victim to the growth-is-always-good formula is fast food—known as quick service restaurants, or QSR, in the investment world. Krispy Kreme Doughnuts was a prime example of this fallacy. Instead of granting its new franchisees one outlet at a time and making them prove themselves before allowing them to acquire new locations, as McDonald’s does, the company negotiated deals with a handful of “area developers” for exclusive rights to large territories. In exchange, the franchisees guaranteed that they would open at least ten stores in their regions and pay top dollar to the parent company for donut-making equipment and supplies.

  On paper, this formula appeared to allow Krispy Kreme to expand quickly across the country. But in actuality it meant that the company had ceded control over the fortunes of its own business. Several of these area developers couldn’t live up to the terms of their agreements, and went bankrupt. Normally, the failure of individual franchisees isn’t a major blow to a large chain. But because of Krispy Kreme’s misguided strategy, customers in many major markets suddenly couldn’t find one of its original glazed donuts within five hundred miles.

  I experienced this vanishing act firsthand. Whenever we’d visit my parents, I would take my kids out for a late-night treat at a Krispy Kreme store in Chandler, Arizona. One night, much to our dismay, we discovered that it had been shuttered the week before. I drove to a store in Phoenix but it was closed, too, as was every other location in the surrounding area. After a half hour of searching, we broke down and went to Dunkin’ Donuts instead.

  By the Book

  Over the years, I’ve seen dozens of companies in all sorts of industries fail because, like Value Merchants and Krispy Kreme, they committed themselves to a formula and stuck with it, even when all the evidence was practically screaming at them to change. I wish I could say my failure to buy into Starbucks and Costco was the only time I committed this mistake myself. But sadly, it wasn’t. I once made a major investment in a company that fit all too neatly into my GARP model of stock picking. A few years later, it was bankrupt—because its management, too, refused to rethink a set formula.

  For the most part, San Diego–based Advanced Marketing Services (stock symbol: ADMS) did one thing and one thing only: it distributed wholesale books to big-box retailers. Along with Sam’s Club, Costco was its main customer. But unlike Costco, Advanced Marketing’s price-earnings ratio lagged its earnings growth rate. Its revenues were growing rapidly, thanks mainly to the phenomenal success of Costco, but its share price wasn’t rising nearly as fast. According to my GARP formula, that made ADMS a very attractive stock. So after monitoring its performance for a little while, I flew down to Advanced Marketing’s headquarters in a business park in northern San Diego.

  I love going to San Diego on business. I always wind up my days in Old Town eating Mexican food and drinking margaritas. I sit outside in the sun—by the late afternoon, it is always sunny in San Diego—and sip my drink and watch the tourists walk by. Maybe I should blame those margaritas for my not spotting the trouble at Advanced Marketing sooner.

  The company’s chief financial officer at the time of my first visit was named John. The only way I can think to describe him is bookish. He was tall and lanky and very soft-spoken. He could have easily passed for a college professor. At one point he told me that he had originally intended to study for the priesthood before switching to business school. And he seemed to have an almost evangelical faith in the importance of what Advanced Marketing did.

  “We give publishers new ways to sell books and we bring more books to consumers,” he said.

  Even before I flew down to San Diego, I was already almost certain I was going to buy ADMS. I was in love with how neatly its numbers fit into my GARP formula. Buying it also seemed like a cheap way to own Costco without actually paying what still seemed like Costco’s inflated share price. But I had one reservation, which I brought up with John: the company was strict about only charging a 15 percent markup on its books, even though it bore all of the expenses for shipping and warehousing them. On top of those overhead liabilities, Advanced Marketing ate the costs of any unsold books its clients dumped back on it.

  John granted that the 15 percent rule was risky. “But that’s how we stay in the game,” he asserted. He went on to describe what should have been an ominously familiar strategy that the company planned to employ to counter its slim margins: “Our competitive markup is what is going to allow us to continue to grow.”

  “What about returns?” I asked. “Last year, they were close to 25 percent. That’s one book coming back for every four that sell.”

  John said the company was steadily improving those numbers. It had opened its own outlet stores to offload the books that came back. It had also beefed up its advertising and marketing divisions to make sure clients only ordered books that woul
d sell out. To help make this happen, it had started promoting books both inside stores and through media campaigns. The company charged for this service, John added, which gave it an extra revenue stream.

  His presentation was quite impressive. And it was hard to argue with the raw numbers. The company was growing like a weed, yet its price multiple was a tempting ten times earnings. After enjoying my customary margarita in Old Town that afternoon, I called my trader and told her to buy 200,000 shares first thing in the morning. For the first few years, ADMS was a GARP gold mine. Just as John had predicted, the company’s earnings kept growing. Only now, the share price started to keep pace. Pretty soon, the stock had doubled, and it kept rising. At its peak, it approached $30, almost triple what I had paid only a few years earlier. That’s not a bad return on investment—if I had sold in time, that is.

  I returned to San Diego a few more times over the next couple of years to meet with Advanced Marketing’s management. John left the company and a new CFO named Ed took his place. Ed wasn’t much different than his predecessor. He genuinely seemed to love anything and everything that had to do books. The same was true for the founder and chief executive officer. Visiting the company felt more like stepping into a faculty lounge than a corporate office. And every time I came down, executives had nothing but good news for me. Returns were dropping and sales were climbing. The company was even buying up competitors and other players in the book distribution game.

  If I’d been paying more attention, though, I would have noticed that something was definitely amiss. For a company that specialized in books, its own financial books were as hard to figure out as a good Agatha Christie whodunit. As Ed was fond of pointing out for me, the company’s sales kept growing every year. Yet its profit margins were actually heading south. For the last fiscal year I owned the stock, 2003, the company’s net sales were up 21 percent from the year before, but its net income was cut in half. You don’t need an MBA to know that rising revenues and falling profits do not reflect a sterling business model.

  Company management kept putting out press releases claiming that the company was on the verge of solving the issue. They were improving their inventory software, they were cutting overhead, they were streamlining their distribution centers. But none of these measures brought margins back up. It was like bailing out the Titanic with a tennis racket. They were working furiously but the ship kept taking on water.

  Around this time, I was at the American Electronics Association Conference in Monterey, California, and I ran into a guy I went to business school with who was (and still is) one of the greatest investors in the country. He managed his fund at Fidelity from a couple hundred million dollars to something like $35 billion. I’m going to spend a fair amount of time in this book bad-mouthing money managers—and the vast majority of them deserve it—but this guy is an exception. When I saw him at the AEA, I realized that he had the same last name as the CEO of Advanced Marketing, so I asked him if they were related.

  “He’s my cousin,” the man replied.

  “That’s great,” I said. “You know, I own the stock.”

  He gave me a look like a bad smell had just wafted into the conference room.

  “I wouldn’t go near that company,” he said. “Their margins are too small. It’s a terrible business.”

  I walked away wondering if I should dump my stake. But even after hearing that a money manager as successful as my old classmate wasn’t willing to invest in his own cousin’s company, I just couldn’t let go.

  Just one year after Advanced Marketing’s stock hit its apex, the company struck an iceberg. By the time I recognized what was happening and sold my holdings, its share price was below what I had paid. Worst of all, I didn’t see it coming. I was too busy being proud of myself, and my formula, to notice that the company was foundering. I allowed myself to trust management’s assurances instead of studying the numbers closely myself. In other words, I believed what I wanted to believe—that my GARP formula had delivered a winner. The illusion worked for a little while. But blissful ignorance has a short shelf life.

  As it turned out, things were worse at Advanced Marketing than anyone knew. It wasn’t just another troubled company with low margins. It was a fraud, a miniaturized version of bigger and more famous phonies like Enron or Tyco or WorldCom. A year after I finally sold my shares, the FBI raided the company’s offices. A couple of lower-level executives eventually pled guilty to inflating the firm’s numbers by about 20 percent. I was stunned when I found this out. I just couldn’t imagine guys like John or Ed being involved in something like that. And it’s important to note that none of the company’s top managers were ever implicated.*

  Advanced Marketing is a classic example of how hard it is to spot frauds. As is often the case, the fraud at the company was perpetrated by a handful of employees in a single department. They were doctoring their accounting statements and charging for promotional activities that they never performed. There was simply no way an outside investor like me could have detected these activities. What I could have—and should have—noticed was something much more prosaic: Advanced Marketing’s margins were simply too small for the company to survive.

  Some fund managers specialize in ferreting out and shorting the stocks of so-called promotes, businesses that put out bogus earnings statements to boost their stock price. But exposing crooked corporations is time-consuming, arduous, and risky work. Not only that, as I said in the introduction, frauds are exceedingly rare. Despite the amount of press they get, there just aren’t that many of them out there. The overwhelming majority of companies that go under every year are garden-variety failures. To this day, I still believe Advanced Marketing fit better into this far more common category. It was well on its way to failure before the FBI raided its offices. Accounting tricks didn’t kill it; clinging to a flawed formula did.

  The Birth of a Contrarian Investor

  Amazingly, even with its lousy business model and investigations into its accounting practices, Advanced Marketing limped along for quite a while. It didn’t declare bankruptcy for another four years after I unloaded my position. Though it seems surprising, this kind of longevity is actually quite common. A lot of companies that have no business staying in business manage to hang on way longer than they should. I first spotted this tendency early in my career when I was managing mutual funds for a company called GT Capital in San Francisco. My focus was investing in smaller, lesser-known companies, and I couldn’t help but notice that a lot more stocks in that sector went down sharply than doubled or tripled in price. I also detected another intriguing trend. While many stocks declined in value, they would frequently not go down enough. Even the stocks of the most severely troubled businesses would often continue trading at much higher prices than they should have, and for far longer than they had any right to. Time after time, I would study a company’s financial statements and be mystified that its share price was anywhere over a penny. And yet people would still be buying the stock.

  Even after all these years, I still don’t know exactly why this happens, but I think it’s due to the same excessively positive outlook I witnessed among the executives at Texas Commerce after the oil bust. Americans’ can-do optimism extends to their investing habits, especially when it comes to smaller companies. They like to think that the little guy will prevail, that the plucky entrepreneur with the novel new product or service will catch fire. And of course, company managements are all too happy to encourage this false hope. Like Advanced Marketing’s brass, they constantly churn out upbeat press releases about better days to come. Meanwhile, their revenues keep falling, their debt loads keep rising, and their creditors keep circling closer and closer.

  While I was at GT, I was forced to watch this potentially lucrative dynamic from the sidelines. As a mutual fund manager, I was not permitted to short stocks. Again and again, I would spot companies that were heading down the drain,
with stock prices far above where they should have been, but there was no way to take advantage of those opportunities. It was frustrating. On top of that, I was getting my first lesson in just how corrupt the mutual fund industry is. After I started having success, GT began to market my funds quite literally to death, sucking in more and more assets even though I kept warning the company that doing so would kill the returns I might earn. Meanwhile, the head of US operations got caught using his expense account for things like tennis lessons for his kids and rent payments on his girlfriend’s luxury apartment. Shortly after the company fired him, GT was sold to the Bank of Liechtenstein—just in time for that bank’s European CEO to be indicted in a massive insider trading scheme.

  Thankfully, a friend and mentor of mine named Gary Smith gave me a chance to escape GT. He offered to set me up with my own hedge fund in exchange for a fifth of my profits over five years. I’ll talk more about Gary later, but for now I’ll just say that I didn’t have to think too hard about accepting his terms. By that point, I was sick of the mutual fund racket. But the main reason I said yes was because I was pretty sure I could reap big returns by shorting the stocks of troubled companies.

  An Inauspicious Beginning

  One of my former bosses at Texas Commerce hired me on at GT Capital and put me in charge of about $60 million. That’s not chump change, but compared to a lot of mutual funds, it was pretty modest. That suited me just fine. I planned to outperform other funds by researching and investing in smaller companies. What’s the old saying? If you want to make the devil laugh, tell him your plans? Less than a month after I started at GT, I came into work on the morning of October 19, 1987. You might know that particular date by its more famous name: Black Monday. I grabbed a cup of coffee, sat down at my desk and watched in horror as just about every stock I had inherited hemorrhaged value. By the end of the day, the funds I managed were down 40 percent. Before I was even able to start implementing my new approach, I was already deep in the hole.