by Scott Fearon
GT Capital laid off a third of its US workforce in the next few weeks. To this day, I still don’t know why I wasn’t fired. But for some reason they kept me on and I kept to my plans. I sought out small, fast-growing companies to invest in, and long story short, things went quite well. Despite our losses on Black Monday and the frustrating fact that I couldn’t take advantage of all the short opportunities I saw, by the end of the next year, my funds had all beaten the S&P 500 Index by between 15 and 20 percent. Lipper Analytical Services rated one of them the Number One Growth Fund in America. I was thirty years old and making $80,000 a year. I was recently married. My wife and I were living on Nob Hill in San Francisco and expecting our first child. Aside from the political turmoil inside GT, life was pretty good.
I started my hedge fund on December 1, 1990, with roughly $3 million under management, including $80,000 of my own money and $300,000 from my brother and my parents. A decade later, it was approaching $200 million. At that point, I stopped accepting new investors because, given the limited liquidity of small cap stocks, my fund was getting too large for my strategy to remain effective. I am not a “perma-bear” like some of my short-selling friends. I don’t believe the markets are always destined to fall. Most of the time, I have more money invested long than I do short. But I would never have been as successful as I have been without the freedom and the flexibility to short stocks.
Let Your Fingers Do the Walking
Let’s move forward in time again to late 2008. Shortly after my trip to Southern California to discover the doomed Brightwater development on Bolsa Chica Mesa, I flew to Dallas to interview the chief executive officer of a company that still produced the Yellow Pages. For you kids out there, the Yellow Pages was a big yellow book that used to be in every house in America. Before the days of Google and smartphones, if you wanted to find the phone number for a plumber, a pizza place, a stained glass manufacturer, or anything else, you had to haul this giant tome out of a drawer and physically leaf through the pages until you found the listing. As their slogan said, you “let your fingers do the walking.”
Believe it or not, this company—known at the time as Idearc (stock symbol: IAR)—was not the only remaining publicly traded Yellow Pages company left in existence. There were two. The other one was in Chicago. Not only that, if you looked at a certain set of numbers, Idearc seemed like a good investment. That might sound outrageous, but it’s true. Despite the fact that it produced a hopelessly obsolete product, according to a popular value investing formula, Idearc was a solid buy.
A lot of investors rely on a calculation known as EBITDA to evaluate companies. Like GARP, it’s an acronym. It stands for earnings before interest, tax, depreciation, and amortization. People compare a company’s EBITDA numbers to its stock price as an alternative to price-to-earnings figures or in conjunction with them. I won’t go into the nitty-gritty details of it all, but suffice to say, when you plugged Idearc’s numbers into the EBITDA equation, this stagnant company printing an antiquated and soon-to-be-extinct directory came out smelling like a rose. How is that possible? The magic of formulas. As you can imagine, Idearc had shrinking revenues and it was loaded down with debt, too. But it was being run by a smart, savvy former venture capitalist, and he was cutting costs aggressively enough to keep the company’s EBITDA looking respectable.
He was also a brilliant salesman. That day in Dallas, he pitched me hard to invest in the company. Idearc’s offices were in the old Braniff Airlines headquarters, next to the runways at Dallas–Fort Worth airport. His office had huge floor-to-ceiling windows. As he tried to convince me to buy the company’s stock, jumbo jets took off and landed behind him. I’ll describe this meeting in more detail later on, but for now I’ll just say the CEO’s efforts were in vain. There was no way I was going to invest in a massively indebted, money-losing company that made an obsolete product, no matter how good its financial numbers looked when you plugged them into a certain formula. But Idearc’s EBITDA figures did convince me not to short it. That was a big mistake. The company went bankrupt shortly after that trip to Dallas. I was furious with myself. Once again, I’d gone against my better instincts and allowed a formula to cost me the chance to make a good chunk of money. But luckily for me, the story didn’t end there.
Like a zombie in an old monster movie, Idearc emerged from bankruptcy and came back from the dead in early 2010 as a newly reorganized company called Supermedia (stock symbol: SPMD). Thanks to people’s blind faith in formulas, SPMD was actually one of the hottest stocks on Wall Street for a brief period of time. You read that correctly. In 2010, a company that derived almost all of its revenues from Yellow Pages—Yellow Pages!—was one of the hottest stocks on Wall Street. I’ve still got a list of the firms that owned big interests in Supermedia. It reads like a who’s who of the investment game: Goldman Sachs, Merrill Lynch, RBS, J.P. Morgan, Fidelity, GE, Babson, Vanguard—they all owned it. Why? Because if you just looked at the numbers and ignored the minor fact that the company produced a completely outmoded product, then Supermedia was a winner.
If you don’t believe me, consider this. I still have a copy of a research report the brokerage Oppenheimer & Co. put out in which it rated SPMD an “outperform” stock, boasting that the company “trades at 5x/6x our 2010/2011 EBITDA estimates.”† There it is. The culprit, the root of Supermedia’s irrationally exuberant rally: the EBITDA formula. The report is dated March 17, 2010. On that date, less than a year after its former incarnation, Idearc, bit the dust, a share of SPMD was $39.65—and Oppenheimer predicted it would hit $50. The stock never made that target. Just prior to the report, it had come close. It went north of $45 a share at one point. But a company can only defy the laws of financial gravity for so long, no matter how many Wall Street brokers want to believe otherwise.
Supermedia was a troubled company with an obsolete product, falling revenues, and ocean-sized debt obligations. In other words, in money manager David Rocker’s formulation, it wasn’t a fraud, it wasn’t a fad, it was just a good old-fashioned failure. And thanks to Wall Street’s misguided enthusiasm for it, it was also a goldmine opportunity. I’d missed my chance with Idearc a year earlier. I wasn’t going to blow it again.
Now, I should say that even though I was sure—about as sure as one can be about anything in investing—that Oppenheimer’s rosy predictions were wrong, I did not rush to short Supermedia when it was near its peak. I waited until it was all the way down to $10 before I pulled the trigger. You might wonder about that strategy. Didn’t that leave a bunch of profit on the table? Sure. But by waiting, I saved myself a lot of risk, too. Generally, I hold off until a failing company’s stock has lost at least half the value of its 52-week high before I initiate a short. I want it to have enough downward velocity that there’s little chance it will stop before it hits bottom. When a stock is up near its peak for the year, like SPMD was when Oppenheimer put out its report, every trader from Frankfurt to Manhattan to Tokyo is going to tune in, and a lot of them are going to wind up buying it, no matter how bad the underlying fundamentals are. If you short the stock at that point, you might make more money, but you also might have to sweat for weeks, months, or even years while the thing continues to rally. And you might just lose a bundle in the end.
Investors perform in irrational ways sometimes, and even junk stocks can live on well past their expiration dates. Advanced Marketing stayed in business for a full five years after I sold my shares. Its stock even went on a couple of sustained rallies, despite the fact that the company was being investigated by the Securities and Exchange Commission and the FBI. If I had shorted ADMS in 2002, I would have been sitting around sweating for half a decade before I made any money. Even Supermedia managed to stave off complete annihilation. In early 2013, it went through bankruptcy and merged with the only other publicly traded Yellow Pages company left standing and became Dex Media (stock symbol: DXM). By the middle of that year, believe it or not, the st
ock of this new incarnation of Supermedia and Idearc was actually north of $20 again. Despite its problems, there were still plenty of people out there willing to believe it would recover.
I’m not immune to this tendency to hold on to troubled ventures. I’m pretty good at cutting my losses when it comes to stocks I own. But I’m not just a fund manager. I’m also a budding restaurateur. So far, I’ve owned two eateries. The second one is still open and it’s doing great. The first one was a much different story, however. It failed miserably. Looking back, it was doomed from the start. Yet I kept throwing money at it until the day it quite literally washed out. That’s right—I’ve personally owned a dead company walking, and it wasn’t pretty.
Squeezed
Sometimes it’s not irrationality that keeps the stocks of troubled companies afloat, it’s raw aggression.
So-called momentum investors will seek out stocks at or near their 52-week highs that also have a good number of short investors. They’ll bid the price up even more, hoping to scare short-sellers into exiting their positions en masse, which serves to inflate the stock even further. It’s called a short squeeze, and it’s a brutal thing to live through when you’re on the receiving end. By waiting until a stock has already shed more than half its peak value, I may sacrifice some potential gains, but I make more over the long run by avoiding these sorts of risks.
Notes
*Penni Crabtree, “Feds Accuse Ex-AMS Exec of Fraud Role,” San Diego Union Tribune, March 3, 2005.
†Ian A. Zaffino and Brian J. Bittner, “SuperMedia Inc. Attractive Near-Term Opportunity, Despite Undeniable Secular Headwinds,” Oppenheimer & Co., March 17, 2010.
Three
A Minor Oversight
Your Customers
Success is a lousy teacher. It seduces smart people into thinking they can’t lose.
—Bill Gates
Treat your customers like they own you, because they do.
—Mark Cuban
One hot, sticky August evening during my first summer in Houston, my friend Bob Gaughan took me to a restaurant called the Atchafalaya River Cafe out on Westheimer Road. We sat down at a table outside, and he ordered me a bowl of something I had never heard of—gumbo.
I don’t think I would be exaggerating if I said that my first taste of gumbo changed my life. It was a revelation to me. The spices, the complex flavors of the roux mixing with the Andouille sausage and the okra and the shrimp, it all went off like a gunshot on my palate. I absolutely loved it. I could have sat there sweating in the humid Houston air all night long with Bob, drinking beer and eating that amazing food. And that’s exactly what we did. We went down the menu and I tried just about everything they had. I was so full by the time we left, I could barely walk to the car.
After I started making a little bit of money as a money manager, I went out to eat as often as I could. It was my way of decompressing. And Cajun food was my favorite cuisine. I went back to the Atchafalaya River Cafe regularly. There were plenty of other places to go in Houston. I also made the trip to New Orleans a number of times and tried all the famous spots there: K-Paul’s, Commander’s Palace, Antoine’s. But I have to say, overall, Houston probably has better Cajun food than New Orleans. It doesn’t get nearly as much press for it. But the food there is more authentic.
Then I moved back to the Bay Area to manage mutual funds for GT Capital. As far as Cajun food went, it was like moving to the moon. At the time, you couldn’t find a good bowl of gumbo within a thousand miles—and believe me, I tried. There was exactly one restaurant in the whole city of San Francisco that served it, a place on Fillmore Street called the Elite Cafe. It’s still there. The food wasn’t all that bad. It just wasn’t up to the standards I was used to. You have to understand, I was a fiend for that food. I craved it. And even though the rest of my life was going great, I was constantly wishing that I could jet back to the South for dinner.
Eventually, I decided to bring the South to me. That’s right—I used some of the money I was making by scouting out dead companies walking to go into one of the most failure-prone sectors in the business world—the restaurant game. Ironically (or maybe fittingly), my first attempt at being a restaurateur went down in flames. But that’s not the interesting part. Restaurants, especially first restaurants, fail all the time. What’s interesting about my experience is how blind I was to a very common mistake that I was making. As an investment manager, I’ve shorted dozens of businesses in all sorts of other sectors because they’ve made the exact same error. And yet, as often happens with business leaders, I was so caught up in my own passion and the work of bringing it to life, I couldn’t see that, just like those other failed companies, I had neglected to account for a relatively important factor in the success of any venture.
My customers.
I could write a whole book on the misadventures of that first restaurant. It would definitely be a comedy, even though it might make me cry to relive it all. Like how I signed the lease on a location in downtown Mill Valley, California, exactly one week after the 9/11 attacks (not exactly a propitious time to open an eatery). Or how I guaranteed a credit card for my first chef and wound up on the hook for $10,000 for what I later learned were hair plugs (even though, as far as I could remember, he had a healthy mane of hair!). Then there was the time another of the five different chefs I went through decided to get into a good old-fashioned fistfight with one of the five different general managers I hired and fired in the place’s three years of existence. Thankfully, the altercation took place after closing, but it didn’t do much for the staff’s already low morale or mine. Neither did the time the overnight cleaning crew set off the building’s sprinkler system. After being called by the fire department at 3 a.m., I watched the sun come up while standing in ankle-deep water in the middle of our dining room.
Of course, every restaurant has troubles. But if you’re losing between ten and twenty thousand dollars a month of your own money, like I was, those troubles are a lot harder to put up with. I was shelling out the equivalent of an all-expenses-paid vacation to Cancun every week to lose sleep and babysit my dysfunctional kitchen team, not to mention the twenty-something GM I fired after he put a dish on the menu called “Airline Chicken” without consulting me. As he argued, that was the technical term for the cut of chicken purchased from our supplier. But would you order something called “Airline Chicken”? I didn’t think so. Neither did anyone else.
The thing that hurt the most, though, and kept me believing that we could turn things around, was that the food itself was out of sight. The CEO of Il Fornaio, Mike Hislop—one of the finest restaurant operators in the Bay Area—told me that he had one of the best meals of his life at my restaurant. He said the flavors were “explosive.” That was my opinion, too, and by that point I’d spent almost twenty years trying every Cajun food place I could find. And yet, as good as the menu was, I might as well have been serving blackened hundred-dollar bills for all the money I was losing. And you know what? It was my own fault. In the end, it wasn’t goofballs like my pugnacious chef or the “Airline Chicken” GM who caused the place to fail. It was me. I was making a classic mistake. I was mixing up what I liked with what my customers wanted.
Let me say up front that Marin County is gorgeous. The weather is great, the scenery is breathtaking, the air is ocean fresh. I can drive ten minutes and be on top of a mountain overlooking the rugged Pacific Coast. Another ten minutes and I’m at the beach. If I go fifteen miles in the other direction, I’m in San Francisco, one of the best cities in the world. But let’s be frank: Marin County is not terribly exciting. Most of the people are old and getting older. Sure, a lot of them used to be hippies and flower children. Some of them did amazing, even revolutionary things several decades ago. But when you get down to it, they’re really not that much different than elderly people everywhere. They might drive Priuses with �
��Free Tibet” bumper stickers instead of Buicks with NRA decals, but they’re just as stuck in their ways as your average retiree in Florida and Arizona.
Put simply, opening a place in Mill Valley that specialized in white southern cuisine was like opening a California cuisine restaurant deep in the bayous of Louisiana. It was just a bad fit. Most people in town half-expected me to hang a Confederate flag in the window. That was pretty much what the food represented to them: southern, fried, and fattening. In other words, the exact opposite of what most Marin County diners want to spend their money on. But because I loved the food so much, and because I knew that all of those preconceptions about it are wrong, I believed I could change their minds and bring them over to my opinion. Over a million dollars later, I finally got the message: they weren’t going to change.
After my place closed, the next tenant opened a restaurant with a fairly generic menu—salmon, steak, garlic mashed potatoes, salads, some pasta dishes. Even though there are probably three dozen places serving almost identical fare in the vicinity, their dining room is jammed every night. Meanwhile, two years after I gave up on bringing southern food to Mill Valley, I opened another Cajun place across the bay in Berkeley, a college town with a younger, more diverse, and food-savvy population. On average, I’d say the food is no better than my first restaurant’s. But this new business is booming. We just leased the space next door and doubled our square footage to accommodate the crowds.
There’s no doubt in my mind that my first restaurant was doomed from the start by my own stubborn belief that I could convince people in Marin to love Cajun cuisine as much as I do. That stubbornness cost me a lot of money. In my experience, I actually got away fairly cheaply, though. I’ve seen lots of other people and companies lose a hell of a lot more trying to market something their target customers wanted nothing to do with.
