by Scott Fearon
I was inclined to short Chemtrak’s stock right away. I was fairly certain that its take-home cholesterol test would flop. But the fact that such an accomplished scientist and professional was so sure it would succeed scared me, so I decided to do a little more research before I made my decision. I sent a gofer who was working for me at the time to twenty drugstores around my office. I had him put a small nick on the packaging of the first five Chemtrak tests on the shelf at every location. He went back every other week for several months. At the end of this process, those first five tests in all the stores still had nicks on them. Not a single one had sold. That was all the proof I needed. I shorted Chemtrak’s stock. It quickly dropped below a dollar. But, as so often happens with failing companies, the company held out for way longer than I expected. Its stock didn’t go all the way to zero for another five years.
When I opened a Cajun restaurant in Marin County, I was too emotionally involved in my business. I was so excited to share my favorite food that I couldn’t see the plain fact that nobody else in Marin County wanted to eat it. Chemtrak’s management was much more cerebral in their approach. They had scientifically analyzed the health-care market and come up with a product they were convinced would fill an important need. The problem was, their analysis was just plain wrong. Even though heart disease is a major problem in this country, American consumers were simply not going to buy what Chemtrak was selling. Lots and lots of very smart people make this mistake. They fixate on some given set of data or analysis instead of the most important data set of all: how people in the real world behave. You can know everything there is to know about your industry—market trends, leading indicators, the latest technology—but if you don’t know your own customers, you might as well be trying to sell gumbo to gray-haired flower children.
Father Knows Best
My dad still lives in my hometown of Tempe, Arizona, but he comes out to visit regularly, especially in the summer months when the temperature in Arizona approaches the surface of your average white dwarf star. He’s a retired college professor, and he’s always been interested in investing, so sometimes when he’s in town, I’ll bring him along to meetings with corporate executives. It’s a fun way to spend some time together. And I appreciate the company while I’m on the road.
One morning in 1999, we drove across the Golden Gate Bridge and through San Francisco to a business park built on a spit of land, called Oyster Point, that sticks out into the bay. A company called PlanetRx (stock symbol: PLRX) had its headquarters there and I had an appointment with the CFO, a fellow named Steve.
This was during the heyday of the dotcom boom, when everybody and their brother was crowing about things like “the new economy” and predicting the end of brick-and-mortar retail. It was a crazy time, and it brought on the most irrational and inflated asset bubble in the history of capitalism. I’ll talk more about that later. For now, I’ll stick to my morning with my father and PlanetRx’s CFO. Steve invited us into his office overlooking the bay and told us all about how his company was going to remake the drug business the way Amazon.com had remade the book business. Instead of schlepping to the local drugstore, he explained, people would simply log on to PlanetRx’s website to order prescriptions and have them delivered straight to their door.
“It’s so easy,” he boasted as he demonstrated on his laptop. “You can do everything with a few clicks of the mouse.”
He then launched into a short presentation of the company’s projected earnings. Of course, it was wildly optimistic. PlanetRx was on the verge of “scaling,” he claimed, or rapidly growing its revenues. That was the big buzz word at the time. I didn’t interrupt him or question his figures. The dotcom mania had been flourishing for three years by then. I was used to those kinds of, shall we say, enhanced prognostications. The whole Bay Area economy had blown up bigger than Barry Bonds’s hat size. To my surprise, though, my father did clear his throat and chime in with a question.
“Excuse me, sir,” he said. “If I were to use your service, how long would it take for my medication to arrive?”
“It depends on where you live,” Steve replied. “In most of the country, it’ll get there in 24 to 48 hours. For more remote places like Alaska or a small town in South Dakota, it might be more like three days.”
“But I can drive down to the local drugstore and get my pills in fifteen minutes,” my father countered.
“Maybe so, but with our service, you don’t have to leave your house.”
“But with your service, I have to wait two days, maybe three!”
They went back and forth like this for a good five or ten minutes. I couldn’t believe what was happening. I just sat there with my mouth open and watched my father debate this executive. It was actually quite enjoyable. A lifelong academic, my dad has developed a very strong and finely calibrated BS detector. And as he was discovering in that office on Oyster Point, BS was the chief product of the dotcom industry in the late 1990s. He pointed out to the PlanetRx CFO that the majority of people who used prescription medications were senior citizens like himself.
“By and large, that population isn’t very comfortable using the computer to shop,” he explained. “Most people in their sixties and seventies don’t even know how to do it. How do you expect to make any money when your main customers can’t even figure out how to use your service?”
“Easy. We’ll teach them. People learned to use Amazon.”
“But Amazon sells books. You don’t need a book. You can wait a few days for it to show up. If you go days without your medicine, you get sick.”
“People just have to get used to ordering their refills a little earlier, that’s all.”
“So you’re going to teach your customers to do that, too?” my father pressed him.
Steve pulled at his tie and adjusted his weight in his chair. I decided to let him off the hook and ended the meeting. As my father and I walked through the parking lot to my car, he turned to me and said, “You should keep your eye on that company, son.”
“What do you mean?” I asked. “It sounded like you disliked everything about it.”
“I did,” he replied with a smile. “Except for one thing. The furniture in their offices was much nicer than the stuff in your office. I’ll bet you’ll be able to buy it for ten cents on the dollar when they go broke.”
I never shorted PlanetRx. In those heady days of the dotcom boom, shorting tech stocks was a scary proposition. Just about every company in the industry was enormously overvalued. I knew there was almost certainly a crash coming. It wasn’t a question of if, but when. But predicting when exactly when that would arrive was impossible.
I did, however, take my father’s advice and keep an eye on PLRX. At the time of our visit, the company had next to nothing in revenues, yet its stock had been flirting with $40 a share. But the high times didn’t last long. Even with the dotcom boom still going strong, the company’s poor sales started to scare investors. Its stock slowly inched down after our meeting. Then it cratered. In mid-2000, barely a year after my father debated the CFO, PlanetRx laid off a large portion of its staff and moved to Memphis. As we used to say in the business before stocks were listed decimally, the company’s stock went “hat-sized,” meaning it sold for a fraction of a dollar.
The reason for PlanetRx’s demise is quite simple. It only took my father a couple of minutes to spot it. The very consumers the company planned to serve had absolutely no interest in what they were offering. In some ways, PlanetRx failed for the same reason my first restaurant did—its founders confused their own tastes with the tastes of their target market. Like most tech companies, PlanetRx was launched by a bunch of techies who used the internet for just about everything they needed. They assumed that your average grandma and grandpa out in Middle America would share their love for the convenience of online shopping. But, as my dad so astutely pointed out, senior citizens
aren’t exactly early adopters of technology. More important, the service PlanetRx was offering was actually less convenient than the method people were already using! In that regard, PlanetRx was very similar to Chemtrak. Its founders had analyzed their industry. They had come up with all sorts of impressive numbers and projections showing that their product would fill a profitable niche. But, as with Chemtrak’s management team, they hadn’t analyzed the thing that would make them money: the way people in the real world actually behave.
This failure to account for real-life human behavior also brought down the most overhyped company of the dotcom bubble (besides perhaps the still unbelievable Pets.com), Webvan. If you aren’t familiar with the story, Webvan delivered groceries. Despite that modest premise, it managed to raise and then blow hundreds of millions of dollars in a few short years. I was not dumb enough to invest in Webvan. I was even dumber. I invested $50,000 of my own money in a copycat business, a small start-up in Texas called Groceryworks. A buddy of mine pitched me on the company. His main selling point was the long distances between most homes in Texas and the nearest grocery stores. Having lived in Houston, I knew what he was talking about. Sometimes just going out for a gallon of milk felt like a sequel to On the Road. I thought people would be willing to pay to avoid that hassle.
I thought wrong.
The shoppers who buy the most groceries have families. They’re usually moms, though there are plenty of dads who shop now, too. And for parents, purchasing food is not like purchasing any other product. We’re talking about the stuff that sustains and nourishes your children. Making sure that you’re getting the best quality merchandise is not just important, it’s an instinctual drive. There’s no way you’re going to trust a website and some kid out in a warehouse somewhere to do it for you. Think about a mother who plans to serve fish for dinner. She has to see that tuna steak or that fillet of salmon. She has to pick it out herself so she can make sure it’s the right color and that it doesn’t smell like it’s been sitting in the display case for a week. If she doesn’t do that, she’s going to feel like a bad mother. That’s not an exaggeration. It’s how people are. You can’t get around human nature no matter how cool and easy-to-use your website is. We’re talking about parental instinct here. That’s a powerful force. And it completely trumped the benefits of shopping online for groceries.
Redelivered
Unlike Webvan, the grocery delivery company I invested in, Groceryworks, didn’t go completely under. It was acquired by the supermarket chain Safeway. I received a check for $9,000 after the deal was completed—better than nothing, but less than 20 percent of my original investment. Ouch. The service went on to become a seldom-used perk for the small amount of Safeway’s customers who preferred to have their groceries delivered.
Recently, companies like Amazon have gone into the grocery delivery business. But, as with Safeway and Groceryworks, these delivery offerings are ancillary services that will likely never make substantial profits. Most shoppers, especially those with families, still want to inspect the food they buy, and they’re simply not going to trust a stranger in a distribution center to choose it for them.
In Amazon’s case, its “Fresh” delivery service gives customers the added convenience of adding a couple boxes of cereal and some cans of tuna fish to their orders for other consumer items. But I doubt Jeff Bezos and other Amazon executives are seriously banking on it to bring in real money. Groceries have low margins to begin with, and Amazon is competing with major players like Walmart. If anything, Bezos might see grocery delivery as a loss leader, a way to drive users to Amazon’s platform so they’ll order more profitable products.
As with a lot of the stories I share in this book, the flaws in Webvan’s and PlanetRx’s business models might seem obvious as I write about them. But they couldn’t have been that obvious at the time, because a lot of very smart people poured a whole bunch of money into the businesses. When it launched its website, PlanetRx had hundreds of millions in venture capital behind it. At one point, its market capitalization reached into the billions. Even after its stock started dropping, there were still plenty of analysts and other experts recommending it virtually up until the day the NASDAQ delisted it. Webvan’s early backers included the same people who had funded Apple, Google, and PayPal. And its executives were absolute all-stars. The founder started Borders Books. The CEO came over from Arthur Andersen. These were not dumb or inexperienced people. They were just so caught up in the mania of the dotcom boom and the almost cultlike conviction that the internet would remake every industry that they forgot to think about—or study—how actual people in the actual world behave. But this kind of mistake didn’t start or end with the tech boom in the 1990s. It happens all the time.
Indeed, failure is one business trend that never goes out of style.
Notes
*Matt Brownell, “JC Penney CEO Ron Johnson Out,” DailyFinance, April 8, 2013.
Four
Madness and Manias
Men, it has been well said, think in herds; they go mad in herds, while they recover their senses slowly, one by one.
—Charles MacKay, Extraordinary Popular Delusions and the Madness of Crowds
In my thirty years of running money, I’ve lived through several historic asset bubbles, otherwise known as manias. I’ve already recounted some of my experiences during and after the housing craze of the mid-2000s. I also had a front-row seat for the last days of the East Texas oil boom. But nothing compares to the dotcom delirium of the late 1990s. Thinking back on those years is like remembering a weird dream. For half a decade, Silicon Valley turned into nothing less than a business world version of Jonestown. The Kool-Aid wasn’t lethal. But it was very potent, and people were drinking it by the gallon.
I remember one particular meeting that captured the mood of the era. In March 2000, I drove to San Mateo to speak with some executives of a website company called Women.com (stock symbol: WOMN). It specialized in content related to, you guessed it, women. Theoretically, the company made money by selling banner ads on its sites. But even after several years in business, no one had figured out how to turn that theory into real-life revenues. Like PlanetRx, Webvan, and just about every other dotcom company at the time, the only thing Women.com excelled at was spending its investors’ cash. Of course, that didn’t stop its stock price from shooting up way higher than it had any right to.
Women.com’s CEO was a petite, fast-talking young professional named Marleen. She showed me a slide deck on her laptop of the company’s various web portals. They had sites that dealt with pregnancy, parenting, fashion, cooking, careers, and dozens of other topics—pretty much anything and everything a web-surfing female might be interested in.
“We’re one of only two companies in the country targeting this demographic,” Marleen explained with a winning smile. “We’re extremely well positioned.”
She went on to describe that women were the fastest-growing population of internet users and how Women.com intended to continue to appeal to them. Then came the usual preposterously optimistic revenue projections and the mandatory talk of scaling.
When she was finished, I asked her a single question: “If I buy 100,000 shares of your stock tomorrow morning, and a year from now it’s lost half its value, why would that have happened?”
“You mean what could go wrong?” Marleen asked.
“Yes.”
“Quite frankly, Mr. Fearon,” she said, “nothing. We’ve looked at all the data, and we’ve discussed this very issue at the board level and we all agree: there’s just no way we can lose.”
She smiled even more brightly now. I cleared my throat to give her a minute to elaborate, but all she did was continue to grin.
“So you’re saying there is no chance that anything will go wrong for your company in the next year?”
“That is exactly what I’m sa
ying,” she beamed. “We’re going to have an incredible year. And the year after that will be even better.”
At the time, a share of WOMN was trading for around $15. Ten months later, it was about 70 cents. Before a full year had elapsed after my meeting with Marleen, Women.com had ceased to exist. It was bought out for pennies a share by its chief rival, a company called iVillage (stock symbol: IVIL), which was also circling the drain. iVillage’s descent had been even more dramatic. Its stock broke the $100 mark at the height of the boom. By the time it acquired Women.com, you could buy a share of IVIL for less than two bucks.*
Not everyone in Silicon Valley got caught up in the hysteria. My good friend Bandel Carano is a long-standing investor in my fund. Bandel’s the senior partner at a venture capital firm in Palo Alto called Oak Investments. He’s one of the shrewdest evaluators of start-ups in the country. For the last twenty years, we’ve been meeting for lunch twice a year down on Woodside Road, either at Buck’s or the Village Pub. At one of these lunches in the late 1990s, Bandel was beside himself.
“None of these companies are ever going to make any money, Scott,” he told me as we ate our salads. “But people just keep pouring capital into them.”
He ticked off a dozen names of now-infamous dotcom busts that were, at the time, swimming in venture capital money. One of the companies he mentioned was Webvan, which really got Bandel’s blood up. He and the other guys at Oak had passed on funding it early on. But just about every other VC firm in the valley was writing seven-, eight-, even nine-figure checks for it.
“It wasn’t a hard decision for us to say no,” Bandel said. “It was easy. We studied their proposal and right away we knew there was no way they would turn a profit in a million years. None. It was obvious. I don’t know what kind of math people are using anymore, but it’s not the math I learned in school.”
