Dead Companies Walking

by Scott Fearon

  “For a whole year, we did the bare minimum to keep from getting fired and then we were gone,” he recounted. “It was actually quite nice. I went home at five every day. I saw my wife and kids a lot. I played golf three, four times a week.”

  Andrew Carnegie has been quoted as saying, “The only irreplaceable capital an organization possesses is the knowledge and ability of its people.” Too many high-level executives overlook this fact and underestimate how important employee morale is. They assume that they can mix and match peoples’ jobs, or move people seamlessly from one role to another, or even demote them to lower positions without any negative consequences. Then they wonder why their companies aren’t growing or producing as much anymore.

  A little over a decade ago, the so-called Four Horsemen of San Francisco investment banks—Hambrecht & Quist, Montgomery Securities, Robertson Stephens, and the Baltimore-based Alex. Brown & Sons—were each bought out by major financial conglomerates. These were all boutique but immensely profitable brokerages, and each fetched a massive buyout price. The big banks that acquired them assumed all those profits would magically shift over to their balance sheets. But what made the Four Horsemen great weren’t figures on accounting statements. It was the people and the culture that they had formed over the years. Each had a small number of smart, highly motivated employees who routinely put in 60- and 80-hour weeks. After getting swallowed up into giant, far-flung corporations like J.P. Morgan and Bank of America, many of those employees failed to take to their new bosses. They lost motivation and focus, and a large number of them took their expertise and their energies elsewhere. As a result, all four of those acquisitions wound up being huge money losers.

  M&A, Inc.

  Mergers and acquisitions are definitely risky methods for growth, but one party always makes a profit on them: the banks who facilitate the deals.

  Most acquisitions in the corporate world begin with a phone call from an investment banker. They’ll dial up executives and drop hints that another company might be interested in being acquired for the right amount. Then they’ll hype the potential benefits of the deal. The word that gets thrown around the most in these pitches is that old standby, synergies. As I mentioned earlier, this is one of the most trite and overused terms in business and investing. When I hear people mouthing it about a given company or companies, I frequently use that as a signal to study those companies further—not as potential investments but as stocks I might consider shorting.

  Investors frequently make the same mistake as merger-happy managements. They get so mesmerized by breathless headlines in the business media about acquisitions that they forget to turn the page on a company’s financial statements and evaluate whether countervailing factors like rising debt actually make such deals worth the costs. They also fail to evaluate whether proposed mergers actually make basic business sense. I was shocked when many respectable analysts praised the potential deal between Blockbuster and Hollywood Video. And yet Wall Street churned out all sorts of optimistic reports cheering the merger’s potential. The same thing happens all the time with companies caught up in the flawed formula of hypergrowth. They tout their aggressive plans for expansion, and stock buyers jump at the prospects of new revenues. But, as with Silk Greenhouse, those promised new revenues can easily fail to materialize. For these reasons, I generally prefer to invest in companies that grow organically, at a reasonable pace. It might be a slower, less flashy process. But it almost always means less risk and more profit in the long run.

  Notes

  *Chapman Capital LLC, Schedule 13d filing for Building Materials Holding Corporation, June 5, 2007.

  †Patrice Apodaca, “Why ‘Dr. Fix-It’ of High-Tech Firms Failed to Save MiniScribe,” Los Angeles Times, September 26, 1989.

  ‡Patrice Apodaca, “Sherman Oaks Businessman Found Guilty of Fraud,” Los Angeles Times, August 9, 1994.

  §Eamon Javers, “Is Snowden Effect Stalking US Telecom Sales?,” CNBC, November 15, 2013.

  ¶Bro Uttal, “Inside the Deal that Made Bill Gates $350,000,000,” Fortune, July 21, 1986.

  **“Turning Silk Greenhouse into a Sow’s Ear,” Businessweek, March 17, 1991.

  ††Pete Carey, “HP’s Acquisition Misstep Far from the First,” San Jose Mercury News, November 20, 2012.

  Seven

  Short to Long

  Rescuing Failing Companies

  History does nothing, it “possesses no immense wealth,” it “wages no battles.” It is man, real, living man who does all that, who possesses and fights; “history” is not, as it were, a person apart, using man as a means to achieve its own aims; history is nothing but the activity of man pursuing his aims.

  —Karl Marx

  Don’t shoot the messenger; analyze the message.

  —Anonymous

  Despite this book’s focus on failure in business, I have not made all or even most of my money from short-selling. As I’ve said, I am not a “perma-bear.” I don’t consistently short the markets and hope that they will fall. I am a classic hedge fund manager in that I make both short and long investments. And even though I haven’t talked about it much, I spend just as much time, if not more, seeking out companies to invest in for the long term as I do scouting failures on their way to bankruptcy.

  The key is flexibility. I try not to have a rigid view of things. I assess the numbers, I meet with management teams, and I do my best to make the correct call on a given stock, whether that means shorting it, buying it, or holding off. Sometimes I hit a home run. Sometimes I lose. But I always do everything I can to stay open-minded and willing to adapt to new information or circumstances. I believe this mental limberness is why my fund has consistently earned good returns, even though it has lived through some of the most volatile and unproductive business cycles in generations. Look at the 2000s. The stock market—after two massive collapses—was essentially flat for the entire decade. And yet my fund, even with a calamitous 2009 (which I will talk about later), managed to rise more than 100 percent after all fees during that lost decade for US stocks.

  I’m not bringing up these numbers to tout my success or pump up my ego. I’m doing it because, so far, I have probably failed to emphasize something that I deeply believe: failure might be more common than people like to admit, but it is not inevitable—even when things look irreversibly dire. I know I’ve presented numerous examples of smart people (including myself) making poor decisions. But the reality is that skillful leadership can, and often does, stave off disaster.

  In late 2013, on a business trip to New York, I was lucky enough to see famed fund manager Stephen Mandel give a talk to a group of visiting MBA students from my graduate alma mater, Northwestern. Mandel very generously shared some of the hard-earned lessons he’d learned over the decades he’d been in the investment business. Right at the top of his list was a very pithy maxim: “Managements matter.” Too many investors, he explained, get so lost in the weeds of a company’s financial results—recent earnings, projections, extrapolations, and other purely mathematical data—that they forget to study the thing that makes any company great (or terrible): the people running it. He called this fixation on evaluating numbers instead of flesh-and-blood managers going “Excel crazy.” As I listened to Mandel, I was taken back to my early days in Houston working under Geoff Raymond. He would constantly chide me for burying my head too deeply in financial disclosures and earnings reports.

  “Get up and go outside, Scott,” he’d tell me. “You’ll learn more in five minutes of talking to someone at a company than you will in a week crunching its numbers.”

  Both Geoff Raymond and Stephen Mandel were well aware that the wrong management team can ruin the most profitable, well-conceived business. On the other hand, they understood that the right set of executives can bring mediocre or even desperately ill companies
back to health. In my own career, I’ve seen plenty of corporate managers recognize the troubles they were facing and make the necessary choices to pull their businesses out of the fire. And I’m not talking about draconian, Frank Lorenzo–style turnarounds, either. Unlike Lorenzo, the executives that have impressed me the most have managed to avoid bankruptcy. And, also unlike Lorenzo, they have set their companies up for long-term health and success. A couple of times, these rescues have been so effective, I’ve even covered my short positions and turned around and bought the stocks involved. In other words, I’ve profited on the same company’s descent and recovery.

  A Bazaar Story

  Ever since Geoff Raymond and I drove out to see Jerry at Global Marine way back in 1984, I’ve visited scores of corporate management teams each year. All told, I’ve interviewed executives at more than 1,400 company headquarters since I started my hedge fund over twenty years ago. Often, I’ll go back to the same company repeatedly, even if I don’t own their stock, just so I can keep an eye on what they’re up to. This is especially true for companies in the Bay Area. I talked about Cygnus Therapeutics earlier. I dropped by its offices in Redwood City five times in eight years and never bought or shorted a single share of its stock. I figured I had no excuse for not keeping up with such a potentially great business that was in my backyard. And I felt the same way about a very different kind of company on the other side of the bay.

  Every year or two for more than a decade, I’ve driven across the Richmond–San Rafael Bridge to Oakland to spend some time with the people in charge of Cost Plus World Market (stock symbol: CPWM). Its headquarters near Jack London Square are housed in a drab, single-story building underneath an overpass of the 880 freeway. The area’s gentrified a bit since I first started going there, with some modern-looking condo towers going up nearby, but it’s still primarily an industrial and warehouse district. One of my favorite barbecue joints, Everett and Jones, is a few blocks away. I usually pick up a plate of ribs on my way home.

  Long before I became a money manager, I had a personal connection to Cost Plus. My father used to bring my brother and me along to San Francisco when he attended conferences there, and I have fond memories of walking from our hotel in Union Square through Chinatown and into the original Cost Plus location in Fisherman’s Wharf. That original location—which opened way back in the 1950s—was the first major treasure hunt retailer, and it was as much of a destination in San Francisco as Coit Tower or Golden Gate Park. Stepping through the doors was like going on a mini round-the-world tour. I can still smell the mix of teak and wood oil and wicker. You never knew what you’d find. It had exotic but inexpensive Asian furniture, weird crackers from Denmark, tins of Iranian caviar, handmade soap from Mexico. It was a complete grab bag. It was also the first American retailer to import cheap but high-quality wines from places like Chile and Australia.

  Given my nostalgia for Cost Plus, when it came public in the mid-1990s and started opening new outlets around the country, I was tempted to buy its stock. Unfortunately, so was everyone else. Buoyed by the crazy bull market of the dotcom mania, CPWM was already trading at $44 by the time I made my first trip to the company’s headquarters in 1999—on a mere 66 cents a share in trailing earnings. That’s a whopping multiple of sixty-seven if you’re scoring at home. (Remember, the multiples of Costco and Starbucks that scared me off of those companies were only in the thirties.) On top of that, no less than ten different analysts from major brokerages were hyping Cost Plus as a buy. I refused to join the herd given this sky-high valuation. But I continued to travel over the bridge every year or two for a plate of ribs and a meeting with Cost Plus’s management. That persistence wound up making me a lot of money, in unexpected ways.

  Not surprisingly, holding off on CPWM initially was a good decision. When the dotcom mania evaporated, the stock sank with the rest of the market. Within two years, it had bottomed out at $18. By the time I went back to Oakland in July 2003, however, the post 9/11 recession had ended and CPWM was back up to $40 again. The company had just hired a new chief financial officer, a friendly, stocky guy named John. I got to know John fairly well over the next few years, because I did in fact become very interested in Cost Plus as a potential investment. It was starting to look more and more like a dead company walking.

  For one, Cost Plus appeared to be subscribing to the risky formula of hypergrowth. It was up to 175 stores by 2003, and John told me management was planning to expand to 600 total in the near future. Even more troubling, I began to notice a shift in the way the company was doing business. Cost Plus got caught up in the housing mania of the time and started stocking more high-end home furniture and fewer quirky knick-knacks. As a result, its stores didn’t have the same feel. The only way I can think to explain it is that they just weren’t all that much fun anymore. Walking into a Cost Plus wasn’t like walking into the eclectic bazaar I remembered from my childhood. It was more like walking into an Ethan Allen showroom. As a longtime (almost lifelong) fan of the chain’s treasure hunt atmosphere, I suspected that the company’s management had decided to stop appealing to people like me. They seemed to want to attract a different, “better” kind of consumer. This was right around the time I was about to close my first restaurant, which meant I had just lived through a painful, firsthand lesson in how dangerous it can be to misread or alienate your core customer base—and Cost Plus’s leaders seemed like they were doing just that.

  The company’s numbers only heightened this suspicion. Its “comps”—same-store sales—were still growing year over year but at a slower clip. And while the average amount customers were spending (known as its “ticket”) was creeping higher, its “counts” were down, meaning there were fewer and fewer of those customers to speak of. Finally, its “turns”—the number of times individual items in its inventory sold out and were restocked—were dropping, too. That all made sense to me. If you’re stocking $800 luxury couches instead of funky $25 end tables, you’re going to move less inventory. The kicker for me, though, was the wine selection. When I came back to interview John again in 2004, he proudly informed me that Cost Plus was about to start stocking fine wines from Napa and France. He seemed genuinely surprised by my negative reaction.

  “People can get a thirty-dollar Napa Cabernet or a forty-dollar Bordeaux anywhere,” I explained. “That’s not what you guys are about. You’re about that great six-dollar Malbec from Argentina or that sweet eight-dollar Riesling from some obscure vintner in Australia. That’s why people have always gone to your stores, to find interesting, inexpensive things they can’t find anywhere else. Now you’re offering them the exact opposite. You’re giving them boring stuff that costs more money!”

  John defended the move with some data about consumer trends. But I didn’t buy it. I decided I was going to watch Cost Plus a lot more closely in the coming months. If its leaders kept up with this new strategy of offering more conventional and expensive goods, I was sure its results would continue to suffer and its stock price would inevitably fall.

  And fall it did.

  By my next visit in August 2005, the company’s comps had turned negative and its stock was down to $20, half of where it had been only two years earlier. During that meeting, John offered a whole raft of excuses for the poor results, including the costs of various promotions they had run, the severance package they had paid to their recently departed CEO, and even something he called “the Walmart effect.”

  “Walmart?” I asked incredulously. “You’re not even in their sector, John. The economy’s booming. Consumer spending is at record levels, and almost every retailer in the country is thriving. You guys are the exception. Don’t you think your problems might be internal?”

  John was silent for a moment. It seemed like he might have been considering my point. But then he quickly started back into the same explanations he’d already offered. I realized he was playing the same “blame game” I’ve seen executives
at troubled businesses engage in for my entire career. His Walmart effect argument in particular reminded me of the CFO of Consilium citing fluctuations in the M-1 money supply for his company’s problems, or the unseasonable weather excuses apparel companies perpetually give for disappointing sales, or the sluggish economy line all sorts of businesses put into their financial disclosures to paper over their issues. I didn’t begrudge John for trying to deflect responsibility, though. He obviously didn’t make the disastrous decision to turn a once vibrant, unique brand into just another stale luxury goods shop. He was just a loyal executive doing his best to put a good face on a clearly bad-and-getting-worse situation.

  I left that meeting determined to short Cost Plus if it dipped below $10. It took a little while but it did so early in 2007. I waited a few more months to make sure the downward trend continued, I pulled the trigger when CPWM hit $8. By February 2009, only twenty months later, the stock was down to 50 cents, and I was about as certain as I’ve ever been that it was heading all the way to zero. But, as with so many of my other assumptions in 2009, I was wrong. Very wrong. Out of nowhere, the stock started to creep up again. By September 2009, it was close to two bucks. I couldn’t figure out what was going on, so I got back in my car and crossed the bridge over to Oakland. The company had installed a new CFO since my last visit. Her name was Jane, and she turned out to be one of the most knowledgeable and transparent executives I have ever met.

  Jane had been promoted from within the company right around the time I shorted its stock. She was young and very bright. She was also refreshingly frank about the state of affairs at Cost Plus. She didn’t blame the company’s woes on Walmart or marketing promotions or even the latest recession. Without any prompting or obfuscations, she freely admitted that its problems had been entirely self-inflicted.