Dead Companies Walking

by Scott Fearon

  You may recall that loads of banks back then had been “lending on iron,” meaning they gave out loans to energy companies using oil drilling equipment as collateral. After the price of oil crashed, almost all of those loans went bad and the “iron” used to back them up was virtually worthless. First National, like just about every other bank in the region (including my own, as I was soon to find out), was in desperate need of a cash infusion. Suddenly, its mysterious plan to spin off its data-processing service seemed a lot less mysterious. The company stood to make millions on the offering.

  The third phone call I made that day was to the brokerage handling the stock offering, Montgomery Securities in San Francisco. The institutional salesman there who had recommended the stock was named Rick. Like just about everybody else at Montgomery, Rick was an aggressive pitchman. The word bulldog gets thrown around a lot, but I don’t think that quite captures the level of mindless tenacity the brokers at Montgomery brought to their work. Picture an angry hyena that hasn’t eaten in a couple of days. Now picture someone throwing a bloody porterhouse in front of it. That’s how hard these guys sold their deals.

  After I introduced myself, I told Rick about the research I had done and informed him as courteously as I could that I would not be recommending the stock.

  “The bank is on the verge of insolvency,” I explained. “If they’re this new company’s main customer, that’s not going to be good for their earnings or their share price.”

  Rick barked into the phone, “How old are you, kid?”

  I swallowed hard and replied, “Twenty-five.”

  “You’ve got a lot to learn,” Rick growled. “Nobody stops me from collecting a commission. I’m not going to waste my time talking to you. I’ll call your boss first thing in the morning.”

  The line went dead. I stared at the receiver in disbelief. I didn’t understand what had just happened. I had informed a representative of a prestigious, well-respected brokerage that a stock they were offering had significant downside risk. I had assumed that he would be grateful for my insights, or at least interested in what I had to say. Instead, he had acted like I had belched in his ear.

  In reality, Rick was right: I did have a lot to learn. The idea that someone on Wall Street would give a damn about the truth or doing the right thing by his clients was almost laughably naive.

  True to his word, Rick did call my supervisor first thing in the morning and convinced him to buy $2 million worth of First Data Management’s IPO for our trust accounts. Needless to say, the stock did not perform well. Two years after my phone call to Rick, First National was seized by the government. With its main customer insolvent, First Data Management scraped by for a little while longer before it was bought out by a larger competitor for a fraction of its IPO value.

  My boss was not a bad money manager. Far from it. When I showed up at Texas Commerce, he had an outstanding investment record. Unlike most of the fund managers in Texas at the time, he had stayed clear of energy stocks during the oil mania, so after the bust our funds significantly outperformed our competition. But for all of his talent, he also had a critical weakness: he thought he had friends on Wall Street.

  After he brought me out to San Francisco with him to work at GT Capital, he bought into two more ill-fated stock offerings on the advice of another Wall Street “friend” at the brokerage Hambrecht & Quist. One was SHL Systemshouse (stock symbol: SBN). The other was Westwood One Radio (stock symbol: WON). Just like First Data Management, they both quickly crashed. The brass at GT Capital were not pleased.

  My boss thought his friends were looking out for his best interests. The opposite was almost certainly true. They knew they were passing off garbage, and they called him because they knew that he might be trusting enough to take it off their hands. After almost three decades in this business, I can say one thing without reservation: people on Wall Street are not looking out for anybody’s interest but their own, and they often take care of those interests by screwing someone else. Many are, by and large, very bad people. But my boss made an even bigger mistake than trusting the morals of his Wall Street pals: he thought they possessed some kind of superior insight for picking stocks.

  Firms like Montgomery Securities and Hambrecht & Quist were famous for hiring the best and the brightest to work in their research departments—smart, highly ambitious go-getters from places like Princeton, Yale, and Stanford. The brokerages would vastly overpay these whiz kids to “analyze” the companies they were underwriting. And by analyze, I mean they paid them to concoct impressive-sounding facts and figures for salesmen like Rick to use to convince fund managers that those companies were good investments. Sometimes, as with the Shoney’s franchisor, this research actually turned out to be true. Just as often, if not more so, it was bogus. Take First Data Management. Here I was, a twenty-five-year-old greenhorn straight out of business school, and it only took me one afternoon to figure out that that stock was a likely loser. And yet, according to Montgomery’s all-star analysts, it couldn’t fail.

  After thirty years of doing this, I can tell you in no uncertain terms that buying stocks on the word of so-called experts is the single biggest mistake an investor can make. If somebody tries to tell you that they know something special about a given stock or the wider financial markets, they’re probably either (a) doing something illegal or (b) trying to scam you. Either way, you would be a fool to follow their advice. I’m not saying you should always ignore stock tips, even from untrustworthy sources like institutional salesmen. But you have to remember Ronald Reagan’s famous adage—trust, but verify. My boss forgot that crucial second step. He let those salesmen schmooze him into believing that they knew something about those stocks that nobody else knew.

  Money managers have wised up a great deal since the 1980s when it comes to relying on advice from broker-dealers like Montgomery. By and large, we’ve learned our lesson. But Wall Street still manages to find plenty of suckers. The entire country of Iceland went bankrupt in the late 2000s because a handful of bankers there committed the same mistake my immediate boss at Texas Commerce did: they picked up the phone when some institutional salesmen called with supposedly can’t-miss deals. Of course, in that case, brokerages like Goldman Sachs and Lehman Brothers were peddling billions in subprime mortgage bonds instead of a couple million in some cash-strapped bank in Oklahoma. But the results were the same. Like my old supervisor, the bankers chose to believe that Wall Street experts had devised new, sophisticated methods for beating the markets—and the whole country went to zero because of it.

  Dim Bulbs

  You hear the phrase “the best and the brightest” all the time these days. But most people don’t remember that it was originally meant as an ironic dig at the arrogance of our country’s elites. It was the title of a book by David Halberstam about how Ivy League technocrats foolishly entangled us in the Vietnam War. In the years since Halberstam’s book was published, the words have lost their original irony. They’ve become a positive way to describe the latest generations of privileged, mostly Ivy League–educated elites. Most of those kids go into finance now instead of government or public service—and they have made as big a mess of our financial system as their predecessors did in Southeast Asia.

  This misplaced faith in Wall Street whizzes is a symptom of a much larger and more destructive problem in the investment world: the cult of the guru. Investors of all types—from fund managers to day traders to mom-and-pop savers hoping to boost their 401(k) accounts—are constantly looking for a market messiah, someone who’s figured out—once and for all—the magical formula for how to beat the Street. It is an understandable but self-defeating desire, because the people who actually possess these kinds of insights almost never share them. Think about it. Why would someone who has discovered an edge destroy its profitability by telling the world about it? And yet a never-ending cavalcade of self-promoters is able to convince peo
ple that they have an easy path to market riches.

  All my life, I’ve watched these types rise and fall. When I was a kid, a guy named Joe Granville was famous for giving his presentations with a parrot on his shoulder. In the eighties, Robert Prechter showed up on the scene with all sorts of charts and graphs and trend lines talking about Elliot Waves and Kondratieff Curves. Both these guys made fortunes selling newsletters and speaking at conferences. Granville once declared that he could use his system to predict earthquakes. He even named a time and date when Los Angeles would break off into the Pacific Ocean. Thankfully, he was as good at calling Armageddon as he was at picking stocks.

  Then there was Elaine Garzarelli, a hotshot young analyst at Shearson Lehman Brothers who became an instant star after she predicted the Black Monday stock market crash of 1987. She went on to make regular appearances as a commentator on television and even starred in a commercial for pantyhose. Her bosses were so eager to believe that they had found a once-in-a-lifetime genius, they handed her control of a giant mutual fund. A few years later, they had to fire her. She’d lost untold millions. In his book The Fortune Sellers, William A. Sherden analyzed her performance during the decade following the crash and found that she had correctly predicted the market all of 38 percent of the time.* As Sherden pointed out, for all of her supposedly sophisticated analysis and widely acclaimed acumen, Garzarelli would have made better forecasts if she’d just flipped a coin. She may have called the crash of ’87 and she may have been a charming guest on talk shows, but like so many other stock market celebrities, her actual investment record was abysmal.

  I could go on and on listing these types. There is never a shortage of them. After Garzarelli, there was the much ballyhooed Jack Grubman. During the dotcom mania, Salomon Smith Barney paid him $20 million a year for his analysis of the telecom sector. Much of this analysis involved praise for companies that were paying Salomon huge amounts of money for banking services. My favorite quote from Grubman was when he said that being objective was another word for being uninformed.† After the crash, we all learned just how little he cared for objectivity. One of the companies he hyped the hardest was WorldCom, which turned out to be a colossal fraud. Salomon later admitted to doling out special shares of hot tech IPOs to WorldCom executives.‡

  Unfortunately, even after this decades-long parade of one discredited expert after another, the cult of the guru is still going strong. All you have to do is turn on the television today or spend a few minutes on the internet, and you’ll see the latest generation of Granvilles and Prechters, Garzarellis and Grubmans.

  The Most Dangerous People in the World

  The financial world suffers from an inherent flaw: the people who work in it, by and large, are terrible investors.

  Number one: They’ve spent their whole lives going along to get along. They’re climbers, strivers, joiners, cheerleaders. (That’s how they got those good degrees and those prestigious jobs in the first place!) This makes them naturally prone to groupthink and all too susceptible to manias and asset bubbles.

  Number two: They are hypercompetitive, which keeps them from admitting failure and adjusting their strategies when things inevitably go wrong. This makes them all too susceptible to disastrous behaviors like averaging down and clinging to bad ideas.

  Number three: They worship rich and powerful people, so they automatically defer to authority instead of questioning popular assumptions. Again, this makes them susceptible to manias and asset bubbles. It also creates an even more destructive mind-set—once they themselves rise to positions of power, they see themselves as infallible and worthy of worship.

  Add it all up and there’s only one conclusion you can reach: these are the last people you want safeguarding your money. And it’s not just me saying this. The numbers back me up. The great author and investor John Bogle—who invented the passive index fund back in the 1970s—examined the average returns of equity mutual funds from 1983 to 2003. A dollar invested in those kinds of funds in the early 1980s netted just $7.10 in profits twenty years later. Over the same period, a dollar invested in the S&P 500 index, which Bogle’s Vanguard 500 Fund tracks, would have brought in over $11.50.§

  Think about those numbers for a second. The overseers of the Vanguard 500 merely invest in all the stocks of the S&P 500. Compare that to your average mutual fund, where you’ve got highly paid professional investors buying and selling individual stocks all day, every day. (And when I say highly paid, I mean it. Bogle has calculated the total fees and commissions reaped by the financial industry at more than $500 billion a year.) For all that extra effort, and all that extra expense, all of those well-compensated experts earned considerably less than an index fund whose managers did next to nothing.

  Not all money managers are doomed to eternal underperformance, just most of them. A handful beat the market consistently, even after all taxes and fees. Warren Buffet comes to mind. Peter Lynch, too. Not to brag or put myself in those guys’ class, but I think my twenty-three-year record as a hedge fund manager is also proof that the indexes are beatable. But finding someone who can do it for you year in and year out is next to impossible. While frauds mug for publicity on cable television, the really gifted money managers almost always go out of their way to avoid attention. Even if you can track them down, good luck convincing them to take your money. Most of them already have more than enough clients and, as I’ll discuss shortly, they know the dangers of growing their assets too large.

  I don’t know how else to put this, so I’ll just be blunt: If you are an individual investor, you should not under any circumstances trust your money to a Wall Street brokerage or investment management company. The vast majority of people in my business have the wrong temperaments for investing. So unless you are uniquely positioned to find that rare manager who can outperform the market over the long term, do what John Bogle has been urging people to do for decades: put your money in an index fund and leave it there. You’ll make more, and you’ll pay less in fees to do it.

  The attributes I listed earlier—joinerism, power worship, hypercompetitiveness, intellectual torpor—lead to some very common investment mistakes like averaging down and trusting the word of so-called experts. Worst of all, though, those qualities also cause far too many money managers to confuse success with the size of their assets. They think bigger is always better—and they screw their clients out of higher returns because of it.

  Back when I was in business school in the early 1980s, the big idea in economics was something called the efficient markets hypothesis. It was formed by University of Chicago professor Eugene Fama. To simplify it as much as possible, Fama said that all stocks are efficiently priced at all times. In other words, the collective wisdom of the marketplace correctly sets the value of all publicly traded companies. In general, I agree. I think the stocks of most companies are efficiently priced. That’s why I believe average investors should only put their money into index funds—period, full stop. However, during my time at Texas Commerce Bank in Houston and even more so afterward, I began to suspect a possibly lucrative flaw in Fama’s thesis.

  Early in my career, I noticed that the stocks of smaller companies are not always efficiently priced. The reason is relatively simple: most people in the financial industry ignore these smaller companies, and it’s awfully hard for the market to be efficient in pricing a stock if there’s no market to speak of for that stock. I exploited this fact to earn outsized returns back when I was running mutual funds for GT Capital, and I’ve continued to make profits as a hedge fund manager by taking advantage of it. But very few of my peers follow this strategy. You might wonder why. The answer is that they’re too greedy and vain to do so.

  Most financial professionals can’t resist maximizing the amount of money they have under their control. The more assets they bring into their funds, the more they make in fees. They also get the ego boost of putting a “b” instead of an “m”
in front of the “-illions” they manage. I can’t fault them too much. Who doesn’t want to make more money? But by sucking so many assets in the door, as the saying goes, they inevitably wind up limiting their own performance potential, thus shrinking the amount they earn for their investors. You might call it the asset-size paradox. It’s a fixed, if seldom discussed, rule of money management: Asset size is the enemy of return. The bigger you get, the lower your returns. That might sound contradictory, but it’s really a simple matter of liquidity and price efficiency.

  If you’ve got billions upon billions of dollars to manage, there’s no way you can invest in those smaller, less-efficiently priced stocks that defy Fama’s theory. There just aren’t enough of them out there to handle that kind of volume. The only options for deploying such massive pools of money are giant, well-known companies with huge market capitalizations. But—of course—everyone else and their uncle and their uncle’s friend Sal is already studying and evaluating and investing in those kinds of companies, too. That means there’s no way to profit from inefficiencies in price because there are no inefficiencies in price. As usual, there’s an old investment saying to capture this problem: when the microscopes come out, returns get microscopic.

  The best example of the asset-size paradox is probably Julian Robertson and his legendary Tiger Management Hedge Fund. The fund’s performance was phenomenal when it was still well under $1 billion. But Robertson kept pulling in more and more assets—the minimum investment in Tiger increased to a cool $5 million—and as the fund got more bloated, it started to act more like an overfed housecat than a tiger. In its last years, Robertson’s fund lost enormous amounts of money, including a reported $2 billion in a single day in 1998.¶ By the time it shut down in 2000, Tiger may well have lost more money in total than it had made. Interestingly, the fund’s CAGR (compound annual growth rate) was strongly positive over the course of its existence. Robertson biographer Daniel Strachman puts the figure at 31.7 percent.** But because he managed much larger amounts during the fund’s final few years, which were also its worst years, Robertson’s record in actual dollar amounts is much less impressive. Famed short-seller John Paulson suffered a similar fate. He made billions for himself and his investors by shorting the real estate market in 2008 and 2009. But after his assets exploded to the massive size of over $20 billion, he quickly stopped looking like a genius. His funds lost half their value in the single year of 2011, and they continued to slide in 2012.