Dead Companies Walking, by Scott Fearon is one of the most fascinating business books I’ve ever read. The author is a talented hedge fund manager with a great track record on both the long and the short side. His ability to spot “Dead Companies Walking” is a key part of his edge. Even for long only investors, the tales of what to avoid are valuable. The book describes 6 main reasons why companies fail:
1) Historical myopia: learning from only the recent past.
This seems to be most prevalent in cyclical industries, such as energy. The author’s formative experience was starting at a Texas bank right before the oil bust of the 1980s. People looked at charts going back only a couple decades, and assumed that prices would drop only to a certain level. Equally absurd assumptions can be applied to all sorts of metrics that people use in the investment decision making process.
2) Relying too heavily on a formula.
If a company follows a strict formula or metric, such as adding a certain number of stores annually, they can quickly find themselves making illogical decisions. Value Merchants, a retailer is an example used in this chapter.
Investors that rely too much on formulas can end up investing in zombie companies on the cusp of obsolescence. Various yellow page companies, for example, looked extremely cheap on an EBITDA basis in the early 2000s.
Relying too much on formulas an result in errors of omission. For example, investors may that relied on a strict valuation formula would have turned down Starbucks and Costco in their early days.
3) Misreading or alienating customers
Investors and executives sometimes assume that their targeted customer base shares their idiosyncrasies. Examples include JC Penney, Rollerblade, and Nordic Track. The executives of these companies, along with bullish stock analysts all assumed that they could get the masses to share their statistically unusual interests. Other cases include painful home blood tests to measure fluctuations in cholesterol, and an early on line business that marketed to elderly people.
The author himself made this mistake the first time he opened a restaurant. It was a Cajun restaurant located in a part of California populated by aging hippies who were too old to try something new. The business failed, costing him an enormous amount of money. Later he opened another Cajun restaurant in Berkeley, and it succeeded.
4)They fell victim to a mania.
This is a pretty common theme in the history of financial markets This book discusses it from the perspective of operating a company. The tech bubble is rife with examples. During that time companies with no revenue commanded massive market caps. Executives of those companies weren’t dishonest- the genuinely believed that their companies were on to something new. It didn’t turn out well for investors.
How to avoid falling victim to manias in financial stock markets.? Independence of thought is key:
“Effective Money Managers do not go with the flow. They are loners, by and large. They’re not joiners, they’re skeptics, cynics even. Whatever label you want to put on them, the trait they all share is that they don’t automatially trust that what the majority of people- especially the experts- are doing is necessarily correct or wise.”
5) Buggy whip syndrome: failing to adapt to tectonic shifts in an industry.
Blockbuster is the most prominent example in this chapter. It could have crushed(or bought) Netflix, but it didn’t properly invest in online operations. Instead it started selling candy in its stores, thinking that would somehow make customers drive far to overpay for videos rather than getting them easily in the mail, or online. Additionally, there were pager companies that insisted cell phones would not threaten their business models. Various yellow pages companies also fell victim to the buggy whip syndrome.
(I would argue that Western Union is a 2017 example of buggy whip syndrome- but more about that in a future post).
6) Executives that are physically and emotionally removed from a company’s operations.
Fearon is highly critical of aloof executives. Palatial offices, expensive suits, and frequent use of a corporate jet are red flags. One example was a residential construction supplier focused based out of a nice office in San Fransico, running a commodity business highly dependent on middle class Midwesterners. Another example is the failed turnaround at JC Penney, where a NY hedge fund manager and Silicon Valley executive attempted to remake JC Penney as a luxury brand, even though most of its stores were located in middle class parts of America. The CEO lasted 18 months, during which he worked out of his California home, alienating the workers at the stores and in the Texas headquarters, in addition to the customers.
Executives who are aloof generally have difficulty admitting mistakes. Frequently they’ll blame external factors such as the Fed, the weather, or shortsellers, rather than looking at their own decisions.As Fearon says: “If you aren’t willing to admit your own mistakes and misjudgements, you’re going to eat them for lunch.”
Another theme that is introduced in the chapter on historical myopia, and present throughout the book is “the doctrine of elite infallibility.” One of the most severe mistakes an investor can make is assume that because company insiders have great pedigree they will somehow make great decisions. One could fill a library with counterexamples. One notorious example is the Stanford accounting professor who was also the chair of the Audit committee at Enron. We all know how that turned out.
I’ll close with another great quote from the book:
“There is no one method or approach that makes for a successful investor. But there is one common trait that I believe all great investors share: intellectual curiosity. Good managers are broad-minded and intellectually curious. They are vociferous readers. They crave new ideas and when they hear them, they’re willing to try them out. They’re not afraid of something just because it is novel or disruptive.“