Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity in Unexpected Places Hardcover – January 6, 2015

Republished from the February issue of my newsletter Mayer's Special Situations:“Failure is one business trend that never goes out of style.” — Scott FearonScott Fearon is an investor who built the foundation of his success on the bedrock of failure. “Things go wrong more often than they go right,” he writes. He calls this insight “the single most important lesson about business and life.”On the plane rides to and from Switzerland, I read his book Dead Companies Walking: How a Hedge Fund Manager Finds Opportunity in Unexpected Places. It is a fun read as he takes you through how he figured out what companies would fail well before the market did.“My specialty,” Fearon writes, “is identifying what I call ‘dead companies walking’ — businesses on their way to bankruptcy and a zeroed-out share price.”He’s good at it, too. His fund has delivered 11.4% annual returns since inception in 1991 — way ahead of the market overall. As a hedge fund manager, he shorted over 200 companies that eventually went bankrupt. (A short seller makes money when stocks go down.) Even if you never short a stock in your life, you’ll still enjoy this book — if only to help you avoid such disasters.An important point in this book is that failure due to fraud or the passing of some fad is relatively rare. Far more common are just plain-old failures,a naturally occurring phenomenon, born of mistakes people make.Failure, Fearon writes, “happens every day to some of the smartest people in the world.” Fearon has also had his share of failure, as he cheerfully admits, and not just in his fund. He’s opened two restaurants, one that failed.He shares six common mistakes he finds these failures make:They learned from only the recent past.They relied too heavily on a formula for success.They misread or alienated their customers.They fell victim to a mania.They failed to adapt to tectonic shifts in their industries.They were physically or emotionally removed from their companies’ operations.Fearon takes us through a number of fascinating examples of each of these.As to No. 1, people do learn from the past, he says — but only the recent past. He tells a story about meeting with the CFO of Global Marine, an owner of offshore drilling rigs. This CFO is unworried by the drop in rig utilization rates. He shows Fearon a chart that shows how every time the rig utilization rate hits 70%, it rallies and recovers.This chart covered just over two decades. In the grand scheme of things, that’s really not a lot of time. And Fearon points out that just because a trend has continued for a really long time doesn’t mean it will always be that way. Needless to say, Global Marine’s rates went well below 70%, and the stock went bust.It seems simple, but it’s amazing how many times smart people suffer from historical myopia. “Failure terrifies people,” Fearon writes. He goes on to note:They’ll do whatever they have to do to downplay it, wish it away and just plain pretend it doesn’t exist. Most of the time, they’ll go on living in denial long after the truth of their predicament becomes obvious.I think this is certainly true. I think it is especially true of corporate executives. Fearon writes that he’s had over 1,400 meetings with executives and declares they almost always err on the side of optimism.As for No. 2, he has a great personal example of how he didn’t invest in Starbucks in the early 1990s. If he had invested, he’d have a 100-plus-bagger just 22 years later. But he missed it because he was too much a slave to his own formula.He used a growth-at-a-reasonable price formula to picking stocks. Starbucks didn’t meet his formula and he passed on it even knowing it was a special company. So he missed a once-in-a-lifetime opportunity that was sitting right in front him.He also talks about businesses commit No. 2 by thinking they have a winning formula and then being unable to see its faults. They roll it out too quickly and the whole enterprise goes belly up. Restaurants and retail chains that seek to double their number of stores in a year is an example.In the course of these case studies, Fearon works in a number of other tidbits of investor wisdom. Take the example Value Merchants. It is a discount retailer that seeks to double the number of stores it has in a year. The CEO is a super-competitive guy. Wakes up at 4 a.m. Runs marathons. Impresses everybody he meets.Fearon hears from other investors about how you don’t want to bet against a guy like that. But in Fearon’s view, being extremely competitive is one of the worst traits you can have in markets.“Competitive types think they can will their way to success,” he writes, “no matter what. But no amount of will can counter a doomed formula — like doubling your number of stores every year.”It can take time for these dead companies to play out. And the enthusiasm of know-nothing investors can carry a weak stock for years. “Time after time,” Fear writes, “I would study a company’s financial statements and be mystified that its share price was anywhere over a penny. And yet people would still be buying the stock.”Turning to No. 3, look no further than Ron Johnson and his debacle at J.C. Penney. He tried to change the store into a hip place that wealthier, upper-class people would shop at. He cut out coupons, got rid of plus sizes and Spanish advertisements. He alienated much of the customer base. We know how this ended — with JCP almost brought to its knees and Johnson’s firing. But this is not an isolated example, and Fearon gives us some entertaining case studies on the theme.On No. 4, there are several funny stories on companies caught up in different manias. One of my favorites is his meeting with the CEO of Women.com, named Marleen:“If I buy 100,000 shares of your stock tomorrow morning, and a year from now it’s lost half of 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.”My goodness. At the time of the meeting, Women.com was $15. Ten months later, it was 70 cents, and within a year,it ceased to exist. No way to lose, indeed. But this is what happens in manias. Stubborn optimism rubs out facts. People forget to do simple things like arithmetic. And downside risk becomes inconceivable.“At their cores,” Fearon writes, “manias are about storytelling. People become enchanted with a story, and they convince themselves — and each other — that it just has to be true no matter what.”We saw it in the tech boom. We saw it in the housing boom. We saw it in the commodity boom that drove oil and other commodities. People begin to craft a narrative that defies common sense and history. There was a “New Economy.” Housing prices never go down. And “Peak Oil” meant the end of cheap oil. People who believe these kinds of things get clobbered. “Manias happen all the time,” Fearon writes.I’m not going to recount all six mistakes. I’ll just recommend that you read the book. It’s an easy read and entertaining as well. It peters out with a preachy last chapter, but otherwise, I enjoyed it.A running theme in the book is what makes a good investor. One of these traits is being a good quitter. The best investors are the best quitters, Fearon maintains. They don’t get sucked up in their own ideas. When things go badly or differently than they expected, they bail. The investors who get tangled up in their own harpoon lines as they obsessively chase their own white whale are the ones who eventually drown.Fearon cites Peter Lynch’s line about how the best you can hope for is to get six out of 10 ideas right when it comes to picking winning stocks. “Think about that for a second,” Fearon writes. “The man most people credit as being one of the greatest, if not the greatest, investor we’ve ever seen readily admitted that he was wrong almost as much as he was right!”Therefore, quit early and quit often, Fearon says. No matter what, you are going to get to know failure really well if you invest in stocks. It’s inevitable. It’s natural. And so you better get comfortable with failure, and plenty of it.Success, as Fearon shows, depends on it!

Scott’s book reaffirmed some of my thoughts on overvalued companies and spotting trends coming to an end. The most difficult lesson for me to swallow is how the rich decide when a company goes broke, not the market. Ouch.

First, the book is well written and an enjoyable read for a financial book. It is full of case studies and background stories from the author's own experience in shorting stocks over his 30+ year career. In both the storytelling aspect and the teaching aspect the case studies are quite good at illustrating his points. Where the book starts to fall down is in the last two chapters, the author goes off the rails a bit in his attacks on wall street and active managers. It is not consistent with the theme of the book which is to find successful shorts and why companies fail. It is more like "why my track record worked and the rest of wall street are crooks."Also, while Mr. Fearon's track record is good, there is a lot of apples and oranges aspects to it, and I think it is intellectually inconsistent to compare a long / short, do anything small, cap oriented hedge fund with less than $400 million of average AUM to the S&P 500. It just doesn't make sense. If you are long short, you should not have the same degree of draw downs, and it would be helpful to know whether one has the ability to be net long or he ran a balanced book which was truly net neutral. Hedge funds are generally not constrained by turnover and most active managers are highly scrutinized in this area. My recommendation would be to tone down the "all wall street are crooks" aspect of the book, and probably explain a bit more about his mandate and why he found success. While hedge fund 101 may not be the purpose of the book, if that is the case, present your numbers vs a representative hedge fund index as well as the S&P, and show that you are in the top two quartiles of your category.Otherwise, it is a solid read, but the tone of the last two chapters detracted from the book. Hence, 4/5 stars. I would love to read a book about how he found success in running his portfolio and find out more about his mandate.

The take-home lesson of this book is to ask yourself what does the business do and is it profitable before investing? Unfortunately, most people will not have the privilege of interrogating management on a one to one basis like the author does. However, it is possible for the average investor to consider the business fundamentals to determine if this is a dead company walking.Within this book, it becomes clear that the author has a very in-depth knowledge of the companies prior to his meeting with management and the only reason he does meet with management is to ensure no competent manager has arrived following his appraisal who could potentially transform the company and therefore expose him to huge loss rather than gaining which is what he aims for profit.This highlights the drawback with this strategy for the average investor! To short a stock one needs to know with absolute certainty that nothing has changed but I am not sure how an average investor could do this? This is why I have given this book only 4 stars from the perspective as an educational book.

Most investment books aim to help you choose winning companies, in this book Scott Fearon takes the opposite approach and shows you how to avoid losers. It is short, pithy, entertaining, informative and, above all, readable. I really enjoyed it. If there is one key takeaway from this book it is that "things go wrong more often than they go right". Both investors and management need to react quickly and decisively to a failing strategy. For investors that means selling failing stocks rather than "double up, triple up, belly up". For management that means first acknowledging that there is a problem, addressing that problem, then formulating and implementing a new strategy. "Believing that you cannot fail is one of the best ways of doing just that." Know when to quit.The book describes Scott Fearon's career and goes into detail on some key successful investments and some failures. It has been written with a professional author so reads very well, and at 200-odd pages is short and too the point. It may not teach you anything new, but it reiterates sound advice in a new and refreshing way. As another reviewer stated it would bear re-reading.

Absolutely amazing, this book blew my mind away. This book is not about short selling as such but about red flags to look for in a short sell. He educates the reader on why the red flags lead to companies stock prices to fall. I like the way the book gets deeper into the financial topic by chapter. It starts off by telling you who the author is and where he began and how his foundations shaped his values and his trading approach. Then topics of ethics, business decisions and personality are discussed. It made me think about a stock ticker in a different way. The last few chapters I enjoyed the most, he talks about the financial market and economy as a whole and how the financial crisis has left a irreversible stain which could have been washed away but was delibaeraly not. Must read.

An interesting, amusing and insightful analysis of the author's experiences in investing, with a particular emphasis on shorting the stocks of companies that are heading for trouble. The author also discusses more general investing principles and does so in a wholly engaging way. I really enjoyed reading it and I've no doubt its messages will come in useful.

A very entertaining and insightful book written with great humour. Shame for the last two chapters that do not really belong to this book despite being serious topics on their own. Scott Fearson's putting the blame for his losses in 2009 on "helicopter Ben" sounds remarkably close to the M1 excuse so often ridiculed in the book...