Scott Fearon knows a thing or two about stocks — especially when it comes to shorting them. His firm, Crown Capital, has averaged an 11.4% annual return since its inception in 1991. And fortunately for us, Fearon has shared his experience and insights through his book Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity in Unexpected Places.
Here’s a few key insights from Fearon:
(I) “Frauds, Fads, & Failures”
According to investor David Rocker, the 3 types of businesses that go under are ‘frauds, fads and failures.’ As quoted by Fearon, “Most companies that enter bankruptcy fall into the third category. They’re just plain old failures, the result of bad ideas, bad management, or a combination of the two.“
To detect failure the author looks for 6 common mistakes by business leaders:
- Only learning from the recent past
- Relying too heavily on a formula for success
- Misreading or alienating customers
- Falling victim to mania
- Failing to adapt to tectonic industry shifts
- Being physically or emotionally removed from company operations
(II) Be wary of ‘Elite Infallibility”
The author writes:
One of the primary causes of this unrealistic optimism in the corporate and investing worlds is an almost slavish faith in the capabilities of our country’s elite. People seem to think that a degree from a top university inoculates its holder from failure. I can’t tell you how many times stock analysts and fellow money managers have tried to convince me that a clearly troubled company would turn around simply because its CEO was a graduate of some distinguished school. “He’s Harvard MBA,” they’ll say in almost reverential tones, or, “He graduated cum laude from Princeton” – as if those facts alone would be enough to offset overwhelming evidence that, despite their impressive backgrounds, they were running their businesses straight into the ground… Whenever I hear this special pleading, I think of a guy named Robert Jaedicke. He was an accounting professor at Stanford when I was an undergraduate there. Shortly after I graduated, he became the dean of the business school. He parlayed that prestigious position into a number of lucrative seats on corporate boards, including the chairmanship of the audit committee for Enron. Jaedicke began that job in 1985, around the time I saw Ken Lay speak in the Transco Tower. Jaedicke held the job all the way until the company blew apart in 2001 in the biggest accounting scandal in American corporate history. In retrospect, it’s obvious that the only thing the board of Enron managed to audit in all that time was the buffet tables at their meetings. But right up to the end, the impression that such a distinguished figure from a top school like Stanford was overseeing the company’s books gave an awful lot of Enron investors a dangerously false sense of security.
(III) When betting against a ‘dead company walking’, it’s okay to be late
Shorting stocks is not for the faint-hearted. It takes a greater amount of skill to make money on the short side (especially if you’re betting on a company going to zero) than on the long side.
Because the market is long-biased (due to optimistic tendencies and a majority of long-only participants) shares of ‘junk companies’ can often stay afloat and ‘live well past their expiration dates.’ Short-sellers have to understand this reality and the opportunity costs and risks involved with it.
Short squeezes are also common and tend to shake short investors’ conviction and tolerance. As Fearon shared:
Sometimes it’s not irrationality that keeps the stocks of troubled companies afloat, it’s raw aggression. So-called momentum investors will seek out stocks at or near their 52-week highs that also have a good number of short investors. They’ll bid the price up even more, hoping to scare short-sellers into exiting their positions en masse, which serves to inflate the stock even further. It’s called a short squeeze, and it’s a brutal thing to live through when you’re on the receiving end. By waiting until a stock has already fallen more than half its peak value, I may sacrifice some potential gains, but I make more over the long run by avoiding these sorts of risks.
(IV) Wall Street’s inherent flaws – something to note
Fearon also makes a rather grim comment on Wall Street, whether you agree or not. He writes:
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.
Overall, the book is an insightful and easy read. It can refresh a veteran investor while at the same time pique the interest of an amateur. The book doesn’t cover the technical parts of the investment process, but it thoroughly explores the qualitative and psychological aspects of a stock picker that’s hunting for gems (or junk in this case).
To learn how the Macro Ops team uses shorting tactics in our own investment strategy, click here.
Co-Founder of Macro Ops. Alex is a former US Government Counterintelligence Professional, U.S. Army Interrogator, and USMC Scout Sniper. He’s an independent trader with over 10-years in markets.