Book Corner: Dead Companies Walking
Hard to think of a more relevant book right now
This is my third post in Book Corner, where I attempt to find investing lessons in any book I think is investing related. Post on Netflixed here and King of Content here.
Hedge fund manager Scott Fearon has all types of amazing anecdotes in Dead Companies Walking that are a constant reminder that skepticism pays and management groups and buy and sell-side research need to be challenged. While the book mostly describes companies in snapshots in time Scott researched during the 90s and early 2000s, I found myself thinking of many stocks that took off in summer 2020, captivated investors largely because of stunning short-term returns and now have fallen back to pre-COVID levels.
This book is mountains of proof that investor expectations are influenced by promotional management groups. I write in this blog a lot about how expectations drive valuation, so the stories here felt very pertinent in terms of thinking about why certain companies in this market have the multiples they do.
The structure of this book I really enjoyed as it’s a collection of stories from Scott’s career that explain why he takes so much stock (pardon the pun) in the following six red flags:
Management over-indexes on the recent past
Management uses a formula without appropriate nuance
Management alienates existing customers in favor of some vision of new customers
Management takes advantage of an ongoing mania
Management downplays industry changes
Management doesn’t show involvement in day to day operations
Scott’s approach is focused on talking to management teams and determining if their business plans hold water. When he sees any of the red flags above, he’ll take it as a sign to do more research and avoid long positions (and potentially initiate some short ones). Some examples I really liked in this book:
One oil driller C-level exec tells Scott that rigs always bounce back when they go below 70% utilization and shows Scott a two decade plus history of this trend occurring. Scott uses the weakness of the argument as a reason to short the company, which surprised me, as I think many investors today might see an argument like that as strong proof a correction is long overdue. Lesson: don’t trust historical trends to continue.
Scott notes how the former CEOs of JC Penney (JCP) and now bankrupt Building Materials Holding Corp. (BMHC) either lived far away from employees or didn’t have a good sense of on the ground conditions. One JCP story I liked - Ron Johnson when he came over from being head of Apple’s retail division was dead set on implementing many Apple like design practices. Ron decided to remove security tags from clothing (used to set off metal detectors for security) because they looked ugly. Theft immediately increased with no corresponding increase in sales. In the case of BMHC, the C-level team worked in a beautiful glass building right through the financial crisis. The CEO when Scott came to talk to him spent time showing him the amazing view of the Bay Area in an immaculate three-piece suit… all while the stock was tanking. Lesson: look for management groups with a good sense of customers and employees. Be skeptical of fancy headquarters and fancy clothes.
Scott talks to a healthcare company with a ground breaking cholesterol test:
After giving me a brief but authoritative report on the epidemic levels of heart disease in our country, and how lowering cholesterol levels was a crucial preventive measure, he delivered an astoundingly dense analogy: “Our research indicates that there are five million home pregnancy tests sold every year. Nearly all of those tests are purchased by women. But both men and women in America are concerned about heart health and cholesterol. Therefore, we are confident our sales will exceed five million units per year.
Lesson: Be extremely wary of total addressable market estimates. I actually read the above quote twice when reading this book as at first it didn’t seem that extraordinarily dense to me. But Scott goes on to make this point - women need to know if they’re pregnant as soon as possible. There is no time-sensitive need to know about heart or cholesterol metrics for most people. Using pregnancy tests to estimate the size of the market makes no sense in this case. I hear tons and tons of TAM estimates in decks and conference calls. It is probably the case that most of them are bullshit.
Scott talks about companies riding the wave of fads or niche markets like televised yacht racing, healthy eating or inline skates. In all cases, management groups think their passion will be shared by the world and it’s just a matter of time before everyone loves the things they love. Growth is assumed to continue for years and investors buy at prices that assume this growth. When results miss expectations, the stocks crash. Lesson: Sustainability of growth is an enormous consideration. When multiples are inflated, any fragility in sustainability displayed in results is going to crush prices.
Lest you think this book is mostly about shorting companies with suspect business plans (and many of the reviews on Amazon suggest this), I’d point out there is a lot of writing on either longs Scott missed because he was skeptical without good reason (Costco and Starbucks he spends many words on) or times he changed shorts to longs because management changed (ex. Zales).
Scott’s miss on Starbucks stayed with me because he wasn’t willing to change his mind in the face of conflicting evidence. One of Scott’s concerns on SBUX was that the company would be limited in how much they could raise prices if coffee beans became more expensive. “How much did you pay for coffee today?” the CFO at the time asked him. Scott realizes he has no idea and has bought three cups of coffee in the last 24 hours. The CFO goes on to make the point that Starbucks can pass through a one dollar increase without the consumer blinking. Scott still holds off on getting long because of the expensive valuation. Lesson: if a company has insanely good unit economics and ability to keep improving them, reconsider the price you’re willing to pay to own them.
I want to end on why I think this book is an important read in 2022. We live in a time of increasing promotional activity everywhere we look. Multiples have inflated across many sectors relative to a few years back. CEOs now go on podcasts, write blog posts, talk on CNBC and say their stock is cheap to everyone who will listen. The buy side amplifies this talk by pitching their own names; a ton of podcasts I listen to are just hedge fund manager guests pitching their favorite longs and echoing what management said. I listen to a lot of earnings calls and it shocks me 1) how many questions are softballs and 2) how companies are now choosing and rephrasing questions before calls. This book motivated me to think more critically about the words management groups say and the value of asking good questions and not accepting answers that seem fine at the surface.