There aren’t many investment books out there that offer thoughts about shorting stocks, since shorting is generally viewed as taboo (which is a misguided connotation since there’s a great amount of empirical evidence to suggest that enabling short activity allows capital markets to be more efficient). Thus, there is a great deal of value to learn from the perspective of the short side, since many investors only focus on the long side (in their worldview). And there’s no better person to learn from than someone who has done it professionally.
Investor Scott Fearon knows a thing or two about investing in stocks – in particular, from the short side. His firm, Crown Capital, has averaged an 11.4% annual return since its inception in 1991. We are fortunate as Fearon has shared his experience and insights from his rich career in his book: “Dead Companies Walking – How A Hedge Fund Manager Finds Opportunity In Unexpected Places“.
Here’s a summary I gathered from reading Fearon’s insightful book:
(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.”
The author looks for the following 6 common mistakes by business leaders to detect failure:
- Learning from only the recent past
- Relying too heavily on a formula for success
- Misreading or alienating their customers
- Falling victim to a mania
- Failing to adapt to tectonic shifts in their industries
- Physically or emotionally removed from their companies operations
These 6 points above are expounded in detail in the book, with each of them having their own chapter. Throughout the book’s chapters, Fearon occasionally shared examples from his wealth of experience when he was an equity analyst and when he was managing his hedge fund, making the reading experience entertaining and insightful.
(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’, its ok 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 one is betting on a company to go bankrupt and its share price to go to zero) than investing on the long side via quality stocks and well-run businesses.
Due to the fact that the market has a bias to the long side (because of optimistic tendencies and because most participants are long-biased), the share prices of ‘junk companies’ can often stay afloat and ‘live well past their expiration dates.’ Many failing companies take long to declare bankruptcy and some may successfully turnaround and restructure. Short-sellers have to understand this and thus, there are opportunity costs and risks involved even if one is betting against a company that is doomed to fail.
Also, there could be short squeezes that could shake one’s conviction and tolerance when it comes to shorting stocks. As the author 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 she 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
The author has a rather grim comment on Wall Street whether you agree or disagree. 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 would refresh the veteran investor and pipe the interest of the amateur. Even the long-only investor can learn from the perspective of a professional shortist as we can simply revert the process and learn from the many failures out there to train ourselves to identify winners better (and avoid losers). While the book does not cover the technical parts of the investment process, it explores the qualitative and psychological part of a stock picker that is hunting for gems (or finding junk).
The author frequently blogs at ‘the confessions of a contrarian investor‘.
Here’s a video of the author at the Stansberry Conference in Las Vegas back in 2015:
*image credits to Amazon.com & Institutional Investor*