- Dead Companies Walking – first published in 2015 – offers interesting insight into the mentality required by short sellers
- Investors pondering the current market irrationality would do well to pick up a copy
Michael Burry, who Christian Bale portrays as the investment world’s answer to Batman, has caused a stir following his recent decision to short Tesla (US:TSLA). Many investors cricked their necks earlier this month after Scion Asset Management purchased put options on 800,100 shares worth over half a billion dollars, wondering whether should they be following suit. Somewhere that they might turn to help them decide is Scott Fearon’s highly acclaimed book, Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity In Unexpected Places.
The tome – first published in 2015 – reveals how to tell when a company is sliding toward bankruptcy, regardless of the stock price, and how to profit from it. Fearon identifies a number of common errors made by both private and institutional investors when picking shares. These include a heavy reliance on basic metrics and formulas, misunderstanding target customers, failing to adapt to industry shifts and remaining physically or emotionally removed from a business’s operations. Identifying and removing those errors can help investors avoid the pitfalls of poor stock picking.
That is easier said than done during periods of stock market irrationality, captured in the chapter Madness and Manias. Here Fearon reports on his experience during the dotcom bust, when tech companies which had enjoyed dreamy valuations came crashing down to reality.
So how does a company go from swimming in venture capital to drowning in liquidation? Fearon confirms that this is what happens during manias, because “people wilfully forget inconvenient facts like arithmetic”. Concrete statistics on financial statements become less of a priority when placed alongside idyllic projections, as an investor becomes carried away by the promise of what is yet to come.
Economist Alan Greenspan called this “irrational exuberance”, but Fearon thinks this an understatement and damningly declares, “you might as well start measuring your head for a shiny new tinfoil hat, because you’ve officially crossed over into an alternate universe”.
Manic stock markets usually involve storytelling from specific companies or wider trends, that are based on fantasy scenarios 10 years down the road. Fearon recalls that during the dotcom era, many investors thought the internet would magically transform human behaviour and because of this they invested everything into such companies. Not just their money, but hopes and dreams, which is another way to get caught up in the allure of a promise. Someone happily looking forward to incoming wealth will not want to prepare for anything less. It becomes far too easy to become infatuated with a positive narrative and ignore the warning signs that emerge from the words almost, nearly and soon.
Similar signs of mania are happening now. For example, one Reddit user has created a graph that projects Tesla sales up to the year 2040. In order to make a prediction this far in advance there is a vast quantity of facts and figures that need to be taken into account from Tesla itself, its competitors and wider global changes (who knows what and when the next coronavirus-like financial challenge will be). It seems improbable that such reliable statistics were available to the creator of this spreadsheet.
Who likes short shorts?
It takes a certain type of character to be bold enough to short stock (particularly those as big as Tesla or the American housing market). Fearon believes that the most effective money managers refuse to go with the flow. That is not to say they make bad surfers, but that they are big loners: a bunch of sceptics and cynics – in fact these are all good qualities for surfers, who spend a lot of time patiently waiting for the perfect wave.
Individuals such as this make vast sums of money for themselves and others. To the average investor their levels of heroism appear completely unreachable: a little bit like Batman. However, in Dead Companies Walking it is inspiring to read about Fearon’s humble investment beginnings. At age 18, his father loaned him $500, and he spent his summer buying and selling “calls” (options to buy stocks at certain prices). After each day of trading, Fearon and his broker would discuss the markets over pizza and a pitcher of beer. He lost all $500 that summer, but he got a taste of investment and never looked back. Today Fearon’s Crown Advisors company manages around $170m in assets.
Not everyone shorts stocks. Not everyone can and not everyone should. But a few do and when they do it right it is a moment of genius...or at least nothing short of it.
