Scott Fearon runs the hedge fund Crown Capital and the book is about the part of his strategy to short “dead companies” that still look healthy. He is mainly looking for “growth companies” that have declining revenues in combination with increasing indebtedness. As a rule, he is quite “late on the ball” and initiates a short position only after the market has begun to doubt the previous growth story. Since 1991, Crown Capital has had an annual return of 11.4%, compared to the S&P 500’s 9.6%. Although this is a book about shorting, Crown Capital is mainly invested in long positions.
LOOKS FOR EASY PREY. Crown Capital manages $ 100m and has shorted over 200 companies that eventually went bankrupt. Fearon does not short companies because they are highly valued. He does not feel confident in deciding whether a fantastic company should be trading at 10x or 2x sales. He is looking for companies that are heading for bankruptcy. Then the valuation does not matter – they are still on their way to zero.
THREE TYPES OF COMPANIES GO BANKRUPT. Fearon has three categories of companies that go bankrupt – frauds, fads and failures. He believes that most companies that go bankrupt are of the third variant – ordinary companies that fail. That is where he is looking. Frauds and fads lie outside his circle of competence.
MANAGEMENT´S SIX MISTAKES. According to Fearon, managements often make the same mistake over and over again. It is to (1) only learn from recent years, (2) rely too much on a single recipe for success, (3) misunderstand the customer, (4) become a victim of manic behaviour, (5) fail to adapt to a new technical shift or (6) be physically or emotionally isolated from the business. When management makes too many of these mistakes, it is very difficult for a company to develop positively.
HISTORICAL MYOPIA. Fearon believes that businesspeople often have an understanding of shorter cycles of 5-10 years and are good at adapting their business accordingly. They do however have very limited understanding of longer cycles of 30-50 years. Examples of this are major commodity crashes or when the housing market collapsed and prices are down 50%. Such things happen – but very rarely.
IT IS OKAY TO BE LATE. When going short a stock, Fearon believes that it is not only okay, but also preferable, to be late. To avoid a short squeeze, he wants the share price to be at least half of the previous top level before entering a short position.
WALL STREET IS MADE UP OF BAD INVESTORS. Fearon believes that there are very few good investors on Wall Street. Success on Wall Street requires qualities that go against what is required to succeed as an investor. He believes that those who have reached the top of Wall Street are those who are “climbers, strivers, joiners and cheerleaders”. That is how they got top marks and top jobs. This makes them naturally prone to group thinking and susceptible to mannerisms and bubbles. They are also extremely competitive, which means that they do not want to admit mistakes and adjust their strategies when something goes wrong for them. By that they are also not built for short-term underperformance, which is often needed to go against the crowd and beat the market over time.
“The financial world suffers from an inherent flaw: the people who work in it, by and large, are terrible investors”
25% WRONG AND GONE. When a position has gone 25% against him, Fearon closes the trade and takes the loss. This is because the downside is infinite in a short position. Fearon believes that the best managers are quick to give up when a situation changes. They are not emotionally attached and simply just sell when their analysis says they are wrong. When it comes to investments, you want to play defensively, not offensively.
FAILURE IS GOOD. According to Fearon, bankruptcy is a healthy part of a successful capitalist society. It is unhealthy if society supports companies that should really go under. It makes life a little more comfortable for shareholders and employees of companies that are saved but it is counterproductive for society at large. This is something that has happened in Japan and is partly the explanation for the country’s protracted recovery from the 1990s crisis – even now, 30 years later.
“Long ago, I learned to appreciate one of the most enduring and important American business traditions: failure”