BOOK DETAILS

Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity in Unexpected Places

Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity in Unexpected Places

by Scott Fearon

ISBN: 9781137279644

Publisher St. Martin's Press

Published in Business & Investing/Investing

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Sample Chapter


CHAPTER 1

HISTORICAL MYOPIA


"How did you go bankrupt?" Bill asked.
"Two ways," Mike said. "Gradually and then suddenly."

—Ernest Hemingway, The Sun Also Rises


A man named Geoff Raymond taught me the basics of money management. He ran the investment division at Texas Commerce Bank in Houston. But Geoff was far from your average straight-laced banker. He wore his flowing blond hair down past his ears. He favored pastel shirts with white collars and gold or silver collar bars. And he was the fastest walker I've ever seen. Anytime we went anywhere by foot, I almost had to jog to keep up with him. He told me he'd learned to speed walk like that during his days working at Citibank in Lower Manhattan. He'd figured out that if you walked like Carl Lewis ran, you could make every green light heading uptown. But when it came to picking stocks, Geoff was never in a hurry. He was very deliberate. And he believed in something extremely unusual in those days—actual research.

More than anything—more than projections and book values and price-to-earnings ratios—Geoff believed human-to-human contact was the best way to gauge a company's future performance. He valued numbers and raw data, but he knew that numbers were easy to fudge or misread. You had to study the people behind the numbers to get the full story. And reading secondhand profiles about a company's executives didn't count. Neither did pressing their flesh and swapping a few jokes with them at an investor conference. You had to go see them where they lived and worked—their own offices.

The very first company I brought to Geoff as a potential investment for Texas Commerce's trust accounts was called Global Marine (stock symbol: GLM). The company owned a fleet of offshore drilling rigs and ships that it would lease out to oil companies. Ten years before I came to Houston, it also got into a funny side business when its former owner, Howard Hughes, built a giant ship named the Glomar Explorer and leased it to the CIA to help salvage a wrecked Soviet submarine out in the middle of the Pacific Ocean. Like just about every other energy-related outfit in Texas, Global Marine had gotten very rich during the oil boom. And even though its stock price was at a multiyear low in 1984, around $5, the company still had a lot of assets. Its book value—assets minus liabilities divided by total shares outstanding—was around $10. That meant, by classic value investment standards, GLM was a potential winner. I grabbed my handmade earnings models and proudly strolled into Geoff's office.

"This looks good, Scott," he said. "Let's go pay them a visit and see what they have to say."


I made a call to Global Marine's corporate office and arranged a meeting with the company's chief financial officer, a man named Jerry. The next morning I found myself jogging through the bank's parking garage, trying to keep up with Geoff. We took my Oldsmobile about twenty miles west on the Katy Freeway, as I-10 is known in Houston, until we reached Global Marine's six-story, glass-fronted headquarters off Memorial Drive. It was late in the summer, the hottest, stickiest time of year in East Texas. The temperature was pushing a hundred, and the humidity wasn't far behind. By the time I chased Geoff from the parking lot to the front door of the place, I was gushing sweat.

It wasn't just the heat that was making me perspire. This was the first company visit of my life. I was nervous as hell. And you know what? Even though I've gone on more than 1,400 office visits since then, I still get a little amped up as I head in to meet management teams. It's exciting. You never know what you're going to hear.

Jerry was a polite, friendly, unpretentious guy. He wore a polo shirt and slacks and drank his coffee from a Styrofoam cup. He was also very bullish on Global Marine's future. I wouldn't go so far as to call him cocky. He was too reserved and soft-spoken for that. But he didn't seem the least bit concerned about the fact that the company's stock had taken a virtual nosedive. He had a ready answer for that, and for why we should snap up every GLM share we could find for the bank's accounts.

"The oil business is cyclical by its nature," he said as he sipped at his coffee. "We're down for a little while and then we're up again. Seventy percent. That's the magic number."

"Seventy percent of what?" I asked, mopping my still-moist brow.

"Seventy percent utilization, the number of our drilling rigs currently leased out worldwide," he explained. "Right now, we're just below seventy. And that means one thing as far as you guys are concerned: buy, buy, and buy some more. I've been in this business for decades, and 70 percent is always the bottom. It never fails. Look, I'll show you."

He pulled a chart out for me and traced the up-and-down cycle of Global Marine's "rig utilization rate" over the previous few decades. Sure enough, every time the rate slipped below seventy, it turned around and shot up shortly thereafter.

Jerry gave me a self-assured smile. "I'm telling you, Scott. Now's the time to get in."

As we drove back on the Katy Freeway toward Texas Commerce's gleaming headquarters in the distance, Geoff turned to me and said, "Well, what do you think?"

I watched the road for a little while, trying to figure out why I was so reluctant to pull the trigger on GLM. It was a classic winner according to the rules of value investing. The share price was half the company's book value. And Jerry's presentation had been very persuasive. I'm sure most twenty-five-year-old financial rookies—and even a lot of seasoned money managers—would have left Global Marine's offices eager to buy into the company. But I just couldn't.

First, even back then, I knew how risky it was to predict the bottom of a downturn. On Wall Street, they call it "trying to catch a falling knife." Second, I recognized that as accomplished, intelligent, and sincere as Jerry was, he couldn't help but suffer from an unconscious bias in favor of Global Marine. His financial security depended on the company turning around as he was predicting. If he allowed himself to believe that Global Marine was at risk, he wouldn't have been sitting in his office sipping coffee and showing me charts. He would have been out looking for another job.

Given these two concerns, I did the same thing I've done countless times since that humid morning in Houston when confronted with a difficult call on a stock: nothing. Over the years, I've found that doing nothing is often the soundest investment strategy.

"I can't recommend that we buy it," I said to Geoff. "Not yet. I'd rather hold off and get it on the way up, at $7 or even $10. It might cost us a few bucks in profit, but at least we'll be sure that they're going in the right direction."

I expected Geoff to test me more or at least to question my reasoning a little bit. What I was suggesting didn't really mean just "a few bucks in profit." If Jerry's predictions came true and Global Marine's stock took off, the difference between buying in at $5 and $7 or $10 would mean leaving millions on the table. But to my surprise, Geoff just shrugged and said, "Okay. What do you want for lunch?"

I never got the chance to buy GLM on the way up, because it never went up. Like every other company in the Texas oil patch after the price of crude collapsed, Global Marine's stock sank faster than a drilling bit in soft bayou mud. And Jerry's "magic" utilization rate number? It went right down with it. As the oil services industry unraveled, utilization dropped from 70 percent to 25 percent. I don't think the trend line in the chart Jerry showed me in his office even went that low. A share of Global Marine's stock was trading under $1 by mid-1985. In January 1986, less than eighteen months after Jerry urged me to "buy, buy, buy," Global Marine filed for bankruptcy.

I do not believe Jerry was stupid for thinking Global Marine would rebound from its slump. For one thing, he was far from alone. If I gave you a nickel for every person in the energy business in 1984 who believed a big, successful company like Global Marine would go bankrupt within two years, you wouldn't have had enough to afford a gumball. No one, and I mean no one, thought things would get as bad as they did.

Nowadays, Dubai is the poster child for petrodollar extravagance, with oil-rich sheiks spending billions on crazy projects like man-made islands and indoor ski resorts in the middle of the Arabian Desert. But trust me, Dubai has nothing on Houston in the early 1980s. On my first morning living there, I woke up to a loud, hive-like buzz above my apartment near Buffalo Bayou. Half asleep, I walked out onto my balcony and watched dozens of helicopters whirring above the choked freeways of the city. A coworker later told me that a quarter of all privately owned copters in the United States flew over the greater Houston metropolitan area at the time. They were there in such numbers because the city's oilmen all wanted to live like James Dean in the movie Giant. They built custom mansions on ranches the size of small nations and rode thirty, forty, even a hundred miles into town every morning by air.

I'll discuss the dangers of getting caught up in manias like the 1980s oil boom later. For now, let's return to Jerry's misguided, but highly instructive, confidence in his magic rig utilization rate number. It's an example of a common mistake I've seen plenty of times over the years.

There is a good reason that Jerry's utilization graph didn't go all the way down to 25 percent—quite simply, it had "never" happened before. I put the word never in quotes because I don't mean it literally. And that's the root of the mistake I'm talking about.

Everybody always stresses the importance of learning from history: "Those who don't learn from the mistakes of the past are doomed to repeat them," the saying goes. In my experience, most people heed this advice, but only up to a point. They study the past quite closely and glean as many lessons from it as they can. But they almost never look back far enough. They confine themselves to the history of the previous few years, or perhaps a decade or two. In other words, it's not that people don't learn from the past. They do—but only the recent past. And that can be a deadly error.

I can't remember exactly how far back Jerry's rig utilization chart stretched in time, but it wasn't more than twenty years. Over that time span, Jerry was perfectly right: Global Marine's utilization rate had never stayed below 70 percent for more than a quarter or two. But Jerry assumed that just because the trend had persisted for as long as he could remember, or even a good deal longer, things had always been like that. Of course, that was not the case. Looking over a longer period of time, the oil business has suffered numerous catastrophic meltdowns. But because he had never lived through one himself, Jerry—along with everyone else in Houston—didn't even entertain the possibility that the time was ripe for another one.

It's a classic mistake in business and in life. Call it historical myopia. We assume the recent past is the most accurate predictor of the future and that the more distant past is less important or less relevant. Yes, as Jerry pointed out to me, business moves in cycles. The energy sector in particular goes up and down all the time. But those cycles are both large and small. Most cycles run their course over the span of months or years. Others take longer to play out—sometimes much, much longer. But that doesn't mean that those larger, less frequent supercycles, as the academics call them, aren't just as regular as the shorter ones. They are. Forgetting that fact has gotten a lot of businesspeople, and investors, in deep trouble. In 2011, scores of textile and apparel companies were crushed when cotton prices suddenly shot up. Nobody in the industry hedged against this kind of supercycle event because, as with the equally steep decline in Global Marine's rig utilization percentage, it had "never" happened before. Of course, in reality, cotton (like oil and steel and every other commodity) has seen numerous large spikes and crashes in the past—just not in the recent past. People didn't look back far enough, and it cost them dearly.

Investors also frequently fail to look beyond the recent past and not just by trusting shortsighted corporate executives like Jerry. When I started out at Texas Commerce Bank, I practiced Geoff Raymond's method for picking stocks, called value investing—that is, measuring a company's stock price against its assets, cash flows, dividend yields, and other fundamentals. As I said, that's how I discovered Global Marine as a potential investment. But as my career progressed, I started prioritizing a company's growth outlook over its current value. The reason I began to shy away from value investing was because I noticed that even its most accomplished practitioners often fall victim to historical myopia. They fixate on a company's recent performance or financials while ignoring larger cycles, trends, and secular changes.

In 2007, a powerhouse private equity consortium backed in part by none other than the great Warren Buffett took on a staggering amount of debt to acquire Texas's largest regulated utility, TXU Electric Delivery. At a cool $45 billion, it was the biggest leveraged buyout in history. Thanks to historical myopia, it will probably go down as one of the worst investments ever, too.

TXU—renamed Energy Future Holdings Corporation after the deal was consummated—derived a great deal of its revenues by operating coal-fired electricity plants, which it used to supply power to customers in the Dallas metro area. For years leading up to the deal, high electricity prices brought in enormous amounts of free cash flow for TXU, and the company's management planned to build a dozen additional coal-fired plants to generate even more cash. With demand for power rising every year, and electricity prices following suit, TXU appeared to be a value investment gold mine to Buffett and the company's private equity buyers. But by focusing on backward-looking metrics like cash flow and electricity prices, they turned deaf ears to two very loud alarm bells.

First, despite the lobbying efforts of the coal industry (and its oxymoronic promise to create "clean coal" technologies), burning coal is still the dirtiest way to generate power, and the political and social climate is not exactly welcoming to new coal-based electric projects. Even in business-friendly Texas, TXU's plans were quite controversial—and before the acquisition was even finished, the buyout group bowed to pressure from environmental groups and agreed not to build most of the new plants. But that wasn't the worst thing that happened to the company's new owners. They were so busy salivating over TXU's cash flows that they forgot the lesson Jerry and the rest of the executives at Global Marine had learned several decades earlier—the energy industry is as volatile as a live wire, and expecting short-term results to continue into the future is almost never a safe bet.

Even as the ink was still drying on the buyout deal, massive new natural gas deposits were being discovered all over North America. As that huge supply of cheaper, cleaner-burning gas came onto the market, electricity prices dropped drastically; TXU's cash flows shrank with them. The only thing that did not shrink was the company's debt load. By 2013, the giant utility was hiring lawyers to handle its impending reorganization. In 2014, the inevitable finally occurred. The company declared bankruptcy. As for Buffett, he was his usual honest and humble self. He called his decision to purchase $2 billion worth of bonds in Energy Future Holdings' "a major unforced error."

TXU's implosion was record breaking, but it was hardly unprecedented. When I was still in Texas visiting companies like Global Marine, so-called fern bar chains like TGI Fridays and Bennigan's were all the rage. TGI Fridays even went public in 1983. Its stock sustained a long rally after its initial public offering, mainly because, like TXU, the company generated a tremendous amount of free cash flow. Selling high-margin products always brings in a lot of cash, and there aren't many products with higher margins than cocktails. Value investors got so drunk on those cash flow figures that many of them missed a sobering reality—the company's growth was slowing. For a good while, its stock sold at a small multiple of its cash flow, which meant, by value standards, it was still cheap. But one thing I've learned in this business is that cheap can be very expensive, and as the fern bar craze waned, those cash flows went as flat as a bad wine spritzer.

(Continues…)
Excerpted from "Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity in Unexpected Places" by Scott Fearon. Copyright © 2013 by Scott Fearon. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided solely for the personal use of visitors to this web site.
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