Scott Fearon: Scott Fearon’s tips to spot doomed companies ideal for shorting

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Prominent hedge fund manager Scott Fearon says investors can find trading opportunities in the most unexpected places which can help them in amassing spectacular long term returns.

According to Fearon, investors can identify and short the stocks of businesses that are on their way to bankruptcy.

Scott Fearon is the founder of hedge fund Crown Capital Management, which he opened in 1991. Since then, he has shorted over two-hundred companies and has earned millions of dollars for his hedge fund over the last thirty years shorting the stocks of businesses he believed were on their way to bankruptcy.

Since its inception in 1991, Fearon’s fund had only one down year and averaged an 11.4 per cent annual return after all fees, which was significantly higher than the benchmark S&P 500 index’s total return over the same time period.

Fearon is also the author of a famous book, “Dead Companies Walking” where he describes his methods for spotting these doomed businesses, and how they can be extremely profitable investments.

Fearon interviewed thousands of executives across the US, many of whom, unknowingly, were headed towards bankruptcy. His suggestions in the book have helped investors better predict the next booms and busts and come out on top. The book is perfect for investors with a great interest in shorting stocks, to get a solid fundamental basis.

“Profiting on these “dead companies walking” has gotten trickier since the financial crisis. Distressed firms have been able to stave off extinction by refinancing debt and tapping into the unprecedented bull market in equities. But even with our capital markets warped beyond recognition in this virtually failure-proof environment, corporate washouts are still far more common than most people believe,” he said in the book.

According to Fearon, corporate managers routinely commit six mistakes that can derail even the most promising companies.

He says these six key mistakes that companies make are quite common and if investors actively look for them they can make a fortune by shorting the stocks of these companies.

Fearon notes that the vast majority of executives of failing companies are neither stupid nor fraudsters, and in fact most of them are intelligent and hard-working. These six common mistakes are traps that anyone can fall into, and that’s why it’s so important to understand, recognize and avoid them at any cost. Let’s look at these six mistakes-


1. Only learning from recent past


Fearon says most companies assume that by looking at the recent past one can predict the immediate future which is never the case.

He says cyclical companies assume that the current cycle will never end and they will continue to perform well but they should realize that every sector passes through many cycles with lots of ups and downs.

“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”, he says.

2. Relying too heavily on a formula for success

Fearon says companies need to be flexible in their strategy and shouldn’t rely heavily on any set pattern for success as there is no sure shot formula for success.


3. Misreading customers


Fearon says companies frequently believe that they know better than the customer.

According to him, it is a big mistake to underestimate the customers and companies should avoid thinking that customers can be made fools.

4. Falling victim to a mania

Fearon says it is very easy for even the best companies to fall prey to manias

“Anyone who has lived through the Dot com mania of 2000 or the Housing bubble of 2008 knows how easy it is for even educated people to fall prey to manias. From Newton during the South Sea Bubble to Stanley Druckenmiller in the Dot com bubble, investors have constantly fallen prey to mania that ended in a lot of grief,” he says.

5. Failing to adapt to tectonic shifts in its industry

Fearon says companies that cling onto their past are the ones who never see the future pan out.

He says the companies that try and adapt are the ones which can perform and the others which stay rigid are the ones who perish.

6. Management being physically or emotionally removed from operations

Fearon says management can’t make major changes in a company with thousands of employees unless they connect with them directly and earn their loyalty.

He says if management is physically or emotionally removed from operations then it usually derails a promising company’s progress.

Fearon says the businesses that commit these mistakes begin exhibiting some symptoms of imminent doom which takes them downhill in their journey. Let’s look at these signs-


Declining revenues and rising debt


Fearon says businesses that are heading for disaster are always having declining revenues and mounting debt.

“These two problems might seem like they should be in separate categories, but they almost always occur together and they are usually the first signs of serious trouble for a business. Growing revenues are the lifeblood of any successful venture. When they begin to wane, debt loads tend to move in the opposite direction as struggling companies are forced to fund more of their operations on credit. Unless their fortunes change dramatically, firms trapped in this corporate death spiral rarely avoid bankruptcy,” he says.


Overexpansion


Fearon says short-term successes convince management teams to leverage up their companies’ balance sheets so that they can expand operations as rapidly as possible.

According to Fearon, this strategy usually boosts top-line revenues, for a little while, but it eats into margins and makes businesses less resilient to downturns.

“Energy companies are notorious for this behavior. During good times, they gleefully suck up debt and grow like weeds. But when the market shifts, as it has in the last six months, scores of them go from heroes to zeroes in a very short time,” he says.


Looking for dubious new profitable opportunities


According to Fearon, when times get tough, even the smartest, most accomplished corporate managers often panic and make mistakes.

Fearon says rather than admitting their own mistakes and confronting the reality of their firms’ position and changing strategy, companies turn to dubious new opportunities.

Corporate bonds with widening yields-to-maturity

Fearon says some retail investors can keep even the worst performing stocks from going all the way to zero.

According to him, bond buying is a different story altogether as it involves usually large institutional investors using huge amounts of capital.

Hence, a company’s bond yields are a much more reliable indicator of its chances for failure.

“When those yields climb above 20 per cent, you’re looking at the business equivalent of a code blue. The only people who are going near paper with that level of risk are corporate distress specialists looking to profit on the company’s coming reorganization,” he says.


A sunsetting industry


Fearon says failure can be a slow-moving process, and even very troubled firms can show positive signs like decent cash flows or low stock multiples.

He says these indicators often tempt value-oriented investors who fail to pay attention to wider secular shifts.

“At some point in their downward journey to zero, almost every single dead company walking I have shorted has been a “cheap” stock on paper,” he says.

Fearon says most investors spend a lot of time analysing financial reports but sometimes it is best to keep these spreadsheets and projections aside and ask themselves a basic question: Will this company even exist in five or ten years?


Insider trading when a stock is at or near 52-week lows


Fearon says investors tend to overreact to insider activity so it can be a useful indicator, but it’s hard to understand exactly why most executives or board members buy or sell their companies’ stocks.

“If a stock is making consistent new lows at the same time as top insiders are bailing, something is definitely rotten. This is a very rare occurrence,” he says.

(Disclaimer: This article is based on Scott Fearon’s book “Dead Companies Walking”)

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