Finance & Accounting Mar 2, 2020
How to Pick a Loser
A hedge-fund manager explains what most traders get wrong about short selling and when to go long on a diamond in the rough.
In more than thirty years in the financial-services industry, hedge-fund manager Scott Fearon has developed a unique take on investing.
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Fearon is the president at Crown Advisors Management, a Kellogg alumnus, a member of Kellogg’s Asset Management Practicum advisory council, and the author of Dead Companies Walking: How a Hedge Fund Manager Finds Opportunity in Unexpected Places.
“His approach combines quantitative screening with fundamental analysis and in-depth analysis of the quality of management teams,” says Bob Korajczyk, a professor of finance at Kellogg.
And despite taking plenty of long positions—that is, purchasing financial instruments in the hopes that their value will increase—Fearon is perhaps best known for going short. Short sellers profit when shares decrease in value: they borrow shares and immediately sell them, betting that they can purchase them in the future at a lower price and keep the difference.
With short selling in particular, Korajczyk explains, taking a different approach from other investors—seeing what other investors can’t or don’t want to see—is critical. So Korajczyk recently sat down with Fearon to learn more about what makes his philosophy so different. The pair also discussed what many investors (and managers) get wrong about short selling, and how financial regulations have been a boon for the casual investor.
This interview has been edited for length and clarity.
Robert Korajczyk: Why don’t you tell us a little bit about your investment philosophy at Crown Advisors Management?
Scott Fearon: We manage $170 million in assets, and our focus is on non-S&P 500 companies: smaller names, the theory being that they are probably more inefficiently priced. Currently we are taking long positions on 45 of them and short positions on another 100+. But, we’re always slightly net long in terms of dollars.
This strategy has served us well. My fund, Foundation Partners, has a compound annual growth rate of 11 percent after fees and delivered positive results in the six years the S&P declined since the fund’s 1991 inception.
What makes us unique is that we begin with lots of screens and company visits. I’ve been to visit 2,200 companies over 28 years. I visited 120 company headquarters last year, across the U.S.
On the long side, we screen whom to visit based on earnings growth or cash-flow growth, or we look for companies that use the cash for buybacks or dividends to benefit shareholders. We try to find stocks of profitable companies that could go into the S&P 500 in two to four years.
On the short side, we look for companies that have debt and shrinking revenues. We are hunting for companies that will go bankrupt—we don’t short Tesla or Netflix. Sixty to eighty percent of our shorts are below $10 a share when we first short them. We believe that they are at $5 or $8 a share but should be valued at 50 cents or 80 cents a share.
We also short those we have reason to believe are in a sun-setting industry. Today that could be the cable industry or the funeral home industry.
Korajczyk: People are going to stop dying?
Fearon: Cremations! About 55 percent of all funerals last year were cremations. That’s going to be 100 percent: my kids and then their kids will all be cremated. Typical cremations—without a service or viewing—are two thousand bucks. But normal funerals cost $10,000—the casket alone is $2,000–2,500.
There are other sun-setting industries, too: the milk industry is in deep distress because a growing percentage of the next generation doesn’t drink cow’s milk; they drink almond milk or soy milk. Dean Foods just filed for bankruptcy.
Korajczyk: So has your approach evolved over time or has it been fairly consistent? What have you learned over the years?
Fearon: Every year I become more convinced that we want to own companies in noncyclical industries. So we are avoiding anything manufacturing-related. And we want to own brands. Brands are important because over time you can get a higher price point and higher margins, and you can continue to grow through the economic cycles. But we also have to believe there’s some kind of misunderstanding that has caused people to undervalue the shares.
Korajczyk: You’ve mentioned in the past that you tend to trade on the opposite side of many individual, or “retail,” traders. Can you describe how this comes to pass? Where, in your view, do the retail investors go wrong?
Fearon: Yeah. We like to short stocks that ill-informed retail investors like to own.
I mean, companies go broke. This is the dirty secret of my business! There’s a study from Vanguard that claims that 47 percent of all stocks over the last 30 years have given a negative return in their life. That might be the single most important statistic I have ever seen in my career: 47 percent of all stocks go down during their life as a public company.
Super Shuttle just filed bankruptcy and shut down last month. Super Shuttle used to be how I went to the airport! But there’s now a better service on the block called Uber, right?
There’s no excuse for short sellers to not do better than they do.
Korajczyk: But it’s a hard craft.
Fearon: People make the mistake of trying to short relative valuation. That’s just lunacy. They’ll short Canada Goose because its price-to-earnings ratio is, say, 70 times for a company selling a goose jacket. Well yeah, it could be 170 times, I don’t know!
I personally don’t care what the valuation is. I’m predicting which businesses and industries won’t exist in the future. Funeral homes, they won’t exist. Neither will senior living. Every month, every year, there’s something new that’s going to help my mom and my dad stay in their home to their death, whether it is food delivery, whether it is Uber and Lyft, whether it is the medical industry wanting to push care into the home.
I’m just looking for failures. I’ll give you another one: asset management. Actively managed mutual funds. I see no end in sight to save that industry. Their fees have to come down—and when people leave a mutual fund with poor performance, they don’t go to another mutual fund. They go into an index product. Today 50 percent of all assets are indexed. In three to five years, it’ll be 60 and then 70 percent. And then there’s a point at which there’s risk that we don’t have enough money for price discovery.
Korajczyk: Right. But that makes active management more feasible.
You’ve talked about how you decide to short companies because they are part of sun-setting industries. But you also mentioned how often you meet directly with executives and tour companies. Are there managerial characteristics of executives that serve as red flags for you when you are looking to take a long position?
Fearon: I always say I want to walk out of a company office with answers to my four Cs. Who is your customer? Who are your competitors? What is your Wall Street coverage, meaning who is recommending your stock? And finally, what’s your capital allocation? And I want people to have answers. If an executive doesn’t know who their customers or competitors are, not good.
Secondly, I do not want cheerleaders. I mean, CEOs are often cheerleaders, but I don’t want them to be pie-in-the-sky cheerleaders. They should simply walk you through the business, top to bottom.
And then thirdly, vanity is a bad thing in a CEO or a CFO.
I personally don’t care what the valuation is. I’m predicting which businesses and industries won’t exist in the future.
— Scott Fearon
Korajczyk: So over the years, there’ve been some regulatory changes. I’m thinking about legislation like Sarbanes-Oxley, which significantly tightened financial oversight of public companies. How has that changed things?
Fearon: Good for the retail investor; bad for the hedge fund manager! The accounting world has tightened up massively since Enron and Worldcom; there are fewer frauds out there.
But in addition to there being less financial irregularity, there’s also just less alpha [or ability to beat the market] today! I want somebody to tell me I’m wrong. And I could be.
Korajczyk: What about regulatory changes around communications and financial disclosure? Have those made an impact?
Fearon: Absolutely. Thirty or twenty years ago, asset managers could go to a company and say, “Hey, Wall Street has a quarterly estimate of $1.65 for the December quarter. Is Wall Street being aggressive?” And they would say, “No problem at all. We are so comfortable with that number.”
But today, they’ll say, “We can’t comment on that, and we’d prefer you don’t ask such questions again.”
Or there used to be a phrase you’d hear all the time: “first call.” What is first call? When I was a kid getting into the business, Wall Street firms would have their morning meeting with the analysts, who might be raising or lowering estimates on stock. Sometimes they’re right, sometimes they’re wrong—most studies show analysts have no clue.
But the guy from a big investment firm would get the first call and hear, “Hey, our analyst is about to raise estimates,” and they would just get in front of that. That’s illegal!
So as I was saying, there’s less alpha out there. All of these changes are good for the little investor. They’re bad for hedge funds.
Korajczyk: People who are involved in short selling tend not to be beloved by corporate management. Can you talk about that? What would you say in response to criticism that short selling simply hurts companies?
Fearon: Some managers don’t like short sellers, but I think that’s a mistake. And I think the really smart management feels differently. They’ll say, “I want you to tell me what’s wrong with my company. I might learn something.” And they’ll never be afraid of a short seller, because if a guy shorts your stock, there’s 100 percent certainty he’s a buyer someday, right? [Because in order to return the shares that they borrowed, they will need to buy them again on the market.] The other guy may never be a buyer, but that guy is a buyer.
Now, of course, the people who worry most about short selling are those who have things to be worried about.
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