Scott Fearon's Secrets of Short Selling: How He Made Millions by Betting Against Dying Companies
Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity In Unexpected Places
Have you ever wondered how some investors make money by betting against failing companies? Do you want to learn how to spot the signs of a doomed business and profit from its decline? If so, this article is for you.
Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity In Unexpected Places.pdf
In this article, we will review the book "Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity In Unexpected Places" by Scott Fearon. This book is a fascinating and insightful account of how Fearon, a veteran hedge fund manager, has made a fortune by short selling the stocks of dying companies. We will explain what are dead companies walking, who is Scott Fearon and what does he do, how does he find opportunities in unexpected places, what are the six signs of a dead company walking, what are the four steps to profit from a dead company walking, and what are the risks and rewards of short selling. By the end of this article, you will have a better understanding of how to identify and exploit the weaknesses of failing businesses.
Introduction
What are dead companies walking?
Dead companies walking are businesses that are doomed to fail sooner or later. They are usually in decline because they have a bad business model, a bad balance sheet, bad management, bad customers, bad competitors, or bad luck. They may appear to be profitable or growing on the surface, but they are actually losing money or market share behind the scenes. They may also be in denial about their problems or try to hide them from investors and regulators. These companies are often overvalued by the market and attract naive or greedy investors who hope for a turnaround or a buyout. However, these hopes are usually dashed as the companies eventually collapse under their own weight.
Who is Scott Fearon and what does he do?
Scott Fearon is the founder and president of Crown Capital Management, a hedge fund that specializes in short selling. He has over 30 years of experience in the investment industry and has been featured in various media outlets such as CNBC, Bloomberg, Forbes, and The Wall Street Journal. He is also an adjunct professor at Northwestern University's Kellogg School of Management.
Short selling is the practice of borrowing a stock from a broker and selling it in the market, hoping that its price will go down. Then, the short seller buys back the stock at a lower price and returns it to the broker, pocketing the difference. Short selling is a way of profiting from the decline of a stock or a market.
Fearon is one of the few hedge fund managers who has consistently made money by short selling. He has successfully shorted hundreds of companies over his career, ranging from small startups to large corporations. He has also survived several market crashes and bubbles, such as the dot-com bust, the financial crisis, and the COVID-19 pandemic. He attributes his success to his ability to spot and avoid the pitfalls of human psychology, such as confirmation bias, overconfidence, and herd mentality.
How does he find opportunities in unexpected places?
Fearon finds opportunities in unexpected places by looking for industries and sectors that are undergoing major changes or disruptions. He believes that change creates winners and losers, and that losers are often easier to identify than winners. He also looks for companies that are facing existential threats from new technologies, regulations, competitors, or consumer preferences. He avoids companies that are in stable or growing industries, or that have strong competitive advantages or loyal customer bases.
Fearon also finds opportunities in unexpected places by doing extensive research and due diligence on the companies he targets. He reads their financial statements, annual reports, press releases, analyst reports, and news articles. He also visits their offices, stores, factories, and websites. He talks to their employees, customers, suppliers, competitors, and industry experts. He tries to get a firsthand impression of how the companies operate and what their strengths and weaknesses are. He also tries to find out if they have any hidden liabilities or scandals that could hurt their reputation or performance.
Fearon also finds opportunities in unexpected places by being contrarian and independent. He does not follow the crowd or the consensus. He does not rely on tips or recommendations from others. He does not care about popularity or prestige. He only cares about facts and logic. He is willing to go against the grain and challenge the conventional wisdom. He is also willing to admit his mistakes and change his mind when new evidence emerges.
The six signs of a dead company walking
Sign 1: They have a bad business model
A bad business model is one that does not generate enough revenue or profit to sustain itself or grow. A bad business model may be caused by several factors, such as:
A low-margin product or service that cannot cover the fixed costs or compete with cheaper alternatives.
A high-cost structure that erodes the profitability or scalability of the business.
A lack of differentiation or innovation that makes the product or service obsolete or commoditized.
A poor value proposition or customer satisfaction that leads to low retention or loyalty.
A narrow target market or niche that limits the potential customer base or growth opportunities.
A flawed revenue model or pricing strategy that fails to capture the value or demand of the product or service.
Some examples of companies that had bad business models are Blockbuster, Kodak, Sears, Toys R Us, and BlackBerry.
Sign 2: They have a bad balance sheet
A bad balance sheet is one that shows more liabilities than assets, more debt than equity, more expenses than income, or more cash outflows than inflows. A bad balance sheet may be caused by several factors, such as:
Overleveraging or borrowing too much money that cannot be repaid or refinanced.
Overinvesting or spending too much money on unproductive or risky assets or projects.
Underperforming or generating too little revenue or profit to cover the interest payments or operating costs.
Overcommitting or taking on too many obligations or contracts that cannot be fulfilled or honored.
Underfunding or having too little cash reserves or liquidity to meet the short-term needs or contingencies.
Misreporting or hiding the true financial condition or performance of the business from investors or regulators.
Some examples of companies that had bad balance sheets are Enron, Lehman Brothers, General Motors, RadioShack, and J.C. Penney.
Sign 3: They have bad management
Bad management is one that lacks the vision, strategy, execution, leadership, culture, ethics, or accountability to run a successful business. Bad management may be caused by several factors, such as:
Lack of vision or strategy: The management does not have a clear direction or goal for the business or how to achieve it.
Lack of execution: The management does not have the skills, resources, systems, processes, or controls to implement the strategy effectively.
Lack of leadership: The management does not have the charisma, influence, communication, motivation, or empowerment to inspire and guide the employees.
Lack of culture: The management does not have the values, norms, beliefs, behaviors, or attitudes that foster a positive and productive work environment.
Sign 4: They have bad customers
Bad customers are those who do not generate enough revenue or profit for the business, or who cause more problems or costs than benefits. Bad customers may be caused by several factors, such as:
Lack of demand or interest: The customers do not want or need the product or service, or they prefer other alternatives.
Lack of loyalty or retention: The customers do not repeat their purchases or referrals, or they switch to competitors.
Lack of satisfaction or quality: The customers are not happy or satisfied with the product or service, or they encounter defects or issues.
Lack of payment or credit: The customers do not pay their bills on time or at all, or they default on their loans or obligations.
Lack of respect or trust: The customers do not treat the business or its employees with courtesy or honesty, or they abuse or cheat the system.
Lack of alignment or fit: The customers do not match the target market or niche of the business, or they have different values or expectations.
Some examples of companies that had bad customers are Groupon, MoviePass, Theranos, Quibi, and WeWork.
Sign 5: They have bad competitors
Bad competitors are those who have a better product or service, a lower price, a larger market share, a stronger brand, a faster innovation, a higher customer satisfaction, or a more loyal customer base than the business. Bad competitors may be caused by several factors, such as:
Lack of differentiation or innovation: The business does not offer anything unique or valuable that sets it apart from its competitors.
Lack of competitiveness or efficiency: The business does not have the cost structure, scale, quality, speed, or flexibility to compete with its competitors.
Lack of awareness or reputation: The business does not have the marketing, advertising, public relations, word-of-mouth, or social media to promote its product or service.
Lack of adaptation or responsiveness: The business does not have the ability to anticipate, react, or adjust to the changes in the market, customer preferences, technology, regulations, or competition.
Lack of protection or advantage: The business does not have the patents, trademarks, trade secrets, contracts, network effects, switching costs, or barriers to entry to prevent its competitors from copying or surpassing it.
Lack of cooperation or collaboration: The business does not have the partnerships, alliances, joint ventures, mergers, acquisitions, or integrations to leverage its strengths and resources with other businesses.
Sign 6: They have bad luck
Bad luck is when the business faces unforeseen or uncontrollable events or circumstances that negatively affect its performance or survival. Bad luck may be caused by several factors, such as:
Natural disasters or accidents: The business suffers from floods, fires, earthquakes, storms, pandemics, or other calamities that damage its assets, operations, or supply chain.
Legal disputes or scandals: The business faces lawsuits, investigations, fines, sanctions, or criminal charges that tarnish its reputation, credibility, or compliance.
Political unrest or instability: The business operates in countries or regions that experience wars, coups, riots, protests, or terrorism that disrupt its security, stability, or access.
Economic downturns or crises: The business faces recessions, depressions, inflations, deflations, or currency fluctuations that reduce its demand, revenue, or profit.
Technological failures or glitches: The business relies on software, hardware, networks, or systems that malfunction, crash, hack, or become obsolete.
Human errors or mistakes: The business makes wrong decisions, assumptions, calculations, forecasts, or judgments that lead to losses, inefficiencies, or missed opportunities.
The four steps to profit from a dead company walking
Step 1: Identify the target
The first step to profit from a dead company walking is to identify the target. This means finding a company that exhibits one or more of the six signs of a dead company walking. Fearon suggests using several sources and methods to identify potential targets, such as:
Screening tools or databases that filter stocks based on various criteria, such as market capitalization, industry, valuation, growth, profitability, debt, cash flow, or analyst ratings.
Newsletters or publications that specialize in short selling or expose frauds, scams, or bubbles.
Conferences or events that feature presentations or pitches from CEOs or founders of questionable companies.
Networks or contacts that provide tips or insights from insiders, whistleblowers, former employees, customers, suppliers, competitors, or industry experts.
Intuition or gut feeling that something is wrong or fishy about a company or its product or service.
Fearon warns against relying on any single source or method to identify targets. He advises to cross-check and verify the information from multiple sources and methods. He also advises to avoid targeting companies that are too popular or too obscure, as they may be too risky or too difficult to short.
Step 2: Analyze the financials
The second step to profit from a dead company walking is to analyze the financials. This means digging deeper into the financial statements and reports of the target company to find out how bad its situation is and how much it is worth. Fearon suggests using several tools and techniques to analyze the financials, such as:
Ratio analysis: This involves calculating and comparing various ratios that measure the liquidity, solvency, efficiency, profitability, or valuation of the company.
Trend analysis: This involves examining and projecting the historical and future trends of the revenue, earnings, cash flow, margins, growth rates, or market share of the company.
Segment analysis: This involves breaking down and evaluating the performance and contribution of each product line, business unit, geographic region, or customer group of the company.
Step 3: Short the stock
The third step to profit from a dead company walking is to short the stock. This means borrowing the stock from a broker and selling it in the market, hoping that its price will go down. Fearon suggests using several strategies and tactics to short the stock, such as:
Timing: This involves choosing the right time to enter and exit the short position, based on the market conditions, catalysts, events, or signals that may affect the stock price.
Position sizing: This involves determining the right amount of shares to short, based on the risk-reward ratio, volatility, liquidity, or diversification of the portfolio.
Margin: This involves using leverage or borrowed money to amplify the returns or losses of the short position.
Covering: This involves buying back the stock at a lower price and returning it to the broker, closing the short position and locking in the profit.
Hedging: This involves using options, futures, swaps, or other derivatives to protect or reduce the downside risk or exposure of the short position.
Fearon warns against being too greedy or too stubborn when shorting a stock. He advises to set a target price and a stop-loss price for each short position and stick to them. He also advises to monitor and adjust the short position regularly and be ready to cover it when necessary.
Step 4: Cover the position
The fourth step to profit from a dead company walking is to cover the position. This means buying back the stock at a lower price and returning it to the broker, closing the short position and locking in the profit. Fearon suggests using several criteria and indicators to cover the position, such as:
Price: This involves covering the position when the stock price reaches or exceeds the target price or falls below the stop-loss price.
Time: This involves covering the position when a certain period of time has elapsed or a certain deadline has approached.
Event: This involves covering the position when a significant event has occurred or is expected to occur that may affect the stock price.
Sentiment: This involves covering the position when the market sentiment or opinion has changed or is likely to change about the company or its industry.
Fundamentals: This involves covering the position when the financial condition or performance of the company has improved or is expected to improve.
Fearon warns against being too late or too early when covering a position. He advises to cover the position when the risk-reward ratio is no longer favorable or when the thesis is no longer valid. He also advises to avoid covering the position based on emotions, rumors, or noise.
The risks and rewards of short selling
The main risks of short selling
Short selling is not for the faint-hearted. It involves several risks and challenges that can result in losses or difficulties for the short seller. Some of the main risks of short selling are:
Limited upside and unlimited downside: The maximum profit that a short seller can make is limited by the difference between the original selling price and zero, while the maximum loss that a short seller can incur is unlimited by the potential increase in the stock price.
Margin calls and interest payments: The short seller has to pay interest and fees to the broker for borrowing the stock, and has to maintain a certain level of equity in the account. If the stock price rises or the equity falls below a certain level, the broker can issue a margin call and force the short seller to deposit more money or cover the position.
Short squeezes and buy-ins: The short seller may face a situation where there is a sudden surge in demand or a shortage in supply of the stock, causing its price to spike. This may be triggered by positive news, earnings, dividends, buyouts, or rumors about the company, or by other short sellers covering their positions. This may force the short seller to cover the position at a higher price or be bought-in by the broker.
Regulatory restrictions and legal actions: The short seller may face a situation where there are rules or regulations that limit or prohibit short selling of certain stocks, sectors, or markets. This may be imposed by governments, regulators, exchanges, or brokers to protect investors, stabilize markets, or support industries. The short seller may also face lawsuits or investigations from shareholders, regulators, or authorities for alleged market manipulation, fraud, or insider trading.
Psychological stress and social stigma: The short seller may face a situation where there is a lot of pressure or criticism from the market, the media, the public, or even friends and family for betting against a company or an industry. The short seller may also face a situation where there is a lack of support or recognition for being right or successful in short selling.
Fearon advises to be aware and prepared for these risks and challenges and to have a plan and a discipline to deal with them. He also advises to have a balanced and diversified portfolio that includes long positions as well as short positions.
The main rewards of short selling
Short selling is not all doom and gloom. It also involves several benefits and opportunities that can result in profits or advantages for the short seller. Some of the main rewards of short selling are:
Profit from decline: The short seller can make money by exploiting the weaknesses or failures of a company or an industry that are overlooked or ignored by the market.
Hedge against risk: The short seller can reduce the overall r