Six Simple Rules for Spotting Stocks Headed to Zero

Doc’s note: One of the keys of successful investing is not losing money. You can limit your losses by using a stop limit or buying safe blue-chip stocks. Another way is to avoid companies that are going to zero.

In today’s essay, my colleague and Extreme Value analyst Mike Barrett shares the six things you should look for in a company that might be on its way to bankruptcy.

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“They’re going broke, boys. Their stock is going to flatline. And I’m going to make a killing when it does.”

In his book Dead Companies Walking, successful money manager Scott Fearon recalls the above comment from Gary Smith some 25 years ago as being a “seminal” event for his career.

It was a conversation that set Fearon on an unexpected new investing course. In the years since, he has shorted more than 200 companies that eventually went to zero… an incredible track record. And spotting these failures has helped him earn market-beating results for more than two decades…

Shorting companies potentially headed for bankruptcy was once a radical idea.

But on that night 25 years ago, Smith’s logic was undeniable… Prime Motor Inns, a major hotel chain, had taken on more than $500 million in debt by gobbling up mom and pop competitors. Yet revenues continued to shrink.

“Pretty soon, they won’t be able to service all that debt,” Smith said. “They’ll go into default… The stock will go to zero and I’ll never have to cover my short.”

A year later, Prime Motor Inns declared bankruptcy.

Fearon attributes his success with shorting “dead companies walking” to a focus on the six management blunders that can help you spot which businesses are just waiting to fail…

1. Learning only from the recent past.

In cyclical boom-and-bust industries (like energy, auto, and housing), Wall Street darlings that binge on debt to grow during an uptrend eventually become prime dead-company-walking candidates during the ensuing downtrend. Fearon calls it “historical myopia” – management’s tendency to assume the most recent past is a better predictor of the future than the distant past.

Since the 2014 oil bust, for instance, Forbes reports that 70 energy companies have defaulted on $40 billion in debt and gone bankrupt. These management teams clearly underestimated the longer-term boom-and-bust dynamics of the oil business.

2. Relying too heavily on a formula for success.

One of Fearon’s favorite hunting grounds for dead companies walking is the restaurant industry. Fast-food chains are notorious for following a growth-is-always-good formula that isn’t always effective.

Fearon names Krispy Kreme Doughnuts as a prime example. Rather than granting franchisees one store at a time, years ago, Krispy Kreme made deals with area developers who agreed to open at least 10 stores in their regions – and pay the parent company top dollar for supplies. This juiced store and top-line growth… until several of the developers could no longer live up to the agreements and went bankrupt, dooming Krispy Kreme.

3. Misreading or alienating customers.

In 2012, Fearon says JC Penney effectively “fired” its customers. The company decided to eliminate coupons and stock more expensive brand-name merchandise.

The abrupt change was the brainchild of newly minted CEO Ron Johnson, the superstar behind Apple’s retail-store concept. Johnson confused his own tastes for those of his core customers, and he ignored the fact that most JC Penney stores were located in middle- and working-class areas. As Fearon says, Johnson’s actions in effect hung a sign on every store with the caption: “If you aren’t a fit, affluent yuppie like me, don’t bother coming in here.”

4. Falling victim to a mania.

Sometimes people just want to believe a good story, whether it stands up to scrutiny or not. That’s the way Fearon remembers Shaman Pharmaceuticals in the years leading up to its bankruptcy.

Bringing plants and herbs back from remote Amazonian tribes to create pharmaceutical-grade drugs was a seductive idea. But the company never produced a single revenue-generating drug. The current biotech mania is being fueled in part by lots of similar feel-good stories generating zero revenues.

5. Failing to adapt to tectonic industry shifts.

Blockbuster Video remains the classic case study for this mistake. In late 2007, the company was clearly in trouble – its 9,000 stores were rapidly losing market share to an upstart named Netflix (NFLX).

Rather than formulating a massive online counteroffensive, management instead doubled down on the store concept. They failed to appreciate, then adapt to, the emerging paradigm we now know as online streaming. (In Extreme Value, we hold one open short that is a perfect example of a company failing to adapt to tectonic shifts in its respective industry.)

6. Being physically or emotionally removed from company operations.

Once again, JC Penney’s ex-CEO Ron Johnson is a perfect example of this mistake. After taking the reins of JC Penney, based in Texas, Johnson reportedly refused to move from his primary residence in a high-end Silicon Valley suburb. Instead, he flew the 3,000 miles roundtrip each week on the company’s private jet, and he was audacious enough to stay at the Ritz-Carlton in Dallas… all on JC Penney’s tab.

Shorting stocks is never easy… even when there is clear evidence a management team is making some or all of these blunders. But in business, failure is much more common than success. These six mistakes are a great starting point when looking for stocks to avoid… or short all the way to zero.

Good investing,

Mike Barrett

P.S. Each month, Mike and Extreme Value senior analyst Dan Ferris look for the safest, cheapest stocks… buying only when the price is right. Click here to learn more.