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A Practical Guide to Finding “Dead Companies Walking”

Scott Fearon is a successful hedge fund manager who founded Crown Capital Management. He has been known for his short selling strategies and authored the book Dead Companies Walking: How a Hedge Fund Manager Finds Opportunity in Unexpected Places.

In his book, Fearon shared his experiences shorting (and failing to short) many publicly traded companies that eventually went bankrupt. After many years in investment management, Fearon shared with us his “six deadly business sins” for losing companies, which were:

  1. They learned from only the recent past.

  2. They relied too heavily on a formula for success.

  3. They misread or alienated their customers.

  4. They fell victim to a mania.

  5. They failed to adapt to tectonic shifts in their industries.

  6. They were physically or emotionally removed from their companies’ operations.

Fearon dove further into these “deadly sins” with anecdotes of specific companies he ultimately shorted or was very close to shorting. A prevailing pattern we found from Fearon’s key lessons on shorting companies is that he heavily prioritizes qualitative information in his investment decision making process.

One of Fearon’s key messages in his book was that if you get too fixated on numbers, you can easily miss out on other critical information. Most of this critical information is qualitative.

Hudson Labs specifically addresses this problem.

We process long-form financial and nonfinancial text from SEC filings of publicly traded companies using Natural Language Processing (NLP). Hudson Labs' NLP model is trained to automatically scan through qualitative information for all SEC-filers and assess whether this information is indicative of downside risks.

Problems at companies are usually reflected in qualitative data sooner than in quantitative financial data. Typically, when frauds or massive failures at companies have affected their financial statements, it’s already too late. Hudson Labs' NLP model is predictive and identifies potential risk from companies’ written disclosures.

1: The Doctrine of Elite Infallibility

One of the red flags that Scott Fearon spotlighted for failing companies was what he calls “The Doctrine of Elite Infallibility”. Essentially, this is the fallacy that having a leader with an elite background (although irrelevant to the company’s industry), such as having an Ivy League education, is sufficient to bring success to a company. Fearon mentioned that there is an unrealistic optimism in the corporate and investing arenas on having too much faith in people with generally elitist backgrounds despite having limited relevant experience.

To further emphasize this fallacy, Fearon recalls how Enron appointed Robert Jaedicke, the dean of Stanford University’s business school, as the company’s audit committee chairperson. Jaedicke held this position up until Enron imploded from one of the largest accounting scandals in history. So much for his elite background!

How does Scott identify this red flag? He explained that if a company hires a new officer or director and highlights the prestige of their backgrounds and not necessarily the relevance of their background, this company is certainly falling for “The Doctrine of Elite Infallibility”.

How can you find this red flag though Hudson Labs? We offer AI-generated news feeds that list red flags from all publicly traded companies filed with the SEC. You can filter out our newsfeed to only show red flags related to management turnover (i.e., the dismissal, resignation, or hiring of directors and/or officers):

 red flags related to management turnover.

You then can click into these management turnover updates by certain companies and review how each company describes their newly hired or appointed director or officer.

You can also review management turnover updates on specific companies when using our forensic due diligence search and using our 8-K view feature:

 Bedrock AI 8-K view feature.

Typically, the announcements of management turnover are Form 8-K Item 5.02.

Red Flag Example: Canoo Inc (GOEV)

We have a great example of Scott Fearon’s Doctrine of Elite Infallibility with the company Canoo, Inc.

On July 26, 2021, Canoo Inc., an electric vehicle manufacturer, appointed one of its board members, Josette Sheeran, to be the new president of the company. In a Form 8-K, Canoo Inc. discussed the prestigious background of Josette Sheeran:

Doctrine of Elite Infallibility

The biography appears quite impressive. She was the Executive Chair for the McClain Institute and President and CEO of the Asia Society. She also worked with the UN, World Economic Forum and the US Secretary of State for Economics, Energy, and Agriculture. She was also a fellow at Harvard University Belfer Center!

If you recall, Canoo, Inc. is an electric vehicle manufacturer. None of Sheeran’s experience directly relates to that of an executive for an EV company. But is her prestige sufficient to bring success to the company?

Since the announcement of Sheeran’s appointment, Canoo’s performance has been lackluster at best. The company has missed expected earnings (per Yahoo! Finance) three quarters in a row:

Example of Doctrine of Elite Infallibility

The company has also recently disclosed that it has substantial doubt on continuing as a going concern. Furthermore, Canoo’s stock $GOEV decreased by 56% since she started in late July 2021. Clearly, Canoo had fallen for the Doctrine of Elite Infallibility.

2: Reliance on M&A for Growth

Another red flag that Scott Fearon highlighted from his book is a company’s reliance on mergers & acquisitions (M&A) for growth.

Fearon asserted that M&A can never replace the true lifeblood of any successful business, which is growing revenues organically.

Whenever a company discloses an acquisition, and Fearon sees the word “synergies”, he is prompted to do his due diligence on both the acquiring company and the target company with the intention of potentially shorting them.

Red Flag Example: Mercury Systems Inc (MRCY)

One company that our team found that fits Fearon’s red flag pretty well is Mercury Systems.

In Mercury System’s most recent Form 10-K, the company states that it has completed 15 acquisitions since 2014:

reliance on acquisitions for growth

It also disclosed that expansion through M&A is one of its primary growth strategies:

 expansion through M&A as a growth strategy

Although it seems that Mercury has been able to grow through M&A, its gross margins and profitability margins haven’t been keeping up:

acquisitions enhance growth but not gross margins and profitability margins

By calculating the gross margin % and profit margin % for the past three fiscal years, you can see that Mercury Systems Inc. has become less and less cost efficient despite their pursuit of revenue growth via acquisitions:

decreased cost efficiency despite acquisitions.

But are you able to find this kind of red flag on companies with Hudson Labs? Are you able to use our platform to find companies that are overzealous in M&A transactions? Yes! And it is quite simple - when using our forensic due diligence search feature, you can view how many M&A transactions a company has entered into within the past two years with our 8-K view. Typically, the announcements regarding M&A transactions are Form 8-K Item 1.01 or Item 7.01.

Below is an example of an M&A announcement from the company Heartland Express Inc. (HTLD) through Hudson Labs 8-K view:

 M&A announcement in Bedrock AI's 8-K view

3: Private Placements (PIPEs) are Desperate Forms of Financing

The third notable red flag that Scott Fearon mentioned in his book was companies using PIPE (private investment in public equity) transactions for capital funding.

He described PIPEs, or private placements, as a “last-ditch funding mechanism for failing companies in which batches of discounted shares are sold to big investors like hedge funds.” PIPEs can also be transacted by related parties of the company. Furthermore, he explained that PIPEs almost never save companies from bankruptcies.

Red Flag Example: Blue Apron Holdings Inc (APRN)

Again, Hudson Labs' 8-K view can be used to see if companies are entering into PIPE transactions. Below is a screenshot of Blue Apron Holdings Inc (APRN) disclosing its private placement agreement. Like M&A transactions, PIPEs are also disclosed as Form 8-K Item 1.01 or 7.01.

 a private placement agreement (PIPE).

As you might expect, Blue Apron’s PIPE transaction appeared to be an act of desperation as the company has been strapped for cash and unprofitable. As you can see below (per Yahoo! Finance), the company has missed its expected earnings over the last four quarters.

 Blue Apron  has missed its expected earnings despite PIPE transactions.

Furthermore, despite getting further funding, the company recently disclosed in its most recent Form 10-Q that it has a substantial doubt on continuing as a going concern!

going concern doubt after PIPE transaction

Hudson Labs and Red Flags from “Dead Companies Walking”

Scott Fearon was able to identify “dead companies walking” by spotting red flags from tons of qualitative information. You too can find red flags and find your own “dead companies walking” by using our forensic equity research platform, Hudson Labs.

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