How to Fail

As investors, we are always looking for the next Amazon.com AMZN, but we also must be aware that some companies don’t make it. Sometimes, the risk is clear from the start: for example, small biotech companies that pin their hopes on one magic new drug. Drug testing is long and expensive, and if the beagle gets diarrhea, so does the stock. But we all can learn a useful lesson by studying failures. Failures that are your own fault can be very dangerous to both your portfolio and your career, so if you can learn from someone else’s disaster, so much the better.

Big-company failures, like Enron, are very important, but in a big multidivision company, there are platoons of executives who screw up and the lesson is fuzzy. Small-company collapses are more dramatic because it’s usually the fault of one person. When Shakespeare wanted to depict a major failure, he did not study Tudor Electric; he brought it down to one man, King Lear, who made disastrous errors in his succession planning.

I’m going to discuss three companies that blew up. All were small companies based in Chicago, and the events happened many years ago.

Stein Roe & Farnham When I started work in 1960, the leading investment management company in Chicago was Stein Roe & Farnham. The firm was run by serious investment professionals with high ethical standards. But as time went on, the founders retired, investment results were uninspiring, and they started scrambling for new accounts.

The firm had hired a young man in the back office named John Giura. He worked his way up in the company and finally became a partner in the firm. He was considered the firm’s specialist in union pension funds. The two biggest accounts he brought in were Teamsters locals in upstate New York. The Teamsters union was famous for leaders like Jimmy Hoffa and others who were suspected of mob ties. At the time, I thought it was unwise of Stein Roe to do business with people of this notoriety, and sure enough, in 1983 the SEC descended on the firm and discovered numerous cases of fraud.

One of the most common transgressions involved new issues. Most investment management firms received allocations of hot new deals from the investment banker. Giura was able to put the new issues in a special account. If the stock did not go up, it went in the Teamsters pension fund; if the stock went up, he would place it in the private account of the union president or one of his family members.

While this was going on, I was asked to talk at an investors meeting, and a gentleman from Stein Roe was also on the panel. Someone asked, “Why should I give my business to little Harris Associates when Stein Roe has been so successful?” I answered, “Well, one reason is that we don’t have any partners who are going to go to jail.” Most of the audience laughed, but the Stein Roe people did not. Stein Roe did not go out of business, but its fortunes never recovered.

Bass Financial Saul Bass was an optometrist who became so skilled at reading fine print that he decided to go into the savings and loan business. He founded Unity Savings in Norridge, Ill., a village completely surrounded by the city of Chicago. Unity became the first publicly held savings and loan in Illinois in 1971 as a holding of Bass Financial Corp. At that time, the great suburban housing boom of the 1950s, '60s, and '70s was in full swing, and savings and loans were formed to write mortgages on the famous 3-6-3 system: You paid savers 3% interest, wrote cookie-cutter mortgages at 6%, and it was easy enough that you could get to the golf course by 3 p.m.

Saul Bass realized that the growth of Unity was only limited by his ability to attract new savings depositors. Interest rates were regulated, but it was OK to give a gift to new savers. Therefore, the key employee was the appliance buyer, and Unity bestowed carloads of electric blankets, steak knife sets, and toasters on the pleased Chicago public. Bass did this better than most of his competitors, and his business prospered. He and his two sons had invented a money pump. I bought stock for the Acorn Fund because the Basses had a simple and powerful business plan, growth without much risk. What could go wrong?

Well, what went wrong was inflation. By 1980, inflation was in double digits, and interest rates went up to match. Savers were no longer content with a waffle iron; they wanted 10% interest on their savings. Meanwhile, the S&L’s mortgage portfolios were still generating the same 6%. The business model had gone from 3-6-3 to 10-6-12, where paying 10% to savers for 6% mortgages kept you awake till midnight.

Bass, like many others, tried to stay in business by investing in commercial real estate loans that paid enough interest to keep the S&L going— as long as the loans were good. They weren’t. By 1986, the industry was in collapse as more than 1,000 S&Ls went bust. The family had been offered $20 million by an acquirer, and the family turned the deal down. A year later, their business was worthless. As it collapsed, the two sons panicked and stole about $40,000 in cash out of the till, knowing that it was the last week they would be in business anyway. The Basses got caught.

The moral here is that on a sunny day all managements look skillful and ethical. But when the storm hit the S&L industry, it was a national crisis, and many respected leaders lost their nerves as they were losing their businesses. When an industry collapses, all you can do is get out of the stocks as fast as you can.

Mercury Finance In 1984, John Brincat, a former Marine officer, started Mercury in the subprime auto-lending market. Subprime is an inherently risky form of business. Your customer needs to buy a used car and will pay a high interest rate to do so, but he has a lousy credit score and is likely to default. If the economy turns down, a lot of them will default. In the early days, the company did well, grew fast, and was described as a "darling of Wall Street" because of its skilled and careful management. Brincat organized the company into regional divisions and made it clear that he expected each of his reporting officers to show strong growth in revenue and profits. Those who did so were praised and promoted. Failure was not an option.

We owned the stock in the Acorn Funds, and our analyst was thrilled by the rapid advance in the price of the stock. One day, he came into my office and said that he was getting nervous about the stock, that “something doesn’t feel right.”

By this time, I had learned that when something is about to go wrong, you feel it in your gut a long time before you know it in your brain. So, I encouraged him to sell the stock. He did. Shortly thereafter, in 1997, it was discovered that the company had been cooking the books. It had overstated its profits by $175 million over the previous three years. What went wrong? The tough Marine had so terrified everybody in the company that it was much easier for the executives to provide false numbers than to tell the truth but face his wrath.

The moral: Tough leadership is good, but too tough is bad. In this case, the rigidity of management caused sudden bankruptcy.

All three of these examples of failure happened in the financial business. In a finance company, there is no physical inventory or big factory, so it is easy to make up stuff. There is nothing easier in the banking business than to grow your balance sheet by making loans if you are willing to make bad loans.

This article originally appeared in the October/November 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.