Saturday, July 6, 2013
Today's essay begins with a story I (Porter) bet you'll think about for a long, long time...
What would you do if your boss were a genuine psychopath?
What should you do, as an investor, if the CEO of the company whose shares you own is a psychopath?
It's 1997. I'm with Steve Sjuggerud and a group of our friends inside the courtyard of an apartment complex, just a few feet from one of the most beautiful beaches in the world – South Florida's Delray Beach.
One of our friends, a guy who regularly surfs with me, suddenly asks, "Hey, you guys do a lot of trading, don't you? Do you know how to structure an options trade – a collar, I think it's called – so that I can protect myself if my company goes to zero? I've been awarded a lot of options, but they won't vest until two or three years from now. And I don't think we're going to make it until then. Our CEO is a psychopath..."
I'll never forget the conversation that ensued. The guy asking the question wasn't your typical surfer. And his boss at the time was the most famous corporate executive in America.
My friend had gone to an elite business school. Then, before he was even 30 years old, he landed a great job as an executive for Procter & Gamble. About six months before I met him, he'd gotten a call from a recruiter. Al Dunlap wanted to hire him at his new turnaround situation – Sunbeam Corp.
This was "Chainsaw" Al, the guy who had just turned around Scott Paper and made $100 million in the process. The business press called him "Rambo" in pinstripes. They meant it as a compliment. If the turnaround was successful, my friend stood to make millions before his 30th birthday.
The idea that Sunbeam would soon go bankrupt seemed preposterous in 1997. The company was on track to earn nearly $200 million that year and was reportedly for sale. The deal to sell the company fell through, so it turned instead to focus on its own acquisitions.
It would soon buy camping-gear manufacturer Coleman and coffee-machine maker Signature Brands (Mr. Coffee). The stock soared and was trading for more than $50 per share. It seemed like a great situation for my friend... a chance to make millions... to learn from Al Dunlap. We had no idea Al Dunlap wasn't merely tough... He was insane.
Years later, in 2001, the man who took over for Al Dunlap at Sunbeam told the New York Times...
It turns out that in every turnaround situation he engineered, Al Dunlap committed massive accounting fraud. And where he'd been caught before, he'd been fired. Repeatedly.
In 1974, Al Dunlap became the president of a paper mill outside of Niagara Falls, New York called Nitec. It was a surprising hire. He'd been fired by another firm only a few months before for speaking so disparagingly of his boss that he'd damaged the company's business.
By 1976, even though profits at the paper mill had soared, Al was fired again. Once again, it was his behavior that had gotten him in trouble. The owner had fired him because of his "grating" management style. Even so, the owner paid handsomely for the result that he believed Al had achieved – a $1.2 million bonus.
But an audit soon revealed there weren't any profits at all... Instead, the company had lost $5.5 million. Expenses were left off the books, inventories were vastly overstated, and sales that were booked never materialized. The case ended up in court for years as both parties sued the other for fraud. But...
The entire experience was left completely off Al Dunlap's resume. It was also omitted from the memoir he published in 1997, Mean Business: How I Save Bad Companies and Make Good Companies Great... as was the story of him being fired from insulation manufacturer Manville Corp. in the early 1980s.
Not many people have been fired from senior positions at three different companies within 10 years for narcissistic behavior and serious accounting fraud. Not many people could have found a way to cover it all up, either. But that's what Al Dunlap did.
As we know now, Al Dunlap had a simple playbook. He would cut expenses by firing people and moving executive compensation off the book, using stock options whose expenses weren't counted against net income. He'd tell his accountants to book revenues long before they should have been recognized by shipping products to "stuff the channel."
Many of these products would inevitably be returned, and the process greatly reduced future sales. Finally, before his schemes were unveiled, he'd sell the company to an unsuspecting buyer. When he got caught, he got fired. When he didn't, he made a fortune.
Later, Al Dunlap would end up paying $15 million to settle charges that he ordered accountants to inflate Sunbeam's earnings by at least $60 million in 1997, resulting in huge losses for the company. The SEC would allege he'd been trying to sell Sunbeam to cover up this ongoing accounting fraud, which the board of directors discovered in 1998.
Turns out, that's why he'd sold Scott Paper to Kimberly Clark. He was accused of the same kind of fraud there and later paid a large fine to settle the charges.
When the sale of Sunbeam fell through in 1997, Dunlap began making big acquisitions to better cover up the accounting fraud. That's when my friend came to me and asked how to protect his equity compensation.
My friend knew these deals would destroy the company. And they did. The expenses of these acquisitions led to the company's bankruptcy in 2001 – with bad debts totaling $2 billion. In 1997, my friend was one of the few people in the world who knew that Al Dunlap wasn't just a mean boss, he was a crook.
The story was a tremendous lesson to me. Even executives and companies with the best reputations can't be trusted blindly. It always pays to look closely at the numbers and to ask simple questions.
It was my friend's experience at Sunbeam that led me to look more closely at the accounting practices tech firms commonly used in the late 1990s and early 2000s. Many firms – like Maxim Integrated and Juniper – weren't merely moving some executive compensation off the books with options. They were moving billions and billions of dollars of compensation off the books. I warned subscribers about Maxim and Juniper and recommended shorting them in the July and August 2002 issues of my Investment Advisory newsletter.
The numbers grew so large that in many cases, it became hard to determine if the companies were being operated to produce anything at all or if they were just cleverly disguised frauds. And of course... the situation attracted some genuine psychopaths.
Take Henry Nicholas III – the founder and former CEO of Broadcom, a maker of microchips and one of the most notorious stocks of the dot-com era. When finally forced to restate its accounting in 2007, Broadcom revealed more than $2 billion worth of options had been granted with fraudulent strike prices.
More important, the restatement also revealed that from 1998 to 2005, on a cumulative basis, the company lost $6 billion. Throughout its entire life as a public company through 2005, Broadcom had only produced enormous losses for investors. But its accounting had been managed in a way that enabled its two founders to become worth more than $10 billion each. They'd been rewarded by the market for failure, rather than success. Incredibly, the company survived the scandal.
But... was Henry Nicholas III merely a greedy businessman? In the years that followed, he would be accused of serious crimes involving prostitution, narcotics, and even planting drugs in the drinks of colleagues at trade shows. Other lawsuits, filed by his contractors, accused him of building a huge, secret "sex lair" in caves underneath the home where he lived with his wife and three children.
Maybe these claims are exaggerated, but dozens and dozens of former colleagues say that Henry Nicholas III became a drug addict and acted like a complete maniac. In 2002, his wife caught him having sex with a prostitute while high on drugs in a warehouse he'd had decorated to look like a brothel. After his divorce, his personal assistant would sue him because of intolerable conduct related to his "sexual cravings" and "constant drug abuse."
I've been pondering the question of whether a certain major software executive, someone who is today lauded by all of Wall Street as a "genius," might in fact be – like Al Dunlap and Henry Nicholas – a genuine psychopath who's going to destroy his company and wipe out millions of investors.
For me, the litmus test has nothing to do with real psychology, abrasive personalities, or even extreme personal peccadillos... like too much booze and too many prostitutes. I've been around wealthy, powerful men for most of my life. Plenty of people out there can successfully manage their vices and their companies. As my most successful mentor told me early in my career...
For me, the telltale sign of a psychopath is someone who knows... or has reason to know... that the policies and procedures he's using aren't going to work. Consider Al Dunlap. From the very beginnings of his career, he was getting fired for horrendous personal behavior and accounting shenanigans. It seems clear that he couldn't control his urges to abuse people and lie.
I spent a good portion of my time in the last few weeks researching one company whose CEO is brilliant. He's far too smart not to recognize that his abuse of employee stock options grants is completely unsustainable. But still... stock-option expenses are now growing faster, year over year, than revenues. Over the last three years, the results of these policies have been massive losses – which are growing larger, year after year.
So far, this CEO has succeeded in distracting Wall Street from these facts with several acquisitions. He's paid the investment banks a lot of money to do bond issuance for him, which has kept the analysts from downgrading his stock.
But... the most recent deal will prove to be his undoing. It was a $2.5 billion deal. And he was forced to pay in cash. Suddenly, the companies he's buying won't accept his stock as compensation. That's a sure sign in Silicon Valley that something is about to go terribly, terribly wrong.
I describe the whole story in the June issue of Stansberry's Investment Advisory. But the real story... the real explanation for why anyone would lead a multibillion-dollar, global business with millions of customers and thousands of employees in this way has yet to be written.
Here's a prediction: Sooner or later, we'll find out that this guy wasn't merely a bad businessman. He was a genuine psychopath.
If you'd like to get the full story – and learn more about Stansberry's Investment Advisory (without watching a long video) – click here.
Date Range:6/27/2013 to 7/4/2013
Date Range:6/27/2013 to 7/4/2013