Chapter 4
MAKING DEALS
“If you’re offered a seat on a rocket ship,
don’t ask, ‘Which seat?’ Just get on!”
—Sheryl Sandberg
There is no such thing as zero risk. Any deal you negotiate pits you and your wits against the stakes, whatever they may be. Some deals end up with winners all around. In other deals, there are only losers.
In my experience, the most memorable deals are those where you are challenged to go so much further than you have ever gone before that you wonder whether you will succeed. These are the deals where you’re forced to take a risk on yourself. And if you win, the payoff is worth more than gold.
LEARNING THE ROPES
The only profit on your first gambles might be experience!
When I started investing, I had no capital, so I looked for really cheap, obscure stocks I could buy. The deals that appealed to me most were those that made good use of my ongoing training and experience in the market. I looked for low-priced stocks with very high potential returns. My hope was to double or triple my money. It was a rookie mistake. If investing were that easy, no one would have to work—they’d just speculate!
The stocks I bought for my clients did well; my own gambles did not. Soon I realized I should be buying the same things for myself! It represented a big shift for me. Once I did that, we all prospered.
In 1963 I bought one thousand shares of the Platt Corporation at one dollar per share. Just three years later the stock was worthless. I couldn’t sell it, not even for fifty cents a share.
When I saw that it was listed as “no bid,” I picked up the phone and called the president of Platt. “Would you be willing to exchange my single thousand-share certificate for one thousand certificates of one share each?” I asked.
“Why would you want me to do that?” the president said cautiously, sensing he was walking into a minefield.
“Well, I just bought a great new home and I’d like to use certificates as wallpaper in the bar to remind myself not to invest like this anymore!” I laughed.
The manager’s laugh was a little more strained, but he was a good sport about it. “To tell you the truth,” he said, “we don’t even have enough money to have the certificates printed!”
After the call, I threw my worthless thousand-share certificate into a drawer and forgot all about it. A few years later, I heard that Platt had changed its name, improved its real estate holdings, and was selling for over ten dollars per share! I rushed back to the drawer and pulled out that thousand-share certificate with a smile.
I was lucky twice over. Not only was the stock worth ten times what I’d paid for it, but I didn’t have to hire a paperhanger to peel one thousand stock certificates off my wall!
Real estate investing caught my interest in 1967 when I noticed that half my income was going to income tax. I didn’t like it and determined to devote at least a fifth of my time to converting those tax dollars into investment dollars.
Luckily for me, my brother-in-law, Lewis Young, was planning to develop garden apartments in Orlando, Florida, and invited me to invest. I was delighted to join him. I’d lived in garden apartments myself and thought that they were a superior concept.
Over the next thirty years, I invested in garden apartments throughout California, Texas, Arizona, and Georgia. My strategy was to find communities where population growth was expected and local politics did not favor rent control. Then I’d buy middle-quality projects suffering from high vacancy and low rental rates. I’d fix them up, supervise an improvement in management, and gradually raise rents as the population growth bailed me out.
The results were exceptional. As I’d hoped, my tax deductions covered my investment dollars. As the properties improved, I refinanced them rather than selling them outright. Over the next decades, these apartment developments became quite valuable.
Unfortunately, my real estate investing skills didn’t extend to all types of real estate. My hotels and land development investments never worked for me. Much more than I’d realized, a hotel is a hands-on business that requires a continuous flow of capital. Land developments are even worse. They take patience and they suck up cash. I find neither one appealing.
In time, my profits in real estate equaled those from my securities investing. Not bad for a sideline! You never know what you’ll be good at until you try it. As the great hockey player Wayne Gretzky once said, “I missed all goals I didn’t shoot at.”
One of the garden apartment complexes I invested in, for example, was a huge success. I just had to wait fifty years. Country Village Retirement Center in Riverside, California, was a 1,189-unit garden apartment complex built on a 113-acre field called Apache Flats.
Its nonprofit sponsor was an all-black Elks Club in Philadelphia that intended to create racial integration in the community and offer rents as low as seventy-nine dollars per month. The FHA had insured the mortgage for $12 million—enough to cover 100 percent of the building cost. Senator Robert Kennedy and soon-to-be vice president Hubert Humphrey strongly supported it. It was a fine objective, but like so many other government efforts in commerce, it was poorly conceived.
For one thing, it was the sixties and the neighborhood they had selected was white. Racial tensions in Los Angeles were exceptionally high. People were still shuddering from the six days of violence, looting, and arson that had broken out with the Watts Riots in August of 1965. Governor Pat Brown had deployed fourteen thousand National Guard troops to stop the rioting and to establish a curfew perimeter. More than a thousand people were injured. Thirty-four were killed.1 Watts is an hour away from Riverside.
Construction of the units was completed in June of 1966, but rentals were sparse. By 1968, vacancies were at 50 percent and the mortgage payments were $1 million behind. Real estate taxes were overdue, and the management was woefully incompetent. The tenants included drug dealers and prostitutes. But both the insurer, the FHA, and the lender, Manufacturers Hanover Bank, were reluctant to foreclose on such a politically sensitive project.
In 1967 I met with the FHA in their Los Angeles regional office. I explained that I believed in the growth of Southern California, and I was looking for a large real estate transaction to provide big profits over the long term. They were thrilled to find a New Yorker wanting to sink cash into a troubled California project! Country Village was the only property that they showed me.
Back in 1968, investors could deduct their tax losses from real estate from their earned income. So I knew that, whatever happened, I could use the depreciation from Country Village to save income taxes for years, as long as I could keep the mortgage alive.
In my negotiation with the FHA, I agreed to pay back all the mortgage, if they would agree to delay the annual interest and principal payments. It was a good offer for them, but inexplicably, they started dragging their feet. Months went by. Finally, I gave FHA an ultimatum. That’s when I learned that a politically connected local investor had been trying to get the project. Fortunately, he didn’t match my deal. We closed on November 29, 1968.
For three years, I relied on outside managers to improve the property on behalf of the investors who owned it, but the results were awful. Finally, I decided to manage it myself. I moved out the criminals, cleaned up the property, and began an energetic marketing program. And despite unanimous advice to the contrary, I insisted on maintaining the multiracial tenancy.
Soon we were prepaying the past-due interest ahead of schedule. Everyone was happy. The only snag was that, until the mortgage was fully paid, the rents were controlled by the FHA, which kept them so low that virtually no profit could be made. Then, in 1978, a windfall occurred.
At the time, large Canadian real estate investors were gobbling up US real estate for big purchase prices. One of them, Daon Corporation, called me. “We’d like to offer you an $11 million profit for Country Village, so we can convert it to condominiums.”
“What about the current tenants?” I asked.
“We’ll guarantee each of them good deals,” they assured me.
We didn’t hesitate to approve the deal. When Daon ran into delays in getting their approvals, they paid us a $500,000 cash advance to encourage our patience. We gleefully accepted.
To Daon’s surprise, the tenants banded together to oppose the purchase and forced the company to walk away. They had not taken into account the persuasive powers of Chuck Hilton.
A very effective and clever fellow, Chuck Hilton organized his fellow tenants and led the standoff with Daon. Soon afterward, he approached me with a proposal. “We recognize that you’ve invested twelve years of hard work in Country Village to create a desirable community. You’ve been so successful that we don’t want to leave!” He asked us not to sell, but to raise rents enough to generate profits.
I thought we could do better than that. After considering his proposal, I came up with a counteroffer to benefit them even more. Instead of paying higher rent, the tenants would pay a small nonconversion fee in exchange for our commitment not to convert to condominiums for the next twenty years, and they would manage the property themselves in order to save money through volunteer services, thereby offsetting the new fee.
We insisted that the tenants hire a good lawyer and have HUD (the new name for the FHA) approve the arrangement. Since the rents and the fee combined were still less than HUD rent limits, they happily approved the deal.
Soon we had an agreement that yielded the owners $900,000 in cash the first year and increased to about $2 million per year over time. I believed that the owners and the tenants had a mutually enjoyable twenty years ahead. I was wrong.
About ten years later, HUD sold the Country Village mortgage to a mortgage pool. Mortgage pools are like robots. Any change in the terms triggers an automatic foreclosure. That meant the end of any future flexibility in dealings with the lender. Then, in 1986, the Country Village tenants fired Chuck Hilton, who was responsible for persuading us to make Country Village a co-op in the first place. No good deed goes unpunished.
When the rents were raised in response to the high inflation of the late 1980s, the tenants launched a political campaign, complaining to the local Housing Authority and their US congressman. The bickering continued into early 1994. The failure of the tenants to maintain the property as they’d agreed resulted in heavy expenditures on our part to bring the property into compliance with the HUD mortgage requirements.
By March of that year, we had restored the property to good condition and resolved all the remaining disagreements by negotiating new agreements with the tenants. Not only was it a great relief to all of us, but it allowed us to refinance the mortgage, which netted the owners about $19 million—our first big payday after twenty-five years of effort!
In June the tenants stonewalled us again. They refused to make the payments due and threatened to turn the project back over to the owners. We were stunned.
We could not avoid the conclusion that the tenants of Country Village were unable or unwilling to manage it responsibly. We offered them advice and ultimately brought in a professional management company. But as the condition of the property steadily declined, the vacancies rose from the 2 percent range to 6 percent. This depleted the Country Village cash account, and the tenants responded by raiding their own cash reserves.
Events escalated from there. We soon learned that tenants had again complained to their congressman, who notified HUD, who sent inspectors to the property without notifying us. HUD concluded that we were obliged to fix everything and the tenants no longer had to pay the nonconversion fee. It was as if our deliberately generous agreement to let the tenants manage Country Village and pay the owners a small fee for not converting it to condominiums had never existed.
We had no choice but to notify the tenants of their breach of contract. When we did, the Sunday Los Angeles Times ran a front-page story on October 22, accusing me of exploiting the Country Village tenants. The article was full of misstatements and malicious innuendo. Despite the facts and subsequent court rulings, I never was able to get a retraction from the newspaper. Remembering the old advice about not fighting someone who buys ink by the tanker carload, I resigned myself to suffer in silence.
Failing to grasp the nature of the situation, a local HUD executive notified us on October 30 that we were in default. On October 31, the tenants refused to hire the management company we recommended until a court determined that they were in breach of the agreement.
The tenants were literally insisting that we sue them to extinguish the agreements that were so favorable to them and that we had honored for thirteen years. It was unfathomable. But on November 6, we sued.
Our court system is the best hope when government power is misused, as it was by this misguided officer at HUD. In my experience, most US judges strive to be fair and to seek a reasonable resolution of disagreements. They are well aware that governments can abuse their power and often need to be brought into conformity with proper practices. Fortunately, our judge in this matter was no exception.
The nonconversion agreement I had so painstakingly created for the benefit of the tenants was canceled. Although that was bad news for the tenants who fought to end the agreement, it was good news for us, restoring the long-term flexibility in rent increases that usually is available to landlords. Nonetheless, we made rental rate increases that were moderate, and they remain at bargain levels today.
The management company we had recommended was made the receiver for Country Village by the judge, giving the management company total power over the property. Very quickly, they discovered a shocking pattern of behavior by the tenant leadership. Bank accounts had not been balanced. Cash had been misused. Friends had been given premium apartments at standard rents. Electricity and other company assets had been stolen outright. Cleaning up the mess the tenants had needlessly created ended up costing us over $1 million. It was an expensive lesson in grass-roots democracy.
Eventually, we started enjoying the normal pleasures of successful real estate investing. Our profits gradually grew. We added many new units and refinanced the mortgage whenever market conditions were favorable.
By 2015 Country Village was valued at $130 million more than our cost. It was one of the largest retirement apartment projects in California at the time, and it still is today. A great result—even if it took fifty years!
INVESTMENT: ARIZONA CITY
In real estate location is everything.
Nestled in the Santa Cruz Valley between Tucson and Phoenix, Arizona City is a picturesque retirement city with an eighteen-hole golf course and a forty-eight-acre lake and today has over twenty thousand residents.
When the great Basque explorer Juan Bautista de Anza emerged from a perilous journey through Apache land in 1775, he rested in Arizona City and marked the spot for future travelers. Spanish explorers had been searching for more than two hundred years to find an overland route through the endless deserts of Mexico and the American Southwest to the Pacific. Bautista succeeded where the others had failed. He was the first European to designate a corridor from Sonora, Mexico, to the Presidio in San Francisco.2 The historic trail runs through Arizona City to this day.3
In 1959 the Arizona City Development Corporation (ACDC) bought five and a half square miles of pristine real estate in Arizona City, intending to develop a retirement community there one day. In their marketing materials, the driving force was the fact that the area has one of the purest water sources in the state. In 1963, the Arizona City Daily Star boasted that every two weeks “we send samples to the state Health Department and their analysis reports come back consistently reading 100 percent pure.”4
In the summer of 1977, my investment banking client J. B. Fuqua called me. His publicly traded conglomerate, Fuqua Industries, had bought ACDC in 1971 and had been trying to liquidate it since 1975.
I reluctantly took the assignment, and I sent out Fuqua’s descriptive brochures to a series of prospects. ACDC seemed to be a viable company in a potentially lucrative position. Tucson and Phoenix are only one hundred miles apart, and Arizona City lies halfway between them. Most predicted that urban sprawl between these two major high-growth cities would eventually fill the gap, sending property values in Arizona City through the roof. It would be a gold mine for a development company like ACDC. The logic sounded correct, but it was totally wrong. ACDC was not in an urban area in 1977 and remains rural forty years later!
I sent the offering materials to many prospects, not even asking for a high price. Shockingly, not one prospect showed any interest. By November, I had no choice but to let J. B. know that I didn’t have a deal. “I can’t even persuade most of the prospects to read the materials!”
J. B.’s response was harsh. “I want ACDC off our balance sheet by year’s end,” he snapped. “You’ve got to do it!” At the time, the only alternative I could see was to buy it myself!
Putting your own money at risk sharpens your analysis. As soon as I decided to invest myself, I started to see the problems. Most of the lots in the retirement community had been sold, for instance, but ACDC had not fulfilled its obligations to build roads to many of these lots. Meanwhile, since so few homes had been built at the time, the population was too low to support the stores, much less the golf course, and building the required streets was increasingly costly, as asphalt prices were soaring.
A huge cash injection would be required before the community would be viable. Obviously, J. B. was determined to sell in order to avoid a bigger charge to his year-end financials.
Although ACDC seemed to have a net worth of millions of dollars, it was losing money every year. When I offered ten dollars to buy all the shares of ACDC and required the seller to inject millions of cash into it, J. B. accepted. I wondered how I could possibly lose. Now I know. He was a very shrewd businessman. I should have known better than be on the opposite side of a deal from J. B. Fuqua!
I lent millions of dollars to ACDC to meet their development obligations. I gave the community all the amenities, including the golf course, in exchange for one dollar. Due to faulty drainage engineering by the county, some improvements were needed, and I made them pay for the improvements. I built homes and condos on speculation. I tried to woo businesses to relocate to Arizona City. Nothing worked.
Location was the problem. Arizona did grow as I predicted—just not between Tucson and Phoenix. I still don’t know why, but it boomed on the west side of Phoenix.
As of 2018, Bill Gates is building an $80 million “smart city utopia” on that west side. If he succeeds, it will be the first zero-carbon community in the United States. Europe and China are already developing greenfield concepts like this, but in the States, developers have been delayed by local governments. With the depth of his financial resources and his high profile in technology, Gates may be able to surmount the challenges that would be prohibitive for other developers.5 This is just one example of the huge growth that Arizona is enjoying. Happily, the apartment project that I bought in Mesa, Arizona, has gone up in value by about 400 percent, more than offsetting my financial losses in Arizona City. But, alas, not my time losses.
Arizona City retirement village had a land area the size of Beverly Hills, California. It’s still the same size, but mostly vacant.
J. B. FUQUA
Over the course of his career, John Brooks “J. B.” Fuqua was an avid investor who bought more than sixty companies—everything from film processors, movie theaters, radio stations, and sporting goods makers to oil distributors.6
Always active in politics, he was elected to four terms in the Georgia state legislature, and he served as chairman of both the Senate Banking and Financing Committee and the House Banking Committee.7 As chairman of the Democratic Party of Georgia in 1962, he ran the campaign for Carl Sanders’s successful bid for governor and was instrumental in the early political career of Jimmy Carter. Along with US attorney general Robert Kennedy, J. B. and Sanders worked to reduce racial violence in the South.8
J. B.’s life had a rocky start on a small tobacco farm in Prospect, Virginia. By the time he was two months old, his mother had died and his father left him to be raised by her parents. As soon as the law would allow, he changed his name from John Brooks Elam Jr. to his maternal grandmother’s name, Fuqua.9
On a Saturday afternoon when he was fourteen years old, J. B. tuned in to a radio station broadcast out of Richmond, Virginia, to hear an engineer teach a course in Morse code. At the end, he announced that listeners could order a pamphlet called “How to Become an Amateur Radio Operator” for twenty-five cents. Fuqua later said it was the best investment of his life.10
By the time he was nineteen, he was chief engineer at a broadcasting station in South Carolina, but he quickly realized he needed to own his own station. Unsure of how to proceed, but unable to afford a college education, he took the initiative to borrow books on finance, banking, and business management from Duke University by mail. The first lesson he learned was that successful businessmen get investors to sponsor their businesses. That business principle had such an impact that he included it in the name of his 2001 memoir, Fuqua: How I Made My Fortune Using Other People’s Money.11
With three investors, he capitalized on what he saw as a promising new industry: television. After securing one of the first TV broadcasting licenses, he founded the first television station in Augusta, Georgia (WJBF-TV), and a radio station affiliate of NBC (WJBF 1230 AM). From that beginning, he built a network of stations that later sold for $30 million.12
In the late 1960s, J. B. bought the smallest company on the New York Stock Exchange, Natco Corporation, a brick and tile manufacturer. Its profits were on a downward trend, but it had a large tax loss carryforward, no debts, and a book value that was double the market price.13 Within three years, he changed Natco’s name to Fuqua Industries and began acquiring businesses. The company was very profitable. It served as his first public vehicle.14
I heard about J. B. from some friends in Georgia. Soon, I was buying all the shares available from a TV station chain company that was merging into Fuqua Industries. They were trading at a big discount to the value because the deal was so obscure. I later sold them for enough profit to buy my first big home!
For the next several decades, J. B. bought and sold companies, building up one of the first highly diversified public companies—a so-called conglomerate—that was later valued in the hundreds of millions of dollars.15 In the 1980s, a private equity firm, Forstmann Little, teamed with four top executives at Fuqua Industries for an offer of twenty-five dollars a share to all stockholders. Unfortunately, they neglected to consult in advance with J. B., who immediately fired all four executives. J. B. called me, and I helped him design a recapitalization that helped him retain control of the company by leveraging it with large borrowings. Years later, he sold control and retired. He did remain active in politics and charity work, though.16 When the 1996 Summer Olympics in Atlanta needed $1 million for more portable toilets, he gave them the money.
J. B.’s big philanthropy occurred in the 1980s when he remembered that he had been able to educate himself in business thanks to the librarian at Duke University who allowed him to borrow books to read at home. To show his gratitude, he enabled $10 million to be donated to endow the Fuqua School of Business at Duke.17 As usual, J. B. was clever. It’s now one of the top ranked among such schools!
INVESTMENT: GLEN IVY
Relying on third parties without oversight can yield nasty surprises.
It’s rare for the government to raid a company due to massive fraud six months after the completion of a sophisticated investor’s due-diligence process, but unfortunately, that’s what happened with Glen Ivy.
In the spring of 1991, Manufacturers Hanover Trust, then a major New York bank, contacted a colleague of mine at Bear Stearns who was a former executive of that bank, to assess our interest in financing the management buyout of Glen Ivy.
At the time of our analysis, Glen Ivy, the largest time-share business in the world, was reporting operating income in the range of $10 million a year. Projections showed it should rise to $30 million a year over three years. Its lenders included some of the leading banks and insurance companies in the world. They would not have been involved without clean audits by a major auditing firm.
Since its inception, the time-share industry had been a fragmented, lightly regulated assortment of small property owners, and the industry was prone to bad practices. Regulatory infractions were common. Misleading sales practices and overselling units for more than fifty-two weeks a year were problems across the industry. Over the past twenty years, however, time shares had gained a more respectable image with the entry of major firms like Marriott, Hilton, and Disney.
When we were first approached with the deal, Glen Ivy’s prospects were so promising that, a year earlier, General Development Corporation (GDC) had purchased Glen Ivy for about $90 million. However, GDC was in bankruptcy. This was just the opening that Glen Ivy management had been waiting for.
This same management team had been operating successful resorts in Aspen, Park City, Hawaii, Palm Springs, Laguna Beach, and Lake Tahoe for fifteen years. Its competitive advantage was that it maintained regional sales centers rather than on-site sales staff at each property, which permitted it to sell a “package of value” (vacation times at a wide range of resorts). This approach also helped stabilize the sales force, since salesmen’s jobs were not limited to any single property. Customers seemed happy. The reports Glen Ivy provided to us showed low default rates.
Customers typically bought the ownership of a specific unit for one week a year in perpetuity in a property that usually had been either a hotel or an apartment building. This meant that a single apartment could be sold up to fifty-two times. The total revenue far exceeded monthly rentals. The downside was that few of the properties sold out all fifty-two weeks, and marketing costs were maybe 25 percent to 50 percent of sales. (And in the case of Glen Ivy, sales costs were almost 60 percent of sales.)
What Glen Ivy seemed to need was committed financing in order to hold the customer loans that equaled 90 percent of the sales price and were paid off over seven years. Also, they needed a balance sheet that was strong enough to sustain the trust of potential customers.
We reviewed two clean audits from major accounting firms. Both reported that Glen Ivy’s equity was over $30 million. We interviewed regulators and visited company sales centers. We spoke to their auditing firm to emphasize the crucial need that their work be of the highest standard, since we were relying on it for the financing. We even went so far as to hire a regulatory compliance expert to review the most vital company systems.
My own personal experience weighed on the matter, too. As a new single dad who had lost his ski house in his divorce in the early 1970s, I had bought a time share in a ski resort during the week of my sons’ spring break every year. It had been a great fit for my needs: a dependable, convenient experience in a spectacular location, with no demands on my time. When it no longer suited my needs, I sold it at a profit. That success, along with the thorough vetting by our professional teams, gave us the confidence to proceed with the financing.
In June 1991, we closed on $15 million financing for an 18 percent note. We also received 50 percent of Glen Ivy’s shares for “free.” We expected to earn a 40 percent return on our investment over the next four years. I bought 20 percent of the issue myself. One of my clients who was an expert in consumer marketing bought 20 percent. A well-regarded private equity firm bought 40 percent. Glen Ivy’s CEO bought 20 percent. All of us were certain we had made a good investment.
So the government raid not six months later shocked us. We watched the news on television, stunned that it was carried out by the local district attorney, the California Department of Real Estate, and the state attorney general.
An emergency board meeting was called. The management seemed as horrified as we were. They blamed the local attorney general for using the raid to further his political ambitions. Whatever the cause, we recommended that Glen Ivy immediately hire top-notch advisers: criminal counsel, insolvency counsel, crisis public relations counsel, a major independent auditing firm, and a savvy consultant who would be given complete access to the company.
However, the court gave an outside chief compliance officer physical control of the facility, and the district attorney seized many of the company files. Reports in the press were killing Glen Ivy’s business. Staff members were becoming demoralized. The board warned us that it needed to raise enough cash to keep the company operating. It was still unclear what the real problems were, but we agreed to help them buy time.
In April, our investor group gave Glen Ivy a $1 million loan secured with property. Smaller emergency loans, large enough to ensure a few months’ operations, were secured by other assets. Then a court-appointed trustee took control of the management of the company and Glen Ivy filed for bankruptcy under Chapter 7 (which calls for liquidation of the business).
It was not until the end of April that we understood the full gravity of the situation. Our special consultant told us the bad news. Some of the properties were in no condition to be marketed. Others were unlikely to be profitable. Inventory control systems were so inadequate that it was unclear which products were available for sale. Even worse, duplicate sales of the same time interval were being made.
As to the government accusation of massive fraud, the consultant found that certain executives had unlimited access to all computer systems, leaving Glen Ivy with no protection against theft, fraud, or anything else. It was a nightmare scenario. We had to assume the worst.
The only good news was that customer sales details, inventory details, and legal records like deed recordings were all kept securely in one place by Security Pacific Bank, which held the custodial document account and was a major bank at the time. These records were in good hands. All of them were accurately accounted for.
It was also the responsibility of Security Pacific to send out exceptions reports to notify management if any problems or conflicts occurred. That system was functioning perfectly. Security Pacific had been sending out report after report, revealing shocking misconduct: multiple sales of the same time intervals, suspiciously slow accounting for cancellations, and fraudulent loans for sales that did not exist.
Apparently no one—not the outside auditors, not the New York bank that made the loans secured by the customer loans, and not the other lenders—ever looked at these reports. The investors, of course, had never seen them.
By the summer of 1992, chaos reigned. The trustee was funding his fees and expenses with emergency loans from the banks. The banks were emphasizing short-term monetization of all assets, which made the likelihood of anything being left over for our investment very low. An increasing number of lawyers was showing up to represent all manner of claimants.
It was clear to us that we would have a 100 percent loss unless we could find someone solvent to take responsibility for the fraud committed against us. Obvious candidates were the CEO and the auditors. Some of the lenders and one of the law firms were also possibilities. We retained a litigator to represent our investor group in November. Since we would probably have to pay them ourselves, we were hoping for a quick settlement.
So I called Glen Ivy’s auditors and offered a proposal. Together we would select a major auditing firm to review the quality of the audit. If the audit was not up to industry standards (as published in “Generally Accepted Auditing Standards”), then they would buy out the investor group’s holdings at our cost of $15 million. If, on the other hand, the audit was good enough, then the investors would give the auditors a full release.
They asked what information we would need. I asked for the audit work papers, especially the bank reconciliations, reasoning that if the sales accounting were phony, then the cash wouldn’t show up, since it had never come in. Surely no auditor would sign off on an intense audit when a company’s bank accounts didn’t conform to their sales reports! With this fail-safe in place, I thought we would settle the issue quickly.
Then I was told that not all time-share borrowers had been sent confirmations and only some of them had responded. Further, the auditors’ work papers only showed that bank records had been reviewed, but none of them were in the files! As the coup de grâce, the auditors refused to buy out our investment if their work was shown to have been inadequate. This made me angry. We had no more settlement talks. It got worse in February 1993, when Bill Lerach, the most notorious class action lawyer in America, filed a class action suit against Glen Ivy and all of its bank lenders.
Allegations were that Glen Ivy had sold the same time intervals to multiple buyers, customer signatures had been forged on crucial documents, properties had been sold without the necessary permits, properties had been sold that Glen Ivy didn’t even own, secret records had been maintained to cover problems, and customer complaints had been kept from all relevant outsiders, including the regulators.
It was becoming more and more clear to us that any recovery by our group from the bankruptcy estate would be very small, especially after this class action lawsuit was settled. So in late March 1993, we reluctantly filed suit against the Glen Ivy auditors and against the executives who had directed the massive fraud.
Three months later, the bankruptcy trustee and the senior lenders settled the class action suit. As expected, this reduced the assets available to us and all other lenders.
A shocking story emerged when the investigations and litigations were complete. The conspiracy was far more calculating and extensive than any of us had imagined. Senior executives had collaborated to create financial reports that greatly overstated their earnings. Phony collateral had been used to secure major loans to the company. Duplicate sales of the same units were not an accident of poorly managed paperwork, but were deliberate and widespread. An enormous number of buyer defaults and customer complaints had been covered up.
Our investment was worthless. What once had been the largest time-share development and marketing company was now revealed as the largest time-share fraud ever.
How could this happen despite our due diligence? Why would the CEO himself have invested millions of dollars alongside us if he knew of this massive fraud? Who could have predicted such a bald-faced fraud? Was there any way we could have avoided it?
Our major mistake had been relying on others. Despite the close relationships, clear expertise, and mutuality of interests, all the other third parties failed to enforce even the most elementary compliance standards.
Any auditing technique requires a cash reconciliation. Glen Ivy’s phony sales and cash collection reports never balanced with their bank records. No honest auditor could have missed it. Yet we never learned why this failure occurred.
Outside experts relied on Glen Ivy to generate samples of accounts on a random basis. The theory is that a large enough sampling of customer accounts, selected randomly, will provide an accurate status of these accounts. Glen Ivy secretly controlled which samples were selected, so that only the satisfied and performing customers were reported.
In retrospect, I wish we had employed an independent computer analyst to test their systems. Since the systems were accessible to many insiders, comparisons of the data may have revealed inconsistencies. Using another auditing firm, instead of relying on our close relationship with their auditors, may have helped, too.
We believed, however, that truly independent experts should have identified enough concerns that would have prevented us from making our investments. That is exactly what our legal team argued in its briefs, and we could prove the failures of established institutions who knew or should have known about these problems.
That is why we were able to settle our lawsuit without ever going to trial. We ultimately recovered all our money. But since it was paid in installments over years, we did have an economic loss.
In the criminal trial, the court found the chief financial officer guilty of carrying out the fraud, and he was sentenced to about four years in prison. The chief executive officer, who must have known about the fraud, escaped with only large financial losses. Although our diligence in pursuing the culpable parties salvaged our investment, I can’t say I’m proud of the result.
Glen Ivy no longer exists, but, at the time, it was the largest vacation time-share company in the world.
ON INVESTING
The great economist Joseph Schumpeter wrote about “creative destruction” in market economies. His theory was that every major new investment attracts capital for expansion until excess capacity lowers prices to a point that destroys much of the new investment. Remember the collapse of the railroads in the 1930s, the digital industry in 2000, and the new mortgage finance vehicles in 2008. As long as human emotions are volatile, so shall be the economy.
While economic factors do influence stock prices, many other variables are involved. In fact, as the chart below shows, it is hard to attribute stock price changes to any particular fundamental driver. They are much more volatile than any single factor—except human emotions.
Since 1900, there have been rolling five-year periods in which stocks went up an average of 35 percent per year, and rolling ten-year periods in which stocks went up an average of 20 percent per year. Most investors during these good periods thought that they were geniuses.
On the other hand, there have been rolling five-year periods during which stocks have gone down an average of 18 percent per year and rolling ten-year periods with average declines of 5 percent per year. With the largest holders of stocks now being institutions, just think about the careers of the professional investment managers whose jobs happened to coincide with a multiyear losing streak.
Perhaps more relevant for the individual investor is a sharp price drop. These occur more often than most people think. Because private investors need not own any stocks, they are prone to sell out when they are scared. How’s the following history for real scares?
| DATE | PRICE | DROPCAUSE (according to popular belief) |
| 1929 | 84% | excessive margin debt |
| 1937 | 74% | bank tightening |
| 1946 | 54% | postwar fears |
| 1962 | 22% | nuclear war risk |
| 1970 | 29% | civil unrest |
| 1972 | 43% | oil embargo |
| 1980 | 19% | excessive inflation |
| 1987 | 27% | computerized stop-loss programs |
| 2000 | 42% | tech bubble |
| 2008 | 50% | housing bubble |
Note that every cause for the drop was different. None of them ever permanently destroyed stock values. The average annual return for the S&P 500 Index over the past one hundred years has been 9.5 percent. Thus, the real cause of interim stock price drops is human emotion!
Over most of this period, stock dividends represented maybe 40 percent of this return—a word of caution regarding investing in low-yielding stocks.
Why, then, do so many investors expect more than 10 percent per year stock returns? Some investors do have great years. And some strategies have great time periods, like global macro hedging during the 1990s, when 20 percent average annual returns with only one loss year seemed to signal that there could, in fact, be a free lunch. Alas, the 2000s were more normal, and only 8 percent average returns prevailed. As my brilliant friend Irwin Gross quipped, “They work until they don’t.”
All these facts have led me to the following investing practices.
1. REALITIES
Error of all predictions is probably high
Prices will be volatile over time
Investment is a highly competitive activity
Emotions (particularly fear and greed) rule in the short run
2. PRINCIPLES
Require large margins for error
Buy out of vogue most of the time
Sell in vogue most of the time (if you sell at all)
Never underestimate your competitors
Keep your discipline
Seek legal informational advantages
Consider event-driven strategies
Avoid narrow mandates, since fashion changes quickly
Understand the industry
3. PROCESS
Hire colleagues with high intelligence
Rely on diverse relevant skills
Emphasize loss avoidance (“no called strikes”)
Concentrate your portfolio (“swing from the heels”)
Give early responsibility to young associates
Hire real industry experts
4. SUGGESTED READING
Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment by David F. Swensen (Free Press, updated 2009)
Value Investing: A Balanced Approach by Martin J. Whitman (Wiley, 2000)
Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay (Richard Bentley, 1841)
Manias, Panics, and Crashes: A History of Financial Crises by Robert Z. Aliber and Charles P. Kindleberger (Palgrave Macmillan, 7th ed. 2015)
“If you want to make money, really big money, do what nobody else is doing … buy when everyone else is selling and hold until everyone else is buying. That is more than merely a catchy slogan. It is the very essence of successful investing.”
—J. Paul Getty
“My options are limited. I’m not going to start playing tennis again. I’m too old for girls. If you could find me something more interesting than the securities business, I’d do it. But I doubt you will.” —Roy Neuberger, at age 91, founder of Neuberger & Berman
“I don’t think about anything. This is supposed to be fun.” —Klaus Obermeyer, at age 85, when asked how he mentally prepares himself before each ski race
“In one important respect, we have made practically no progress at all, and that is in human nature. Regardless of all the apparatus and all the improvements in techniques, people still want to make money very fast. They still want to be on the right side of the market. And what is most important and most dangerous, we all want to get more out of Wall Street than we deserve for the work we put in.” —Ben Graham (1945)
After describing an investor with the courage to be “eccentric, unconventional and rash in the eyes of average opinion,” Keynes says that his success “will only confirm the general belief in his rashness; and … if his decisions are unsuccessful … he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”—John Maynard Keynes
“Whoso would be a man must be a nonconformist. He who would gather immortal palms must not be hindered by the name of goodness, but must explore if it be goodness. Nothing is at last sacred but the integrity of your own mind.”
—Ralph Waldo Emerson, Self-Reliance
“In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”
—Rudiger Dornbusch
“I can calculate the motions of the heavenly bodies, but not the madness of people.” —Sir Isaac Newton (after losing his investment in a bubble)
“Prediction is very difficult, especially if it’s about the future.” —Niels Bohr, Nobel laureate in physics
“You’re leaving a business where 90 percent of the people are employed and 10 percent are competent for one where 10 percent of the people are employed and 90 percent are competent.” —Marty Whitman, famed investor, to his daughter, who left his firm to work in the theater
“Once I thought I was wrong, but I was mistaken.” —Anonymous