We successfully shorted CompuCredit, a credit card issuer to customers with poor credit. Its rapid asset growth masked the losses in its reported results. We looked at the losses on a “lagged” basis. This allowed us to analyze the credit performance without the influence of fresh loans that had not yet had time to default. We saw that CompuCredit’s losses adjusted for growth were 18 percent a year, rather than the 10 percent touted by management. The company held an analyst day in Atlanta and, aware of our bearish view, pointedly told us that we could only listen by phone. One brokerage firm analyst helpfully pointed out, “Buy the stock. They are having their first analyst day ever. If the news weren’t good, they wouldn’t be calling the meeting.” The stock doubled in our face. This time, we stayed patient. Weeks later, the company announced disappointing results, and our losses turned to gains. As credit losses mounted, CompuCredit’s next quarter’s results were even worse.
Triad Hospitals (a spin-off from Columbia/HCA) and MDC were two large long positions that each doubled during the year. Most of the rest of the shorts contributed to our returns, and we recovered from our tough February to finish 2000 up 13.6 percent. Again, we did not achieve our annual target, but demonstrated a lower risk profile than the market—where the S&P lost 9 percent and the Nasdaq imploded, falling 39 percent. No one was complaining. We finished the year with $440 million under management.
We closed the fund a second time. Except for a few formal capital-raising rounds when the portfolio was fully invested and we needed capital to pursue new opportunities, we have remained closed ever since. The market continued to return to rationality in 2001. Like 1997, we went the whole year without a serious setback. The large long positions all performed, as did our biggest short position, Conseco, an insurance and annuity company.
Conseco started as a “capital structure arbitrage,” an investment based on our assessment that one part of a firm’s capital structure is mispriced relative to another. We do not do a lot of arbitrage, but participate in extreme opportunities. Conseco had terrible news: It lost its A-rating from the A. M. Best rating agency. This made it difficult to compete to obtain and retain customers without making dramatic price concessions that eliminate the profit opportunity. Conseco bonds traded at sixty-five cents on the dollar, while the equity market had a different view and valued the company at $10 billion. The debt yielded over 20 percent, while the equity traded as if bankruptcy were improbable. We purchased the bonds and sold short the common stock.
At first, we lost more on the short sale of the stock than we made on the bonds. Conseco brought in a new CEO, Gary Wendt, who had a great record running GE Capital. Wendt signed for $45 million cash and 3.2 million shares of stock up front. He led an analyst day and promised an immediate turnaround. He would implement fancy-sounding GE management concepts like Six Sigma, where its people would be trained to become Six Sigma Black Belts and turn Conseco from its present weak state into a strong man, which he depicted with a cartoon of a powerful weightlifter. Wendt convinced the market that the problems would soon be fixed, and Conseco refinanced some of its debt at 11 percent.
I attended a meeting Wendt held in Conseco’s office in the GM building. About thirty investors and analysts stood around in a warm conference room until the group was fully assembled. When Wendt was ready to join us, we were asked to sit around a very large conference table. When everyone was seated, an assistant came in dragging a conspicuously fancy chair. Space was cleared at the middle of the table and when the throne was in place, Wendt joined the meeting. After a lengthy pitch, Wendt took some questions. To any question that involved the numbers, Wendt had no answer. Over and over, his response was, “Someone will get back to you.” I had seen enough. We sold our bonds and added to our short.
Conseco issued a series of “turnaround memos.” These self-congratulatory tomes appeared designed to provide good news to juice the stock at random times. It seemed to work, and the shares doubled. However, each time Conseco reported quarterly earnings, there were more questions without answers. For example, in one quarter, corporate overhead magically turned to a corporate profit. How do you turn overhead into a profit? No answer. The next quarter, the premiums and float fell in the insurance business, but capitalized customer acquisition costs and profit rose. How? No answer. Quite simply, the numbers did not add up, and Team Wendt was not interested in clarifying them. The stock continued to rise. Until it didn’t.
The next quarter, Conseco reported better-than-expected results. The results were, again, of low quality and raised many questions. The results were no worse than the previous batches. Nonetheless, this time the market did not buy it. The shares imploded. Eventually, Wendt resigned and the company went bankrupt. Subsequently, the company has reorganized, but is now much smaller. Its name lives on most conspicuously as the Indiana Pacers’ home court, the Conseco Fieldhouse. Some have observed that naming a sports arena is a good way to identify short-sale candidates.
Another troubled company with odd accounting was Orthodontic Centers of America (OCA), a rollup of orthodontist practices. The company accelerated revenue recognition and recorded more than all the profit from patients in the first months of a multiyear treatment cycle. As a result, toward the end of the treatment cycle, the average patient generated a reported loss. OCA had to rapidly grow the number of new patients to outnumber the old patients.
