The Rational Walk
Intelligent Investing is not a "Random Walk"

Sears Chairman Lampert Releases Annual Letter to Shareholders February 23, 2010

Edward Lampert

Edward Lampert, Founder of ESL Investments and Chairman of Sears Holdings Corporation, has released his annual letter to shareholders.  Mr. Lampert’s investment style has often been compared to Warren Buffett’s approach particularly when it comes to capital allocation.  While many companies fail to adhere to disciplined capital allocation practices, Sears has taken a more intelligent approach.

Maintenance vs. Expansion Capital Expenditures

Mr. Lampert has been criticized for failing to make the necessary investments to keep Sears and K-Mart stores competitive.  Personal experience and anecdotal evidence does suggest that Sears Holdings retail properties are not necessarily the most modern facilities in many locations.  However, this fact alone does not automatically justify blindly committing funds to expansion or improvements beyond “maintenance” levels of capital expenditures:

I have written previously about what I believed was the reckless expansion of retail space leading to lower profitability for many retailers and to low or negative returns on the investment required to expand space. In other industries, consolidation rather than expansion has led to a more sensible competitive environment and better returns for shareholders. If you examine the level of capital expenditures over the past decade at many large retailers and compare that expenditure to value created, it would not paint a pretty picture.

Additionally, the dramatic declines in capital expenditures over the past couple of years at most large retailers are strong evidence that the level of maintenance capital expenditures for a big box retailer is materially below what many analysts and experts previously believed. Most of the capital spent over the past decade has been largely for store expansion, with some lesser amount required for maintaining existing stores.

The cost of updating or expanding properties must be weighed against the best possible alternative uses for the funds such as improving Sears’ strongest brands like Kenmore and Craftsman or authorizing share repurchases:

While we continued to repurchase shares during the economic crisis because the value was attractive and because we had significantly lower leverage than others in our industry, many of our competitors suspended their repurchase programs to appease credit rating agencies only to resume them again after their share prices recovered significantly.

Mr. Lampert also criticizes ratings agencies for simplistic analyses that automatically favor capital investment to share repurchases ignoring the fact that capital investment at negative rates of return can end up harming bondholders as well as stockholders.

Owner Orientation

While many executives only pay lip service to “shareholder value” and “management alignment with shareholder interests”, Mr. Lampert’s record and ownership interest in Sears Holdings serves to back up his claims.

We do some things differently than others, and we have certain beliefs that differ from theirs. Our culture is owner-oriented, because we have owners who serve on the board that governs the company. We believe that ownership makes a difference, especially when owners have significant financial interests in the company and a long-term perspective. Instead of this raising concern, rating agencies should welcome and value owners with a demonstrated track record of long-term value creation and conservative capital policies, even when some of the capital allocation preferences differ from those that others believe lead to higher long-term credit performance.

This is the type of owner orientation that makes it preferable to repurchase shares rather than plowing funds into capital expenditures at negative rates of return even though doing the latter is more popular within any organization in the short run and also will win the praises of local community leaders at ribbon cutting events.  The problem with companies that pursue popularity rather than intelligent capital allocation is that eventually the day of reckoning will arrive and the music will stop.

Regulation and Politics

Wading into more controversial topics, Mr. Lampert is critical of policies that may over-regulate the economy by placing government bureaucrats in place of private sector capital allocators when it comes to sustaining an economic recovery.  In terms of financial regulation, Mr. Lampert advocates the removal of the implicit “too big to fail” guarantee which would level the playing field.  However, it is unclear how the government can remove the “too big to fail” perception without some form of regulation to constrain financial institutions from reaching the size and interconnectedness that makes government bailouts inevitable.

Capital can quickly reorganize and provide financing for businesses and projects that create value for our society, without the heavy hand of government planning and policy. I disagree with most people calling for a gigantic overhaul of our financial system led by new and “improved” regulations. Instead, begin the process of allowing more competition in financial services and begin the removal of implicit and explicit government guarantees that provide the perception that some are “too big to fail.” While there are those that claim that their institutions are not too big to fail, they surely recognize the significant competitive advantages that come from this perception. Of course they will accept regulations as long as these regulations do not permit additional competition from entities and institutions that do not take insured deposits, do not have access to Federal Reserve funding, and do not have government guarantees associated with their debt offerings. Regulatory capture comes when there is little competition allowed outside regulated entities and a “freezing” of competitors and innovation in an industry.

Mr. Lampert also protest the special treatment given to Amazon.com and other online retailers that are not required to collect sales and use tax in locations where they do not have a physical presence.  It is difficult to argue with the logic behind treating traditional retailers and online retailers in a uniform manner and the observation that current practices will prove unsustainable as more commerce shifts online.

The real story here is that it is not the payment of taxes or the charging of taxes that is at issue. It is the collection of taxes on behalf of local governments from purchasers of goods and services from stores in a locality or for use in such locality. It is the latter fact that is often ignored. A person who buys products from Amazon.com is required by law to pay sales or use tax to their local jurisdiction. In practice, almost nobody does so. The cost and unpopularity of enforcing such laws has allowed customers to avoid paying sales or use taxes, even though they are required in many states and localities. If you buy a work of art or piece of jewelry in NYC, for example, and have it shipped to New Jersey or California, the seller does not collect sales tax on that purchase but the buyer would be required to pay sales or use tax on the purchase where they receive the merchandise and use the merchandise. So, a piece of jewelry shipped to California would require the buyer to pay California sales or use tax.

Mr. Lampert recommends Thomas Sowell’s latest book Intellectuals and Society.  Although I have not kept up with Mr. Sowell’s work in recent years, I consider one of his previous books, The Vision of the Anointed, to be one of the best essays on the mentality that often drives the decisions of those in high positions of power.

Click on this link to read Edward Lampert’s full letter to Shareholders.

Disclosure:  The author does not own shares of Sears Holdings.

Avoid Relegating Investment Errors to the “Memory Hole” January 6, 2010

No one enjoys dwelling on past errors whether we are talking about investments, career choices, or poor decisions in personal relationships.  It is far more pleasant to think about what has worked well in the past and to relegate unpleasant memories to what George Orwell referred to in 1984 as the “memory hole”.  In Orwell’s story, the “memory hole” is a chute through which all evidence of unfavorable events are sent to an incinerator by order of a totalitarian government. The attempt to erase bad memories by a government is tyranny;  doing the same in business and investments can lead to repeating the same errors again and again.

While it is never productive to endlessly dwell on mistakes, it is healthy to examine key errors to see whether any lessons can be learned.

“Pie on Face Award” for 2009 …

The Rational Walk is not an investment newsletter and does not provide investment advice.  Nevertheless, at times, we discuss specific securities and views regarding the business prospects for companies.  One such example last June involved a decision to favor shares of Wal-Mart Stores over shares of Sears Holdings.

Let’s be clear:  The mere fact that a stock was sold that has since appreciated by nearly fifty percent does not, by itself, justify the “pie on face” award.  During any six month period, virtually anything can happen in the stock market and price movements cannot be used to evaluate the success or failure of an investment decision.  The reason this decision was a mistake was based on faulty reasoning at the time rather than subsequent short term stock price movement.  Let’s take a look at the two main factors behind the decision.

Error #1:  Excessive Fixation on Macroeconomic Factors

As described in the article, the decision to purchase Sears Holding shares was based on a belief that the underlying real estate assets far exceeded the overall market capitalization of the company.  While the book value of the real estate holdings are carried at historical cost, evidence existed to justify much higher valuations.  In fact, Bruce Berkowitz of the Fairholme Fund assigned his team to a methodical examination of property tax assessments and concluded that the real estate alone could be worth $80 to $90/share.

Throughout the spring of 2009, like most investors, I spent significant time following macroeconomic trends and thinking about the implications of the severe recession on my investments.  Since the tax assessments the Fairholme team examined were from 2008, I became concerned that the values of the real estate may have become impaired since the analysis took place, particularly due to the impact of the recession on commercial real estate such as malls.

Error #2:  Changing Investment Rationale After Initial Investment

The second error involved changing my investment rationale after the initial investment was made.  In the case of Sears Holdings, my initial investment rationale was a play on a severe undervaluation of the company’s real estate holdings rather than an investment in the retail operations of the company.  In my view, if Sears Chairman Edward Lampert could engineer a turnaround at the retail operations, that could add even more value but was not essential to the investment thesis.  In other words, the investment came with a free option on the recovery of the retail operations.

In addition to allowing my macroeconomic concerns impact my views on the value of the company’s real estate holdings, I also became worried that customers would abandon the retail stores given the weakness of Sears and Kmart relative to stronger competitors.  But it made no sense to allow this to impact the investment decision since the retail operations were not part of the original investment thesis.

Lessons Learned

Perhaps the most important lesson to learn is that paying excessive attention to the macroeconomy is generally unhelpful when making specific investment decisions.  This is why Warren Buffett always says that his investment decisions are not made with regard to macro conditions.  It was easy to justify making “exceptions” to this rule in a year like 2009 when talk of depression was widespread.  But it was an error.

The second lesson is to always remember why a security was purchased to begin with.  If the investment thesis centered on real estate value, then only a true erosion of the original thesis should justify a decision to liquidate below appraised intrinsic value.

As of today, Sears Holdings has reached my original high estimate of the intrinsic value of the real estate holdings at nearly $90 per share.  A buyer of the shares today might have to justify the purchase based on the retail operations; a buyer at $50 did not need to consider the retail operations to justify a purchase.  Based on the original investment thesis, Sears shares would be sold at current levels.  However, due to the faulty thinking discussed in this article, they were sold prematurely at $61 thereby giving up an additional 50% of upside.

It so happens that even at $61, the shares were sold at a significant profit.  The performance even exceeded the S&P 500 return over the holding period.  But that is hardly the point.

Examining this type of mistake is never pleasant but it is necessary to avoid repeat performances.  All investors should take the time to do the same to avoid the risk that the “memory hole” will extinguish such experiences and lead to future errors.

Berkowitz Sticks to Time Tested Principles September 30, 2009

In a conference call this afternoon, Bruce Berkowitz answered a number of shareholder questions regarding The Fairholme Fund, the state of the overall stock market, and prospects for health care reform.  Mr. Berkowitz’s record at The Fairholme Fund since its inception on December 29, 1999 has been nothing short of extraordinary.  Based on the fund’s semi-annual report dated June 30, 2009, annualized performance since inception has been a gain of over 12% annualized compared to a loss of over 3% annualized for the S&P 500.

This article documents some of the notes that I took during the call and are not necessarily direct quotations.  This is not a comprehensive transcript of the event, but focused on areas that I found particularly interesting.  A replay of the conference call should be available on The Fairholme Fund’s website in the near future.

Disclaimer:  I took notes quickly and while I believe the content of this post to be accurate, it is possible that some errors were made.

Update:  Fairholme Funds has posted a transcript of the September 30, Conference call.  Click on this link for the transcript (PDF).

Due Diligence Process

Here are some of Mr. Berkowitz’s comments in response to a shareholder question regarding how he goes about performing due diligence on prospective investments:

  • Review all securities in the capital structure of a company rather than just the common stock.  Common stock should be viewed as the most junior “bond” in a company’s capital structure.  The free cash flow generated by the business is akin to a coupon without a maturity date.  Count the cash after all bills, interest on senior securities, and maintenance capital expenditures.  The free cash flow can then be compared to market prices to come up with free cash flow yields.
  • Fairholme reviews SEC reports, company conference calls, presentations, and other sources when researching an investment.  It is important to focus on every business element that requires management to exercise judgment.  Examine the accounting carefully and pay particular attention to pensions, health care liabilities, regulatory, and tax issues.  Management is “guilty until proven innocent” if there are inconsistencies between the balance sheet, income statement, and cash flow statements.  Be particularly wary of “kitchen sink” charges that could enter into the picture.
  • Examine whether a business model can exist without leverage.  Avoid having to rely on the “kindness of strangers” whenever possible.  Examine where the security being analyzed lies within the overall capital structure.
  • Examine whether managers are true owners rather than just option holders.  This test can be applied by determining whether an executive has actually purchased shares in the open market rather than only through option grants.  It is hard to make a good investment with bad people.  Examine their capital allocation decisions over time.
  • Try to “kill the investment idea”.  If you cannot kill the idea, then it should be compared to other investment candidates that have gone through the same research process as well as existing portfolio companies.  Fairholme focuses on fewer investments than most others in order to have superior understanding of the businesses.  They try to avoid growing their circle of competence too quickly if the risk is losing money.
  • Fairholme uses industry experts and consultants as part of the research process in order to contain costs by avoiding the need to retain such experts on payroll on a full time basis.

Health Care Reform

Many of The Fairholme Fund’s investments are concentrated within the health care sector.  A number of shareholders submitted questions asking about the impact of health care reform on the portfolio holdings.  Mr. Berkowitz turned this part of the call over to Charlie Fernandez.

  • The fund’s analysts and managers are following developments in health care reform on a daily basis.  The mission of the various reform proposals is to expand health coverage for 20 to 25 million Americans and will result in modifying insurance rules and changing rules for Medicare payments.  Mr. Fernandez expects that a bill will pass this year and should cost around $900 billion.  He noted that most reforms do not begin until 2013 and that the plans under discussion include ten years of revenues to pay for seven years of the program.
  • Medicaid expansion will result in opportunities for insurers while the key hospital groups and the pharmaceutical industry have already cut deals with President Obama.  Mr. Fernandez noted that hospitals will have lower bad debt expenses under the reform proposals and that part of the benefit will flow to pharmaceutical firms which typically have claw back agreements with hospitals related to bad debt expenses.  He expects that a 5% increase in revenues for pharmaceutical companies could result from lower bad debt expense for hospitals.
  • Pfizer is The Fairholme Fund’s largest holding and a number of shareholders submitted questions or concerns regarding the investment.  Mr. Fernandez believes that the Wyeth merger will close in Q4 and probably prior to Thanksgiving.  $6 billion in cost reductions are expected within 18 months.  Within one year of the merger, no product will represent more than 10% of profits, a statistic similar to Johnson & Johnson.  Pfizer is also expanding its presence in generics.  The company has growth from 13th to 8th place in the United States in generic drugs.  Fairholme believes that double digit free cash flow yields will accrue to buyers of Pfizer common stock at current market prices.

Other Comments

  • Inflation. Mr. Berkowitz believes that the best way to protect against inflation is to find companies with large and growing free cash flows which are either paid out or reinvested in the business at satisfactory rates of return.  Also, tangible assets will become more valuable if inflation accelerates which is one of the reasons behind the fund’s investment in St. Joe, a large real estate development company in Florida.
  • Sears Holdings. Mr. Berkowitz does not appear to be concerned with the factors discussed in a recent bearish article on Sears that appeared in Barrons.  He still believes that the value of the sum of the parts of Sears is worth more than the current stock price.  If Sears Chairman Eddie Lampert can turn around Sears and K Mart, the shares would be worth considerably more, but this is not central to the thesis.  If Sears Holdings stock price declines, more repurchases of shares are likely and this will benefit shareholders.  If the stock price goes up, shareholders also win.
  • Any Interest In Emerging Markets? Mr. Berkowitz believes that it is hard enough when you’re the home team and he doesn’t want to play “an away game” where he doesn’t know the rules.  There is plenty to do here in the United States.
  • Thoughts on Berkshire and Leucadia. Although a great deal of information is available on these investments, both can be considered “blind trusts”, but being an investor for decades makes it sort of like marriage.  Mr. Berkowitz fully respects the managers of both companies.  He previously sold shares of Berkshire due to the company’s size, age of management, and Warren Buffett’s statement that Berkshire cannot be expected to beat the S&P 500 by large margins.  However, now that Mr. Buffett has put a significant amount of cash to work at higher returns, Fairholme bought back some shares at the “excellent prices” offered earlier in the year.

Value investors would be wise to pay close attention to The Fairholme Fund’s holdings as well as future statements by Mr. Berkowitz.  While SEC filings are available for The Fairholme Fund’s holdings, GuruFocus.com makes it easy to monitor Mr. Berkowitz’s moves along with the activities of many other super-investors.  Investors should always do their own work on any idea, regardless of who is buying a stock.  However, there is no shame in using super-investors as idea sources and coat-tailing when it makes sense to do so.

Disclosure:  The author does not own shares of The Fairholme Fund or any of the other companies discussed in this post with the exception of Berkshire Hathaway.

Wal-Mart Stores Looks Attractive; Sears Holdings Shares Sold June 1, 2009

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Over the past decade, there has been a significant divergence between Wal-Mart Stores’ experience from a business perspective and the returns experienced by the company’s shareholders.  In April, I wrote an article outlining Wal-Mart’s track record over the past ten years and the risks of overpaying for a strong growth record.  There are numerous other examples of well known companies that have advanced significantly in terms of business results over the past decade while stockholders received little if any return.

New Position Initiated

A new position in Wal-Mart has been initiated based on a number of factors.  Much of the case related to Wal-Mart’s business track record was made in my prior article so I will not repeat all of the factors here.  However, a few factors related to this decision are discussed below.

First, as my previous article outlined, Wal-Mart has proven its business model over a long period of time by demonstrating a remarkable ability to grow its top and bottom lines despite already being a very large enterprise ten years ago.  During this time frame, store count nearly doubled, gross margins actually improved, and net profit margins remained relatively constant.

Wal-Mart has also made progress attracting middle class and upper-middle class customers who “traded down” to the retailer as consumer confidence plummeted over the past year.  Many of these shoppers will not quickly abandon Wal-Mart when the economy recovers given that confidence will be shaky for some time to come and familiarity with the stores could build customer loyalty.  Just as the Great Depression created a generation preoccupied with thrift, I anticipate that the current economic dislocation will lead to more appreciation for low prices in the coming years.  As the low cost provider, Wal-Mart fills a need that will remain in demand.

Wal-Mart has been criticized recently by its decision to stop reporting monthly sales and sales forecasts.  My view is that moving to quarterly reporting is a healthy development that will reduce investor fixation on ultra short term results and trends that can be influenced by numerous factors unrelated to the underlying economics of the business.

Although Wal-Mart’s valuation is now far more reasonable than typical valuations over the past decade, it should be noted that investors purchasing shares at current levels should be satisfied with returns correlating with business results rather than counting on a return to very high multiples of earnings.

Sears Holdings Shares Sold

To make room for Wal-Mart in the portfolio, profits were taken on shares of Sears Holdings after the recent advance in market price.  While Sears Holdings is a retailer given its operations of Sears stores in the United States and Canada as well as K-Mart stores, the investment case for Sears Holdings has been related to the value of its real estate assets rather than the value of its declining retail businesses.

Chairman Edward Lampert is attempting to save the retail operations in an attempt to minimize job losses and impacts to local communities served by Sears and K-Mart.  However, both retailers are suffering long term declines in business and it is clear that Sears Holdings is unwilling to make dramatic investments in the retail operations.

Bruce Berkowitz of The Fairholme Fund was recently interviewed by Outstanding Investor Digest regarding his investment in Sears Holdings among other topics.  Berkowitz conducted an analysis last summer of the property tax assessments for real estate owned by Sears Holdings and came up with a valuation of $80 to $90/share for the real estate alone.

While these valuations may hold up, it is worth noting that much of the real estate is held in mall locations that are experiencing a long term decline as consumers increasingly favor big box store formats.  Given that assessments for 2008 were set prior to the recent economic turmoil impacting commercial real estate, it seems prudent to assume that the real estate valuation is quite a bit less than $80/share today.  If one further concludes that the retail operations are in a long term runoff, today’s price of $61 for Sears Holdings appears to lack a sufficient margin of safety even if some upside remains.

Disclosure:  The author purchased shares of Wal-Mart Stores today at an average price of $49.99 and sold Sears Holdings shares at an average price of $61.05.  This article should not be considered a recommendation to buy or sell securities and readers should conduct their own due diligence prior to making any investment decisions.  The author has no obligation to update this article in light of changing future circumstances or post an article prior to taking further actions in either security discussed.