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.
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.