Is Sears the Next Berkshire Hathaway?

I originally penned this articled in December 2011.  Given Sears’ stock action in the year that has passed, it’s worth another read.

A well-respected value investor buys an old American company in decline, promising to restore its fortunes.  Alas, the recovery never comes.  The economics of the industry have changed, and the company cannot compete with younger, nimbler rivals.  The company ceases operations, but the value investor holds onto the shell to use as an investment vehicle.

Could this be the future of Sears Holdings (Nasdaq: $SHLD) under Eddie Lampert?  Maybe; maybe not.  But it was certainly the case for Warren Buffett’s Berkshire Hathaway (NYSE: $BRK-A).

Unless you’re a history buff or a dedicated Buffett disciple, you might not have known that Berkshire Hathaway was not always an insurance and investment conglomerate.  It was a textile mill, and not a particularly profitable one.  It was, however, a cash cow.  And after buying the company in 1964, Buffett used the cash that the declining textile business threw off to make many of the investments he is now famous for, starting with insurance company Geico.

So, when hedge fund superstar Eddie Lampert first brought Kmart out of bankruptcy in 2003, the parallels were obvious.  With its debts discharged, the retailer would throw off plenty of cash to fund Lampert’s future investments.  And even if the retail business continued to struggle, Lampert could—and did—sell off some of the company’s prime real estate to retailers in a better position to use it.  Lampert sold 18 stores to the Home Depot (NYSE: $HD) for a combined $271 million in the first year.

That Lampert would use Kmart’s pristine balance sheet to purchase Sears, Roebuck, & Co.—itself a struggling retailer—seemed somewhat odd, but his management decisions after the merger seemed to confirm that his strategy was cash cow milking.   Lampert continued to talk up the combined retailer’s prospects, of course.  But his emphasis was on relentless cost cutting, and he invested only the absolute bare minimum to keep the doors open.  Sears Holdings didn’t have to compete with the likes of Home Depot or Wal-Mart (NYSE: $WMT). It just had to stay in business long enough for Lampert to wring out every dollar he could before selling off the company’s assets.

The strategy might have played out just fine were it not for the bursting of the housing bubble—which killed demand for the company’s Kenmore appliances and Craftsman tools—and the onset of the worst recession in decades.  With retail sales in the toilet (and looking to stay there for a while), there was little demand among competing retailers for the company’s real estate assets.

It’s fair to blame Lampert for making what was, in effect, a major real estate investment near the peak of the biggest real estate bubble in American history.  But investors  frustrated by watching the share price fall by more than 80 percent from its 2007 highs have no one to blame but themselves.   Anyone who bought Sears when it traded for nearly $200 per share clearly didn’t do their homework.  They instead were hoping to ride Lampert’s coattails while somehow ignoring the value investor’s core principle of maintaining safety by not overpaying for assets.

Lampert is a great investor with a great long-term track record, and there is nothing wrong with paying a modest “Lampert premium” for shares of Sears Holdings.  If you like Lampert’s investment style but lack the means to invest in his hedge fund, Sears may be the closest you can get.  But at $200 per share—or even $100—the Lampert premium had been blown completely out of proportion.  The same is true of Buffett, of course, or of any great investor.  As the Sage of Omaha would no doubt agree, there is a price at which Berkshire Hathaway is no longer attractive either.

This brings us back to the title of this piece—is Sears the Next Berkshire Hathaway?

I would answer “yes,” but not necessarily for the reasons you think.

Everyone assumes that Buffett’s decision to buy Berkshire Hathaway was a typical Buffett stroke of genius.  Nothing could be further from the truth.  In fact, Buffett revealed in an interview last year that Berkshire Hathaway was the worst trade of his career.



If you cannot view the video above, please follow this link: “Buffett’s Worst Trade
 

We like to think of Warren Buffett as the wise, elder statesman of the investment profession, but Buffett too was young once and prone to the rash behavior of youth.  He had been trading Berkshire Hathaway’s stock in his hedge fund; he noticed that when the company would sell off an underperforming mill, it would use the proceeds to buy back stock. Buffett intended to sell Berkshire Hathaway its own stock back for a small, tidy profit.

But due to a tender offer that Buffett took as a personal insult, he essentially bought a controlling interest in the company so that he could have the pleasure of firing its CEO.  And though it might have given him satisfaction at the time, Buffett called the move a “200-billion-dollar mistake.”

Why?  Because Buffett wasted precious time and capital on a textile mill in terminal decline rather than allocate his funds in something more profitable—in his case, insurance.  Berkshire Hathaway will still go down in history as one of the greatest investment success stories in history.  But by Buffett’s own admission, he would have had far greater returns over his career had he never touched it.

So, in a word, “yes.”  Sears probably is the next Berkshire Hathaway.  And investors who buy Sears at a reasonable price will most likely enjoy enviable long-term returns as Lampert’s plans are eventually realized.   But Mr. Lampert himself will almost certainly come to regret buying the company—if he doesn’t already.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Review of Nassim Taleb’s Antifragile

We all know what “fragile” means.  But what is the opposite of fragile?

If you are like me, your instinctive response would be “robust” or perhaps “durable.”  But you would be wrong.

Something that is fragile is damaged by an unexpected shock, whereas something that is robust or durable is able to withstand it.  To be robust is to be neutral to shocks.

But what do you call the true opposite of fragile—something that actually benefits from shocks?

As Nassim Taleb points out, there is no word in English (or in any other language, ancient or modern) that conveys this idea.  So he invented one—antifragile—and wrote an entertaining and enlightening book around the concept.

Taleb is at times playful and even self-effacing in his writing and at other times insufferably arrogant (“non-meek” in his words).  But he is always—and I mean always—thought provoking.

Years ago, before Taleb become something of a celebrity, I picked up his original Fooled by Randomness and had something of a “eureka” moment.  Taleb put into words (and numbers) many of the abstract ideas about risk and randomness that I instinctively felt yet couldn’t articulate (he had that effect on a lot of people, it would turn out).  In particular, I had always mistrusted the Value-at-Risk metric and its offshoots that had been crammed down my throat as an undergraduate finance student.  It registered on my “bulls_t detector”, to borrow one of Taleb’s earthy phrases, and history would vindicate this gut reflex with implosion of the financial system in 2008.

I still consider Fooled to be his best book, and if you have never read Taleb’s work that is where I would recommend you start.  But Antifragile: Things That Gain From Disorder expands on the concepts in Fooled and its follow-up The Black Swan and goes far beyond financial markets into a more general theory of randomness and volatility and their importance in life and nature.  “Living things are long volatility,” he emphasizes often.

Perhaps Taleb’s greatest gift as a writer is his ability to speak in metaphors, the best of which is his analogy of the Procrustean Bed (see my review of Taleb’s The Bed of Procrustes).

Procrustes was a nasty little fellow from Greek mythology who would invite guests into his home and then either stretch or amputate parts of their legs to make them fit just right in his guest bed.  In Taleb’s analogy, much of the modern world is a Procrustean bed of sorts.  People, markets, and economic systems are contorted to fit tidy theories.

But in Antifragile, Taleb goes beyond this “square peg in a round hole” argument to a larger critique of “soccer moms” (both figurative and literal) who naively attempt to make the world safer by “sucking randomness out to the last drop.”  Doing this provides the illusion of safety while actually making us less resilient and more fragile.  In other words, not only are scraped knees and bruises ok, they are an essential part of growth.

Many readers misunderstand Taleb’s core message.  They assume that because Taleb writes about unseen and improperly calculated risks, his objective must be to reduce or eliminate risk.  Nothing could be further from the truth. 

If anything, Antifragile is a celebration of risk and randomness and a call to arms to recognize and embrace antifragility.  Rather than reduce risk, organize your life, your business or your society in such a way that it benefits from randomness and the occasional Black Swan event.

Taleb’s own life is a case in point.  He had the free time to write Fooled, The Black Swan and Antifragile because—in his own words—he made “F___ you money” during the greatest Black Swan event of our lifetimes, the 1987 stock market crash.   And to demonstrate that Taleb’s trading style is antifragile, had the 1987 crash never happened, Taleb would not have been materially hurt.  His trading style puts little at risk but allows for outsized returns.

In what may seem somewhat disturbing to some readers (and Taleb himself is disturbed by it as well), what makes a system antifragile is that its individual pieces are perishable.  Natural selection—the survival of the fittest—requires that the unfit are allowed to fail.

Using the example of restaurants, the restaurant sector is robust because the failure of any one restaurant does not affect the others.   And the restaurant sector is antifragile because the remaining players actually learn and grow from witnessing the mistakes made by the failed restaurant.

Now, compare this to the banking system.  The world banking system is inherently fragile because the failure of one bank leads to contagion that can cause the failure of other banks and of the system itself.

The importance of failure to an antifragile system is a recurring theme to the book.  As individuals and as a collective, we learn more from mistakes than from successes.  In a capitalist system, you need a replenishable  supply of entrepreneurs willing to take risks.  For every failed business idea, our knowledge base expands.

Taleb goes so far as to advocate we treat ruined entrepreneurs in the same way we honor dead soldiers, “perhaps not with as much honor, but using the same logic.”

As Taleb explains, just as “there is no such thing as a failed soldier, dead or alive (unless he acted in a cowardly manner), likewise there is no such thing as a failed entrepreneur  or failed scientific researcher.”   Their sacrifice makes the system stronger.

I commend Taleb on another book well written, and I recommend Antifragile along with Fooled by Randomness and The Black Swan.

Investing Lessons: Avoiding the Peter Lynch Bias

The single most important lesson I’ve learned about being a successful investor is the need to maintain emotional detachment.  Any feelings you may have towards a stock are unrequited.  If you love a stock, it will not love you back.  And if you hate a stock, it will not give you the satisfaction of responding in kind.  (As tragic as unanswered love may be, unanswered hate is often more damaging to your pride.)

A stock is like that unattainable cheerleader you had a crush on in high school.  She neither loved you nor hated you; she was completely unaware you existed.

No matter how much you love a stock (and write favorably about it in MarketWatch) it will not reward your loyalty by rising in price. And heaven help you if you allow your emotions to cloud your judgment in a short position.  I know of no surer way of losing your investment nest egg than to short a stock or other investment you hate.  Alas, I know from experience; I shorted the Nasdaq 100 in the fall of 2003.  In an outbreak of moral high-horsing that has (thankfully) now been purged out of me, I decided that tech stocks were overpriced and needed to fall further.  The Nasdaq had very different ideas, and I was forced to cover that short at a 20% loss with my tail tucked between my legs.

A closely-related investment mistake is succumbing to what I call the “Peter Lynch bias.”

Peter Lynch ran the Fidelity Magellan fund from 1977 to 1990 and had one of the best performance records in history for a mutual fund manager—an annualized return of over 29% per year.

Unfortunately, he also offered some of the worst advice in history when he recommended that investors “invest in what they know.”

On the surface, it seems like decent enough advice.  If you stumble across a product you like—say, a particular brand of mobile phone or a new restaurant chain—then it might be reasonable to assume that others will feel the same way.  If the stock is reasonably priced, it might make a good investment opportunity.

Unfortunately, “investing in what you know” tends to create muddled, emotionally baggaged thinking.  The fact that you like Chipotle (NYSE:$CMG) burritos and are intimately aware of every ingredient used in the red salsa does not automatically make Chipotle a good investment any more than your liking of Frappuccino makes Starbucks (Nasdaq:$SBUX) a good investment.   Rather than give you an insightful edge, liking the product causes you to lose perspective and see only what you want to see in the stock.

How do we mitigate our emotional impulses?

In a prior article, I noted that “brain damage can create superior investment results.”  But short of physically re-wiring our brains, what can we actually do?

I try to follow these basic guidelines and recommend them:

  • If you like a company’s products, try using one of their competitors before seriously considering purchasing the stock.  If I had really taken the time to learn how to use an Apple (Nasdaq:$AAPL) iPhone or Google (Nasdaq:$GOOG) Android device, I probably wouldn’t have gotten sucked into the Research in Motion (Nasdaq:$RIMM) value trap. Yes, RIMM was one of the cheapest stock in the world when I recommended it last year.  But I cannot deny that my decision to recommend it was biased by my ownership of a BlackBerry phone.  Likewise, many iPhone owners are probably buying Apple for similar reasons today.
  • To the best extent you can, try to follow trading rules and use stop losses.  What works for one investor will be very different than what works for another.  Perhaps you use a hard stop loss of, say, 10% below your purchase price.  Or perhaps you use a trailing stop or 20-25%.  If you are a value investor, perhaps you base your sell decision on valuation or fundamentals rather than market price.  But in any event, my point stands.  Lay out the conditions under which you intend to sell and stick to them.  Stock ownership is a marriage of convenience with quick, no-fault divorce if your situation changes.  Don’t make the mistake of falling in love.
  • Unleash your inner Spock.  For readers who are not Star Trek fans, Spock is an alien from the planet Vulcan who is incapable of feeling emotions.  When talking about a stock or watching its price fluctuate gets your heart racing, take a step back and try to look at the investment through Spock’s eyes.  Is it logical?  Do the numbers make sense?  Are the growth projections based on reasonable facts or on optimistic hope?  Would you buy a different company if it were trading at the same price multiple?

Admittedly, these are not precise guidelines.  But then, another lesson I learned is that it is a mistake to try to be too precise in this business.  Follow the lead of great value investors like Benjamin Graham and Warren Buffett by making sure you have a wide margin of safety in your assumptions.

Disclosures: Charles Sizemore has no positions in any securities mentioned. This article first appeared on MarketWatch.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

What to Read: The Best Financial Newspapers and Magazines

I’m often asked where I get my investment ideas and what sources I read to keep abreast of financial news.  The fact is, you can’t read everything that comes across your desk; there is simply not enough time in the day to get through it all.  You have to prioritize and organize your reading list, or you’ll waste your entire working day reading information that is irrelevant to your investing.  Let us not forget that time is money!

I created the list below to highlight some of my regular news sources.  I hope you find them as valuable as I have in my investing career.

If I could only read one publication, it would without a doubt be the Financial Times. The FT is the premier global financial newspaper for serious investors, and it covers the entire globe.  Most newspapers, even the good ones, are at least half full of trivial fluff and local interest.  Not the FT.

I started reading the FT when I was a graduate student at the London School of Economics, and I haven’t stopped reading it since.

If you want to know what is happening in the world, laid out in a clear, concise manner, you need to be reading the Financial Times.

For American financial news, it’s hard to beat The Wall Street Journal.  I must admit, I am very partial to the Financial Times, but I do consider the Wall Street Journal a worthwhile read as well.  In a typical morning, I read the FT cover-to-cover, whereas I skim the Journal for any relevant points that the FT might have missed.

Barron’s is my favorite weekly financial publication.  Much of the news will be repeated from daily sources like the FT and the Journal, but Barron’s has a lot of original reporting that makes it a staple part of my weekly reading.

Barron’s routinely polls money managers about their favorite sectors, and this is a contrarian indicator I use to watch for herding behavior.  I also find the annual Barron’s Round Table to be a good source for investment ideas, and I enjoy the interviews that the magazine routinely does with fund managers.

The magazine is also busting at the seams with financial statistics.  Barron’s is probably the best source I’ve found for data on closed-end funds.

My only complaint with Barron’s is that its overall tone tends to be quite bearish, but this is also a source of credibility.  If the editors were a bunch of glassy-eyed optimists, they wouldn’t be adding a lot of value.

If you don’t have time to read the Financial Times daily (or even if you do), reading The Economist weekly is the next best thing.

I like The Economist for two primary reasons:

1. It is an excellent source for global news and analysis.

2. I find value in seeing American domestic news through the eyes of a foreign publication.

This magazine is certainly worth including in your weekly reading routine.