Case StudiesCharlie MungerInvestment Philosophy

Importance of Knowing Your Investment Boundaries (Sears Mini-Case Study)

A few months ago we had an interesting post/discussion on the site where Matt Brice and I share some of our research and investment ideas. The topic was Munger’s ability to quickly discard an investment opportunity if it was something he didn’t understand or a business he didn’t like. The comment that Munger made regarding the business of cattle ranching was one of the key takeaways that stayed with me from the 2016 Berkshire Annual Meeting—in short, the discipline that Munger has when it comes to his “too hard pile”.

A week ago I read an article in Business Insider that referenced a Q&A from 2005 where Buffett was talking to a group of students from the University of Kansas and he was asked about the chances of success of the Sears/Kmart merger (which had just recently occurred at that time).

Buffett’s answer—as so often is the case—was quite simple-minded and succinct, yet very logical and packed full of good advice to consider. What really struck me was the same thing that struck me in Munger’s reply to the cattle rancher: Buffett’s ability to quickly discard an investment opportunity that belongs in his too hard pile. He wastes very little time and energy considering these types of ideas.

Here is the question from the student:

“What is your opinion of the prospects for the Kmart/Sears merger? How will Eddie Lampert do at bringing Kmart and Sears together?”

Buffett’s reply is simple and brief, but contains some really valuable gems on the circle of competence concept, the too hard pile, and more specifically, the dangers and difficulty of the retail business:

“Nobody knows. Eddie is a very smart guy but putting Kmart and Sears together is a tough hand. Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to be a good salesman. The network paid you, car dealers paid you, and you made money.

“But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

“Retailing is like shooting at a moving target. In the past, people didn’t like to go excessive distances from the street cars to buy things. People would flock to those retailers that were nearby. In 1966, we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn’t going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn’t win. So we sold it around 1970. That store isn’t there anymore. It isn’t good enough that there were smart people running it.

“It will be interesting to see how Kmart and Sears play out. They already have a lot of real estate, and have let go of a bunch of Sears’ management (500 people). They’ve captured some savings already.

“We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

“How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than Wal-Mart’s and Sam’s. In comparison, department stores have 35% gross margins. It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

“If Eddie sees it as impossible, he won’t watch it evaporate. Maybe he can combine certain things and increase efficiencies, but he won’t be able to compete against Costco’s margins.”

Circle of Competence and the Too Hard Pile

There are a few really valuable comments in this reply, but probably most significantly to me was the ease with which he passed on the investment idea. Buffett didn’t necessarily say he knew Sears would fail or that he was shorting Sears, or anything certain. He definitely expressed doubt about the company’s prospects, but he simply said it was too difficult of a business for him to want to own. There were too many things that needed to go right for Sears to work out as an investment, and Buffett just felt the odds were against him.

Everyone talks about circles of competence, but one of the greatest skills Buffett and Munger have is their ability to say “no” to ideas that are too difficult. Their ability to successfully stay within their boundaries (most of the time) comes from their unique combination of incredible brain power and unusual humility. Most people who are smart and ultra-driven (character traits of most successful people) have a hard time saying “no” to challenging new ideas. They tend to believe that their will power can overcome most obstacles. These are attractive character traits in many business fields—but they can, at times, become a liability when it comes to the field of investing.

Retail is Difficult

The more specific takeaway from Buffett’s comments is that retail investing is difficult. Buffett makes a few really valuable points. The first point is that he couldn’t find any evidence or cite even one example of a retailer that turned around after suffering a major decline in business. Customer tastes change often, and once a retailer loses a step with customers, it is extremely difficult to gain those customers back. Buffett mentions department stores “will keep their old customers that have a habit of shopping there, but they won’t pick up new ones”.

The second point he made is that retail is not just competitive, but that you often don’t have control over how you run your business because you are constantly required to keep up with both the whims of customer tastes and also match whatever your competitors are doing. Buffett has said before that his Baltimore department store would see the competitor across the street offer some special promotion for the weekend, forcing Buffett’s store to offer the same discount or else lose business. It’s a game that forces you to react in ways that you might not want to, but have to.

The third point is that even a high-quality manager can’t save a retail business that has lost its way. Buffett learned this first-hand with not just Hochschild-Kohn, but also with Associated Cotton. The latter was a business run by a manager that Buffett praised as an outstanding operator numerous times in his early Berkshire Hathaway annual letters, but despite the high-quality, cost-conscious manager, the business ended up liquidating for pennies on the dollar a decade or so later.

Be Careful With Sum-of-the-Parts Analysis

One other interesting note is that the key pillar of the Sears’ investment thesis (the sum-of-the-parts real estate value) is one that has been around long before the time that Eddie Lampert entered the picture. Two years ago I wrote a post that references a 1988 article that was written in a Chicago Business Newspaper titled “Sears: Why the Last Big Store Must Transform Itself, Or Die”. This article is a really great read from a case study perspective, but one quote really stood out:

“Certainly, the profit potential of a Sears bust-up is tempting. Despite hidden assets, especially a coveted real estate portfolio valued as high as $11 billion, Sears’ shares are selling at about $36.50 each–slightly above book value and a whopping 160% less than Sears’ estimated break-up value.”

Investors were talking about the value of Sears’ real estate as far back as 1988, almost 20 years before Lampert merged the company with Kmart and began discussing plans to monetize those assets. At the time the 1988 article was written, Sears had a market value of $14 billion. But this value largely lied in the insurance and financial services businesses that Sears owned (All-State and Dean Witter) and not in the retail businesses that generated most of the revenue at that time. Today, the market value of Sears Holdings is under $1 billion. In the last 10 years alone, Sears Holdings (SHLD) has lost over 90% of its value. Even after accounting for the various spinoffs and asset sales, the last decade hasn’t been a good one for the retailer.

While hindsight is always 20/20, Buffett saw the difficulty Sears/Kmart was facing in 2005 because he experienced the same headwinds in his own travails in the retail business. Investing is largely a game of pattern recognition, and Buffett saw this pattern before.

“Don’t Bet Against the Best”

Finally, Buffett touches on the economics of the retail business, and how important scale can be, given that retail is an ultra-competitive industry. Buffett mentions Costco’s “10-11% gross margin that is better than Wal-Mart’s and Sam’s.” He goes on to mention that the typical department store has a gross margin of 35%, meaning that customers at Costco are getting a significantly better deal (in the form of lower markups from cost) than customers of department stores. Yet the department store’s fixed operating costs are too high to be able to lower prices to a level that would allow them to be competitive with the discount chains.

I checked out the current gross margins for a number of retailers, and the same dynamic that Buffett referenced twelve years ago is almost exactly the same today. Costco beats Wal-Mart and its prices are much lower (relative to its cost) than the department stores:

Almost all the department stores are right in that 35% gross margin area that Buffett referenced, with the coincidental exception of Sears, which is an example of what happens to a department store’s overall profit margins when it tries to lower its markups:

Sears, like most other department stores, has fixed operating expenses that are too high to support lower gross margins. These types of retailers have a tough choice:

  • Sell merchandise at higher margins (and thus higher prices to customers)
  • Price merchandise at lower markups (making it difficult to cover operating expenses)

The first option allows for the retailer to make a profit in the near-term but takes the existential risk of losing customers who leave to buy the same products at lower prices elsewhere. The second option makes an attempt to stave off customer defections, but then might result in significant losses as the lower gross margins aren’t sufficient to cover the company’s fixed costs.

The problem is that lower margins might be too little, too late. Sears seems to be pricing its products at consistently lower markups each year, but sales have gone from $53 billion to $23 billion in the last 10 years. They’re losing customers even while trying to appease them with lower prices. It’s kind of the opposite of having your cake and eating it too.

Amazon

One company conspicuously absent from Buffett’s comments of course is Amazon, and while Amazon’s gross margins are higher relative to other retailers, this is in part due to the extremely high-margin business of Amazon Web Services (AWS). If not for AWS and if we just focused on the company’s core retail business, we’d likely find Amazon’s margins to be razor thin relative to its competition. When combined with its massive buying power, the result is extremely low prices (like Costco). It’s clear that Amazon’s price and selection is impossible for most retailers to match, and when the customer-value proposition of convenience is added, the result is the following:

(source: visualcapitalist.com)

So retail is a competitive space that rewards vast economies of scale that allow for large quantities of products available at very low markups (i.e. low prices for customers). There are a few businesses like Costco and Amazon that have succeeded, and Buffett wisely says not to bet against the best. Unlike some industries where second or third-rate businesses can thrive, retail is an uphill battle that makes success very difficult.

To Sum It Up—The Takeaway

Perhaps the biggest takeaway from Buffett’s comments on retail is that when a retailer loses the favor of its customers, it is likely a situation that will not be reversed. But the broader investment takeaway is that understanding the boundaries of your circle of competence and having the discipline to avoid crossing those boundaries is one of the most important attributes for an investor.

___________________

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

21 thoughts on “Importance of Knowing Your Investment Boundaries (Sears Mini-Case Study)

  1. John,

    Any thoughts as to why Lampert didn’t break up the company and sell off its “valuable” real estate holdings despite everyone being aware of this strategy since at least 1988?

    1. I think it’s mostly because it’s not as easy as many make it out to be to turn those real estate assets into cash. Real estate (especially big box anchored malls) are really oversupplied in the US. We have more than twice the amount of retail square footage per capita than any other country in the world, and given the nature of ecommerce (which is certain to make up a greater and greater percentage of overall retail sales going forward), it’s a real headwind for mall property owners. A class malls might be okay, but many of SHLD locations are B and C class (not all, but many). So there is no lack of supply for mall property (and no real lack of land to build more even if demand came back). This means that while on paper it might look like these assets have a certain collective value, the nature of absorption rates in this asset class means that only a small percentage of them could be sold in any given year without flooding the market. I think one of the key mistakes people make when valuing real estate assets as part of a “sum of the parts” valuation is that they forget to factor in the time value of money. Even if we assume that the estimated value of Sears’ real estate is accurate, they can’t turn that into cash in a short period of time. If it takes 20 years to liquidate that portfolio, the present value of those assets is a lot less. I don’t know exactly how long it would take to turn all of Sears’ real estate into cash, but I know it will take a long time, and I see many valuations that value those assets almost as if it was cash. Also, I think the values are probably much lower than people think, given the oversupply I mentioned above and the subpar locations of many of these properties.

      Just my two cents on that. Thanks for reading!

  2. I just finished reading the Brad Stone book about Amazon “The Everything Store”, and one anecdote in particular stuck with.

    “The comment reflected his distinctive business philosophy. Bezos believed that high margins justified rivals’ investments in R&D and attracted more competition, while low margins attracted customers and were more defensible.”

    I’ve always been partial to higher margin businesses, but this opened me up to the possibility that low margins can also be an advantage. Costco figured this out a long time ago; not sure why it took me so long.

    On a separate note, have you looked at SRG—the Sears REIT spinoff which Buffett purchased an 8% stake in?

    1. That’s a great point about Amazon and margins. As for Seritage, I have looked at it. I outlined some very general reasons why I’m not a big fan of mall property in one of the other comments, and that generally applies to Seritage. Also, more specifically to Seritage is the issue that if SHLD files for bankruptcy (which I think is likely at some point in the next few years), then they are left with a large number of assets that will have a vacant big box for an anchor. These can be redeveloped, and as many have pointed out, there have been some attractive conversions that SRG has done so far in terms of swapping out a $3 per square foot tenant for a group of smaller tenants that pay $15 or so for the same aggregate space. But this doesn’t work if SRG is burdened all at once with a bunch of vacant assets. These renovations take a significant amount of capital, which will force SRG to take on much more debt or issue more equity. Just last week they announced an incremental increase to one of their credit facilities to help finance the conversion of the 19 stores that SHLD just announced they were closing. I have decided to pass on this company before really doing a deep dive, so I could be wrong on this, but I really don’t like the fundamentals of this situation. Converting those properties all at once will be nearly impossible. Even if they raise equity (which obviously wouldn’t be ideal for shareholders), it will tie up capital for years before shareholders begin to see any return on that investment. And that’s assuming they can lease up all of those vacant boxes (which as I described in one of the previous comments, due to the huge oversupply of retail property in this country, that is far from a given). Most brick and mortar retailers are closing stores and reducing their footprint, which will make it hard for an owner of a bunch of vacant properties that need those same retailers to become tenants.

      Thanks for the comment, and thanks for reading!

  3. Thank you for sharing your insights on that. Always good to analyse some of Buffetts knowledge.

    “It isn’t good enough that there were smart people running it. ”
    Ackman wasn’t happy with JCPenny either.

    I agree that the real estate value ist mostly “locked-in” and should not be calculated as long the company plans to keep on using that real estate.

    Wal-Mart (and Target) are now on a lot of Dividend-Investors radar … I’m not sure on that – maybe they are on a Turningpoint now (no Revenue growth in 2015 for WMT).

    Have Berkowitz made some money out of sears? I thought with the Spin-Offs it wasnt that bad?

    1. Thanks for the comment. I haven’t done the math on the spinoffs, but SHLD is down over 90% in the last decade, and so I’d be surprised if the collective value of the spinoffs (Orchard which went bankrupt, SRG, Lands End, Sears Canada, etc…) is nearly enough to make up that gap. I think the overall investment has probably been a fairly large money loser for him, but I don’t know exactly when he bought his stake or what his average price was, etc…

  4. John, great article, thank you. Though, I think Eddie Lampert is trying to keep the real estate for him in this process, he is acting as a vulture investor, lending Sears money in exchange of mortgage real estate. If Sears goes to chapter 11, he is first in the line of creditors.
    I don´t think he is trying to improve much of the operation, he is closing stores and burning a lot of cash and in that process he´s getting interesting mortgages. But of course, he won´t say it like it is. It has conflict of interest, he is the CEO and it is supposedly to represent all shareholders, not just him and his hedge fund.
    Regards

    1. I agree with that Hernan. Lampert and ESL (his fund) are in position to protect themselves when Sears finally has to file for bankruptcy. I think it’s not Lampert’s ideal strategy (he obviously would have preferred turning around the retail operation), but it is and probably has always been his personal plan B. But even though he holds the collateral and will recover much more value than SHLD common shareholders, I really wouldn’t want to be in his shoes for the reasons I outlined in a few of the other comments. He’ll have a difficult time trying to monetize those assets once his name is on the deed.

  5. Hi John
    I became arware of your blog in early 2016 and I am following it since then. Thank you for all the great posts and insights!

    When I was reading this post, the first thing that came into my mind when Buffett was talking about the retail business was “base rate”. The base rate, i.e. that turning around a retailer has not really happened before, lead him to disregard the investment.

    My definition of the “too hard pile” was always linked to the understanding of a business. In your definition above, it is more (or also) about the fact that there are too many things that have to go right for this to be a successful investment. I like that interpretation.

    How do you personally consider something to be inyour circle of competence or not? When analyzing a chemical company, for example, that produces high performance plastics (with names that only chemists can spell correctly), and you understand where and what these products are used for (e.g. in the automotive industry), however do not understand the process of how the plastic is actually produced (only that it is based on crude oil derivatives), would you disregard the investment case? Where do you personally draw the line?

    Thanks.

    1. Thanks for reading the blog. I appreciate the nice feedback. That’s a good topic for another post. It’s hard to specifically answer your question because each business is different and has its own unique circumstances. Also, each individual investor’s knowledge, world view, experiences, etc… are different and thus everyone has their own circle of competence. One thing I would say is that if you are asking yourself if a specific company is in your circle of competence, then it probably isn’t. Usually you just know if you have a firm understanding of a business. It doesn’t mean you shouldn’t study that plastics producer though, because over time you’ll learn more about it and eventually it might become part of your circle. This might not be true for every investor because each investor has their own style and approach, but for me, I like studying and learning about businesses slowly over time, and then slowly and steadily adding the ones I understand to my watchlist, and then making investments from that list. Sometimes special situations present themselves and this isn’t always the case, but for the vast majority of my investments, I prefer to pick them from a well-researched list that was prepared well in advance.

      Thanks for the comment.

  6. Hi John,

    Another great post. Just to nitpick a little bit: I find it unlikely that Amazon would operate at low gross margins even if they focused solely on retail. We can never prove it because their disclosures are not perfect, but humor me for a moment:

    In 2015, Amazon earned $107B. Of that, $22.5B was media, $7.88B was AWS, and $1B was “other” (which they describe as non-retail activities such as services and co-branded card agreements). The remaining $75.6B is electronics and other general merchandise, their core retail franchise. If we assume for the moment that media, AWS, and “other” all had 100% gross margin, then what is the lowest the last category can be in order to achieve the consolidated gross margin of 35%? The answer is 7.7%.

    Normally the analysis would stop here. You cannot tell which components of the operating expenses belong to their core business versus AWS, media, or “other” unless the company breaks it down this way in their financials. Fortunately, there IS one component of the operating expenses that is predominantly comprised of retail costs: fulfillment. For 2015, this cost was $13.4B, or 17.7% of retail revenues. That would already bring the company in to the negatives, and doesn’t even consider the marketing and SG&A involved.

    Viewed this way, I cannot fathom how the general market considers Amazon a low-cost provider in retail. They don’t even come close to Costco.

    Thanks again for the great, thought-provoking blog post. Keep up the good work! We’ll talk again soon, I’m sure.

    -J

  7. Another great post John. Sears is a poster child for a lot of investor issues including the sunk cost fallacy as Lampert continues to throw good money after bad and the difference between being an investor and an operator. I’m not sure he’s ever actually stepped foot inside a Sears…

    So timely, I had to share: http://www.businessinsider.com/sears-failing-stores-closing-edward-lampert-bankruptcy-chances-2017-1

    A few great quotes:

    “The only way you see Eddie is through a screen,” one former executive told Business Insider. “We used to joke about who had to go upstairs to get fixed and see Oz.”

    He refuses to put a dime in updating stores,” one former vice president said. “You walk in and you are embarrassed as an employee when the ceilings are leaking and the floors are cracked.”

    “No one believes in Eddie’s vision,” this person said. “He has just gone rogue.”

    The employees who spoke to Business Insider describe an internal mess with a revolving door of executives and low morale. Senior executives say Lampert has cut investments in stores because he’s trying to turn it into a tech company that collects and sells customer data through the Shop Your Way program.

    He has publicly compared Sears’ strategy to Apple’s and Microsoft’s, and in his most recent letter to shareholders, he said that Sears is trying to meet new customer needs like Uber, Amazon, and Tesla are doing. Sears is facing more scrutiny from Wall Street than those companies, however, because of the sheer fact that it’s a retail company, he said.

  8. How is it that Walmart and Target are able to be relatively more profitable with gross margins in the 20 % range and Sears is not? I would assume operating expenses’ would be similar, as all three stores tend to be massive.

    If that were true, then that would imply Walmart and Target are making it up on asset turns ( Sales/Assets). Then what is preventing Sears from experiencing the same level of asset turns ( Sears product mix of kitchen appliances, furniture etc by its nature is purchased less then products found at Walmart and Target?).

    Thanks and big fan.

  9. Great article! You just convinced me to stay away from a similar play in Canada, Hudson’s Bay Company (HBC on the TSX) that is rumored to buy Macy’s. This too is a “real estate” play.

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