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Learning from the JC Penney Fiasco
Posted by: Chandan Dubey (IP Logged)
Date: November 19, 2013 04:29PM

I did not invest in J.C. Penney (JCP). I was severely tempted, several times, because it seemed like a good company to coat-tail. It felt like a stock with small downside and arguably huge upside. The newly hired CEO (Ron Johnson) gave up $100 million in stock options at Apple (AAPL) and put down $50 million of his own money to buy stock of JCP. The incentives were aligned. Johnsons’ track record in retailing was also fabulous. He had worked at Mervyns, Target (TGT) and was the pioneer of the Apple Retail Stores. JCP seemed like a good asymmetric bet. Given its extensive real estate ownership and a well recognized brand name, it seemed that given time, Johnson will be able to turn the company around.

If I had taken the time to read the investment thesis of JCP, read their annual reports and make my own due diligence, I would probably have bought the stock. As it is, I had to control myself several times from pulling the trigger. I succeeded only because I felt that JCP was a high-risk scenario, and I have better things to invest in, like Bouygues (XPAR:EN) and CAF (XMCE:CAF).

Reading the article by Vitaly Katsenelson (What I Learned from the JC Penney Fiasco), I tripped on the following assertion.
Quote:
“We thought there was a very high likelihood — 70 percent or so — that Johnson would be successful; if so, the upside would be threefold or more. If he failed — a 30 percent chance — the downside was probably 40 percent or so. The risk-reward scenario was very attractive.”
It led me to think about the following question: How does one go about calculating the probabilities of investment success versus investment failure? It is a very important question because I completely agree with Vitaly when he says that “uncertainty is the nature of investing.”

If Vitaly’s assumptions are correct, i.e. JCP had a 70% likelihood of 300% return and 30% possibility of -40% return, then the expected return for this endeavor was 198%.

The determination of expected return hinges on three important variables: the probability of success, the upside and the downside. The upside is much easier to deal with. One can use several valuation tools to calculate the “normalized” value of the company and hence the upside.
Quote:
“If Penney achieves the pre-Johnson level of $150 per square foot and gets to keep $700 million of cost cuts, its earnings power will be $3 to $4 per share. If sales per square foot come back to the 2007 peak of $170, earnings will jump to $6 a share.”
Ever optimistic, the downside is generally ignored. In many cases, investors plug in an arbitrary value which seemingly looks reasonable. But it is important to come up with the process to calculate the downside. The situation of JCP is a familiar one. When the new CEO is hired, he probably has enough money and good enough balance sheet to turn the company around. But the company starts bleeding money, it needs to take on additional financing and the book value deteriorates as time passes. Glancing at Morningstar, the book value of JCP has gone from $20 in 2010 to $7.

The real estate value of JCP was the downside protection in this case. Taking the real estate value and subtracting the net debt of the company was not a good way to measure the downside of the company.

I will momentarily defer the discussion on calculating the downside and talk about the third variable in the calculation of the expected return, i.e. the likelihood of success. This is probably the most important variable in the discussion, and we must at least make sure that our process for arriving at this value is correct.

The task seems intractable. Vitaly comes up with a 70% chance of success. But what is the process behind the number? Is it just a number which he thought plausible? Or was there a process involved?

The ever quotable Mark Twain has a solution hidden inside his famous quote. “History does not repeat itself, but it does rhyme.” The answer is to look at the history of such turnarounds. As much as we would like to believe that we are unique, someone has gone through very similar experiences and has fantastic lessons for us.

One might start by answering the following questions.

How many retail turnarounds have been successful? You might try to find cases which bear similarity to the case in hand like a star CEO being hired to save an ever-fading brand. If you do not have data on retail turnarounds you can instead look for the cases were hiring a good CEO to save the business has worked (or not). This will give you a baseline estimate for the success.

What was the time it took them to become successful? This will give you an estimate on the number of years you have to hang around for the company to realize its value.

What is the track record of the CEO, if any? Always adjust for luck in this case. If the CEO has been successful once or twice, the chances are higher that he will fail this time. The luck is bound to turn at some point.

Once we have a baseline probability of success, we can adjust it according to the situation we find ourselves in. Buffett has mentioned that “retail turnarounds rarely turn” and I venture to guess that the 70% probability of success was quite optimistic. It means that hiring a very good CEO will lead to turnaround in 70% of cases.

I think a better proxy will be closer to 30%. I emphasize that I am pulling this number out from thin air and probably committing the same mistake. But this number seems more plausible because the process to reach it is less arbitrary.

Coming back to the downside, a very similar process is advisable. You start with the average duration of the turnaround and then come up with the losses/debt taken in the intervening period. This will lead to a smaller value than just taking the real estate value and subtracting the net debt.

I trust Vitaly on the calculation of the downside. I respect his opinions and have learned from his writings.

If we run the calculations for the expected return with 30% chance of success with 300% upside and 70% chances of failure with 40% downside, then the expected return reduces to 62%. If we assume that it would have taken JCP at least two years to turn itself around, a very conservative estimate in my opinion, then the compounded return reduces to 27% a year.

The investment is not so attractive anymore.


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Re Learning from the JC Penney Fiasco
Posted by: The Science of Hitting (IP Logged)
Date: November 20, 2013 06:58AM

Spot on Chandan - thanks for the great article


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Re Learning from the JC Penney Fiasco
Posted by: cdubey (IP Logged)
Date: November 20, 2013 11:45AM

@Science: You disappoint me ;) I hoped you would argue that my 30% chance of turnaround was too low. And I would do nothing and you would research and find disconfirming evidence to that end.

I am actually interested. If someone has access to data. To find out how many turnarounds do actually turnaround.



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Re Learning from the JC Penney Fiasco
Posted by: The Science of Hitting (IP Logged)
Date: November 20, 2013 03:28PM

Chandan,

The 30% measure is tough to argue: if you can even find enough instances to make a statistically significant case for what has historically happened in these type of situations (good luck), I'd still question the results (little more than food for thought in my mind). I'm increasingly convinced that formulating success / failure probabilities is little more than pseudoscience; that certainly doesn't mean the math can be ignored completely - but it suggests to me that focusing on a rough downside measure and a range of probabilities (as well as the timing to revert to that downside level if the market overshoots, as it likely will in the fail state) is more important, as you suggest in the article.

Not to point the finger at Vitaly, but look at his own measure - he believed that the fail state, with a 30% likelihood, was ~40% downside. I'm not sure what his entry point was, but let's consider Ackman's basis around $25 - from top to bottom (~$7), the stock fell by nearly three-quarters; even at today's price (~$10), JCP is off about 60%. If downside meant as low as the stock could go (and this is how I interpret explanations of downside risk - people are generally suggesting it as a floor), then 40% proved to be a grossly inadequate estimate; to be clear, I made the same mistake.

I was never sure what the upside probability or value was - but I thought I had a good grasp on the downside potential, and only needed about half the upside that Ackman was looking for to overwhelmingly justify the purchase on an expected value basis (and I thought it made a great deal of sense). I believed the combination of real estate and other assets, plus the normalized earnings power experienced over the prior decade, put the downside risk within reach (~25%) of my basis around $20. Ironically, looking at where we are today, the market cap is about in-line with what I was looking for - unfortunately, there was a near 50% dilution in the process.

We'll see what happens in the coming quarters / years, but there's good reason to question my original downside calculation from where we stand today; I'm willing to bet that is more common than not when things go bad in these type of scenarios...


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Re Learning from the JC Penney Fiasco
Posted by: vgm (IP Logged)
Date: November 20, 2013 05:25PM

"Once we have a baseline probability of success..."

CD,

I'd question (as you hint yourself) whether a statistical analysis is at all meaningful to evaluation in this case. Logically, it would only be meaningful if the sample set was closely comparable. I'd tend to suggest that no two turnarounds are similar enough for inclusion and therefore conclusions would not be valid.

I considered JCP briefly, but it went into the "too hard pile". Just too many unknown unknowns. I like Charlie Munger's notion that an opportunity should scream out at us, without alot of head scratching.

Thanks for the stimulation.


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Re Learning from the JC Penney Fiasco
Posted by: cdubey (IP Logged)
Date: November 21, 2013 09:13AM

@Vgm: Theoretically, you are quite right. No two turnarounds are quite similar. This makes the question more complicated i.e., how does one decide about the investment ? A good option is to put it in "too hard pile" and forget about it.

But for the investors who think they can do it, it is better to have a process of evaluation, rather than pulling out a number from thin air. This is actually quite hard and reminds me of "safety in numbers" and "being precisely wrong vs approximately right". Maybe coming up with a range of probabilities is a better idea ?

The questions is, will you find a systematic way of evaluating downside. If yes, how ? Even in the easy cases it is not clear how to arrive at the probability distribution. I mean Mohnish Pabrai's book goes into extensive details of Kelley's formula and he has also committed very similar mistakes of "approximating" the probabilities of success and failure.

Just for the sake of argument, I think computing the baseline probability is probably a good number to start with.


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Re Learning from the JC Penney Fiasco
Posted by: Koheleth (IP Logged)
Date: November 21, 2013 01:05PM

"I considered JCP briefly, but it went into the "too hard pile". Just too many unknown unknowns. I like Charlie Munger's notion that an opportunity should scream out at us, without alot of head scratching."

Amen, VGM. Like Buffett has said also, I don't need a scale to tell if someone is obviously overweight.

btw I love also Munger's other quote about walking past boulders of gold to stoop over and sift dirt for gold nuggets. There were other games to play instead of JCP.

I just never saw the moat, so I had no conviction in any calculation of future earning power, and therefore no confidence in where it would be five or ten years hence.

To me this analysis had to fall under the qualitative, intuitive realm. What kept me out of JCP? I kind of did what Lynch and Buffett have done: I went to my local store and checked it out several times. I never saw a screaming business, it was never crowded. Kind of reminded me of walking into Kmart after having visited Walmart -- and that was after Kmart's store renovations.

Remember how Buffett analysed American Express in the 1960s? He may have crunched all the numbers and probabilities but didn't invest until he stood behind a cash register at his favorite restaurant to see for himself if people were still pulling out their Amex cards.

Ultimately it was my simple, wholly unscientific observation of the fact that my wife never shopped there, so there it went into the 'too hard' pile. For me it's as Buffett has said: "If I cannot figure out who the winner is, I'm not interested in playing."


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Re Learning from the JC Penney Fiasco
Posted by: cdubey (IP Logged)
Date: November 22, 2013 03:59AM

So, the overwhelming conclusion is to put it in "too hard" pile and then keeping control on yourself and not thinking about all the cash you can mint in the short term. :)

Thanks everyone for the discussion and the inputs.


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Re Learning from the JC Penney Fiasco
Posted by: vgm (IP Logged)
Date: November 23, 2013 05:16AM

Perhaps it's more to do with worrying about the risk and downside before contemplating "all the cash".
;-)
Thanks!


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