I don’t think buying the department store chain’s shares was a mistake. Investing is a probabilistic adventure: You assess upside and downside probabilities of a potential investment, and if at the end the balance is significantly favorable, you pull the trigger.
Uncertainty is the nature of investing. Let me illustrate. Suppose you were offered a coin-flip game: Heads you win $10, and tails you lose $1. It makes complete sense to play this game; the expected return (probability times outcome) is overwhelmingly in your favor. So if you flip the coin and get tails, was playing the game a mistake? No, of course not.
In the case of J.C. Penney, the story was fairly straightforward. The company had been neglected and undermanaged. Old management was fired, and brilliant new management was brought in. New management developed a plan for completely redesigning the stores, giving them a real face-lift, upgrading merchandise and turning J.C. Penney into one of the best-looking stores in the mall.
The new CEO, Ron Johnson, had been instrumental in creating Apple’s stores and was a very well-respected retailer. At the time Johnson was executing on his plan — remodeling stores as J.C. Penney continued to bleed money — this is what I wrote: “The best thing about Penney is that the bar for success is set very low. Since he took over, Johnson has taken out $900 million in costs. Sales per square foot should rise with every redesigned store. 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.”
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.
Johnson failed. Well, we are not 100 percent sure he failed — he was fired before he had a chance to prove himself. But there is another sublesson we learned: Don’t underestimate U.S. consumers’ desire to be deceived by coupons and sales. Part of Johnson’s strategy was to have honest, everyday-low prices. That did not fly with American consumers. They wanted prices to be raised and then discounted. After the CEO was fired, stories started to leak out that he was a visionary but not a good manager. He canceled multibillion-dollar brands without consulting with the board. Also — this is clear now — Johnson should have tested his pricing strategies first, maybe in a few stores in one market, rather than rolling out a new, completely different pricing strategy all at once.
When Johnson was fired, we sold the stock. Our bet was on Johnson. Myron (Mike) Ullman, who replaced Johnson, was the old CEO who had slowly but surely guided J.C. Penney into irrelevance for years. With Johnson’s departure our wisdom on the upside and downside was gone. In fact, the downside started to look deeper.
Johnson came from Apple, a company that does not believe in making incremental decisions. If you make leaps, as Apple does, you had better be right or you might be dead — at least, you had better be able to afford to be wrong. This leads to my real reason for reopening the J.C. Penney wound. I want to visit a topic rarely discussed by investors: position sizing. How do you determine the correct percentage of a portfolio to allocate to a single idea? We believe position sizing should be driven not by reward but by risk. J.C. Penney had a terrific upside, but it still had a 40 percent downside, with a meaningful 30 percent probability. However, when we sold the stock at a loss, the impact on the total portfolio was less than 1 percent.
In the past our position sizing was driven by intuition. J.C. Penney made us rethink that. We turned position sizing into a fairly rational and well-defined process. Each company in our portfolio gets a rating for the quality of its business: the size of its moat, the strength of its balance sheet, how it fits in its industry. We assess its management in two dimensions: how good it is at running the business (building moats around it) and at allocating capital. Last, there is an X factor, where we judge business cyclicality, complexity and transparency (banks, for instance, would never get a high score there). Then we balance the totality of these factors against the cheapness of the stock: Should we take a starter position or a full position?
We arrive at a fairly disciplined decision about how much we should allocate to the stock. This way our portfolio will always tilt toward higher quality and risk is minimized, not just through valuation (providing a margin of safety) but through quality as well. There is a place for J.C. Penney–like positions in the portfolio — but not too many.
As Warren Buffett put it: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”