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2013 Year-End Reflections

December 29, 2013 | About:

As the year 2013 draws to a close, it is time to sit down and reflect upon the investment mistakes that I’ve committed during the year.  In doing so, I am immediately reminded of an excerpt from Warren Buffett’s 1989 letter to shareholders.

“To quote Robert Benchley, ‘Having a dog teaches a boy fidelity, perseverance, and to turn around three times before lying down.’ Such are the shortcomings of experience. Nevertheless, it's a good idea to review past mistakes before committing new ones.”

Alas, how I wish I had a magic dog to teach myself to avoid soggy cigar butts on the street. The biggest mistake I made this year unmistakably falls under this “cigar butt” category. In a year where S&P advanced more than 30%, I’ve brilliantly managed to invest in a company whose share price has sunk over 50% since the beginning of the year. It is certainly not fun to slip up but getting up and learn from the fall has proved to be extremely rewarding. Heck, in fact, I consider this the best investing lesson that I have ever learned because as a result of the mistake, I now have a much better understanding of the shortcomings of the cigar butts approach to investment.

This cigar butt is called JC Penney. The mistake I made is a multifaceted one that involves analytical errors, human psychological biases, and a horrible purchase price.

To be clear, I don’t think buying JC Penney is a mistake per se. I’ve bought JC Penney in 4 tranches, the lowest at $8 and the highest at $17.Whether it is a mistake depends on the price paid.  As Howard Marks has said before:

“In investing there is no such thing as a good or bad idea. Only a good idea at a price. Anything can be a good idea at one price and time, and a bad one at another. There is no investment idea so good that it can not be ruined by a too-high entry price. And there are few things that can not be attractive investments if bought at a low-enough price.

It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough. No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.”

I have certainly paid too much for JC Penney and that was a huge mistake that has cost me dearly. At the time I bought the first tranche of JC Penney, it was around $17 per share. In an article I wrote called “JC Penney – Maximum Pessimism,” I laid out my thesis based on JCP was trading around the liquidation value estimated to be between $13 to $16 per share.  One of the readers made the following great comment: Liquidation value is one of those things with a big range of possibilities IMO. In a bankruptcy preceding, I doubt current shareholders will get even $9 per share or even $5 for that matter. Although I don’t know this member personally, I can tell he is without a doubt a much better investor than I am.

I’ve learned the hard way that liquidation value is as real as a mirage. First of all, the liquidation value is very likely to evaporate like liquid left in the sun if the business is not improving. JC Penney’s book value dropped almost by half within a relative short period of time. Therefore, using the present liquidation value was very foolish. Had I extrapolated the liquidation value for JC Penney based on the speed at which the business was deteriorating, I would have come up with very different scenarios. Secondly, as I have learned through studying Buffett’s partnership letters, liquidation value itself provides very limited downside protection unless you can accumulate a controlling position and even if you can end up controlling the business, the liquidating process is likely to be very painful.

Given the inadequacy of liquidating value, it is not surprising that my worst case scenario was way too optimistic, which leads to another lesson – risk means worst case scenario can happen more often and can be more severe than you think. Frankly, I did not think JC Penney was going to drop to merely $6 per share. Mark Twin said “a man who carries a cat by the tail learns something he can learn in no other way.” My experience with JC Penney has certainly proved his point. Almost everything that could go wrong did go wrong. Sales dropped precipitously; the board room was full of dramas; drastic leadership turnovers; solvency issues; liquidity crunch; massive equity dilution. Even when sales are improving, no one seems to care because everyone is now concerned that margin will stay low forever. I would be lying if I tell you that all the negativity did not bother me one bit. It was unpleasant mentally to go through the turmoil but I am also fully aware that I deserve such agitation. Without such agitation, I probably won’t be able to fully appreciate the beauty of “it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”  

I wish I could stop right here and tell everyone that’s all the mistakes I’ve made about JC Penney. Unfortunately, the dimension of this flub extends beyond sheer analytical blunder. I also failed utterly to recognize the human psychological forces that were in play.

At the time I made my purchase decision, JC Penney had a very promotional CEO and a promotional activist, Bill Ackman, who I actually admire a lot. Looking back, my analysis was heavily influenced by the way Ron Johnson and Bill Ackman presented information (framing bias) and the ease at which the information can be recalled (availability bias). What initially got me really interested in JC Penney were a few articles on gurufocus and Bill Ackman’s presentation. Unfortunately, the presentation served as my initial anchor.  Below are the slides that got the neurons in the nucleus accumbens part of my brain fired like wild.

Upon deep reflection, I think the root of my mistake lies in the part of my brain that handles anticipation for rewards. In Chapter 3 of the great book “Your Money or Your Brain” by Jason Zweig, the author noted that “Making money feels good, all right; it just doesn’t feel as good as expecting to make money. In a cruel irony that has enormous implications for financial behavior, your investing brain comes equipped with a biological mechanism that is more aroused when you anticipate a profit than when you actually get one. The arousal piece is actually the main component of euphoria, and it’s expectation- not satisfaction – that causes most of that arousal. When rewards are near, the brain hates to wait. Neurons in the caudate nucleus, a region in the center of the primate brain, become active even before the predictive cue is presented.”  Now I can imagine that the neurons in the caudate nucleus must have been fired up when I saw Mr.Ackman’s base case offered a 6.5 times upside when JC Penney was trading at $17 per share.

Fixating on the upside made me overlook the magnitude of the downside. Under influence, my calculated risk reward ratio seemed favorable:  using 20 year low of $10 as worst case and $39 - only half of Mr. Ackman’s base case as fair value, at $17 per share, the downside was $7 and upside was $22 with. For every dollar of risk, I thought I was getting 3 dollars of rewards. The odds were favorable.

The reward seemed so real and the anticipation was so exciting. There was only one little problem – in reality, it doesn’t work that way. The rewards are imaginary while the risks are real.

I had the fortune to talk about JC Penney with a few renowned investors including Arnold Van Den Berg, Stephen Yacktman and Michael Shearn. All of them have considered investing in JC Penney yet all passed. Among the reasons they ultimately did not invest are promotional management, too hard to figure out and too much downside. None of them even mentioned the upside during our conversations. This is the difference between a wise man and a fool when it comes to investing. The wise man knows that if you take care of the downside, the upside will take care of itself. Now I realize that even though the risk reward was favorable, the downside of 40% was too much and because the uncertainty was so high, one should pay a lot less for taking on the risks, not more.

The above may all seem very obvious to most of the readers but I had to learn it the hard way over and over.The confluence of the framing bias, the availability bias and the anchoring has been skewed my reasoning in the past to the more euphoric side of the pendulum. It was not until the second half of this year did I recognize the power of the lollapalooza effect, which Charlie Munger has warned us. But better late than never. The JC Penney experience will definitely serve me as a reminder going forward.

The last mistake I made with the JC Penney investment is related to portfolio sizing. It had been a 15% position in my portfolio. I am still debating whether this is as huge as a mistake as the analytical error and the lollapalooza effect. After all, I resonate with the idea of concentration unless everything gets cheap like the experience of 2008. Nevertheless, a 15% position in a struggling retailer does seem too high with the benefit of hindsight.

Now that I have finally listed out all the mistakes I’ve made with JC Penney, I feel obligated to apologize for having rambled so much on an investment that has been discussed very extensively on gurufocus. Of all the mistakes I have made and believe me, there are a lot, the JC Penney blunder is by far my favorite because I have learned tremendously from a multidisciplinary approach.

Charlie Munger once said “I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.

Therefore, at the end of 2013, I’d like to admit that I was a complete stupid horse’s ass but I’ve learned to rub my nose in my mistakes.

Thanks for reading and happy new year!

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Rating: 4.5/5 (25 votes)

Comments

The Science of Hitting
The Science of Hitting premium member - 8 months ago
Great article; like you, I hope I've learned a life long lesson from the JCP debacle (and Ackman's wildly promotional statments at the time of the investment, which I fell for in addition to my own analytical blunders). Unfortunately, that lesson has proved to be quite expensive for both of us...
20punches
20punches - 8 months ago
It is certainly a life long lesson but better to make the mistakes when we can still afford it. Maybe this is one of those 'my-wife-away-withmy- best- friend- and- I- still- miss- him- a- lot" investments we are bound to make:) Bill Ackman has an incredible batting average and of all the investments he has made, this is the only one I followed. I am actually grateful for him to teach us such a great lesson because both of us will be less likely to make the same mistake in the future when our investable capital is likely to be much higher:)
varunfriend
Varunfriend premium member - 8 months ago
Excellent article ... I came very close to investing in JCP. The cheapness of the stock compared to "tangible" value was very alluring. The two (lucky) reasons I did not go with JCP was that I found, what I thought, was a better alternative and I happen to reread Buffett's quote" When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." the more interesting question now is ... are you guys still holding on to JCP or have you sold it/planning to sell it?
The Science of Hitting
The Science of Hitting premium member - 8 months ago
I still hold it, and will stick with it at least through all of 2014 (as I've previously committed).
vgm
Vgm - 8 months ago
Science - to clarify your statement, are you saying that you're sticking with it because you committed to it? Surely we should only hold if we believe our investment case is still intact, despite Mr Market's tantrums? You mention "blunders" above, including your own and Ackman's. That would imply the investment case is impaired now compared to your original analysis. Thanks for your thoughts. 
20punches
20punches - 8 months ago

Varunfriend:Buffett's wisdom is ageless and boy I bought JCP even though I could recite Buffett's quote. On your question, yes,  I still hold it and as I said, I've bought a few tranches on the way down from $17 to $8. It is a mistake to buy at $17, that's for sure. But at $8 or even $9, it's a different game in my opinion. I am not holding JC Penney because I've committed to the business. I am still holding it because I think it is significant undervalued at the current price. The sales are improving and margins will very likely to gradually improve after Q1 2014 and the U.S customer confidence is rising too. The previous management team is gone and the board room is not filled with drama now. I think things are shaping up to be better for JC Penney. I don't like the equity dilution and I don't like the debt issuance collaterized by their real estate assets but I do think JCP is currently priced below the conservatively estimated instrinsic value. Thanks for commenting. 

The Science of Hitting
The Science of Hitting premium member - 8 months ago
Vgm - Partly, yes; not because I'm committed to JCP in particular, but because that is the approach to investing that I find most sensible for the long term (it works for me). I don't think the worst thing in investing is to be committed to being a long term investor; as an example, Warren makes that committment everytime he purchases a company in its entirety - and he wouldn't sell, period, as he has made very clear with his See's Candy example (would not sell for 2-3X intrinsic value). The best way I know of ensuring that I act like a long term investor / owner is to force myself to be one. Sometimes it will come at a cost and be painful, as is the case here; that should teach me a lot about position sizing, potential investments, and retail turnarounds (the fact that this was the first investment that I've made this commitment on, and my subsequent inactivity since that time, are likely correlated). I think the end result will be an investment approach focused on buying great businesses with staying power at attractive prices. Last thing: I don't think JCP is overvalued - but the fact that I was not a buyer under $6.50 / share should tell you all you need to know. Hope that answers your question!
vgm
Vgm - 8 months ago
Science - in part yes :-) It answers my question, but leaves me a bit perplexed. On the one hand there's great merit in being a truly longterm and individually minded investor ('You are right because your data and analysis are superior'; Ben Graham). On the other there's also merit in admitting a mistake and getting out immediately ('When the facts change I change my mind. What do you do Sir?'; Keynes) and into a better investment. The fact that you did not buy down at $6.50 betrays a certain lack of conviction. I agree it's good to rub our nose in our errors, but that's different from keeping our nose in the dirt! I don't really buy the comparison with See's. It's been a textbook example of a great company with a moat which has gone from strength to strength. A closer comparison might be Kraft/Mondelez where Buffett has sold because he didn't like what he saw unfolding. Thanks. 
The Science of Hitting
The Science of Hitting premium member - 8 months ago
Vgm - This certainly isn't something others must follow; it is an approach that I consider appropriate, at a cost that I consider quite small relative to the benefits (which admittedly are hard to quantify). You might not see it that way, and can choose to avoid it entirely. On See's, I think you're missing the point: Warren has said he wouldn't sell See's at 2-3X intrinsic value - i.e. he would not sell it under any circumstances. From a financial point of view, that is clearly illogical; but that is the way he has chosen to approach his life and business - and I think the small potential cost is easily justified by the benefits of this approach. My thinking is in those same regards; you can judge on your own whether either approach is justified.
arurao7
Arurao7 - 8 months ago
Great article! I really liked your analysis on JCP.What do you think about real-estate though? In ackman's presentation, the value was close to $11 billion. The goldman sachs loan is about 2 billion, but it was interpreted as if the real-estate is now suddenly worth only $2 billion. Don't you think they could put their real-estate as collateral further, in case they are faced with a liquidity crunch? Worst case, it means that we have wait longer for JCP shares to rise again. All JCP has to do is first get back to the old JCP for the stock to reflect reasonable valuations. I haven't seen much analysis on JCP real-estate.. what is put up as collateral and what is not. Thanks.
20punches
20punches - 8 months ago
Arurao7: Thanks for the nice words. In terms of the real estate portfolio, I don't think it's worth $11 billion for sure but Ackman's probably done a great deal of due diligence to come up with his $11 billion replacement cost. For me personally, I've pegged the real estate value to the third party appraisal of a little over 4 billion and over half of that 4 billion is put up as collateral. This is certainly good news for bond holders but the equity holder suffers from less downside protection. I also think the liquidity crunch wasn't as bad as the media portrayed and Mike Ullman did the equity raise to appease the noises from analysts and naysayers. With the debt issuance and equity dilution, it's unlikely that they will face a liquidity crunch anytime soon. I also don't think JC Penney is going to go out of business as some analysts predict. Even Warren Buffett said he is not worried about JC Penney's survival. We will see how things go in 2014. I'm expecting a so so Q1 and gradual margin improvement since Q2. 
The Science of Hitting
The Science of Hitting premium member - 8 months ago

Vgm - By the way, here's a quote from the 2001 shareholder meeting: "The businesses we own aren't for sale at any price. It's my natural inclination. If I owned 100% of Berkshire, I wouldn't dream of trading businesses around so that I could die with an estate that was 5% bigger than it might have been. Since I don't own 100% of Berkshire, I want shareholders to be aware of this. This loyalty helps us buy businesses, but there is a cost as well."

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