In 2012, I published an article outlining why I believed J.C. Penney (JCP) was a solid investment (here). At the time, the stock was trading at ~$22 per share; three years later, it’s at ~$8 per share, for a loss of more than 60%. Clearly this is not how I envisioned this investment playing out.
As painful as this experience has been, it has given me the opportunity to learn and improve; as an investor, I hope that I’ll take away the lessons needed to avoid similar mistakes in the future. I would consider the failure to learn from this mistake an even greater error than the investment itself.
This article will revisit my original analysis in an attempt to root out the flaws in my thesis.
Business
“While Penney’s put up good numbers in the middle of the decade (average net income from 2006 – 2008 was more than $1B annually), the company has been on a downward trend in recent years, with poor performance being exacerbated by the bursting of the housing bubble: revenue has fallen, margins have collapsed, and total shareholder return is last among its peer group. Looking over the past ten years, the company has averaged annually net income of roughly $560 million, equal to roughly $2.6 per share (there were 218M shares out as of the end of Q1).”
Looking back, I took too much comfort from the fact that the business had operated profitably over the prior decade. I was too quick to accept that as a measure of “normalized” earnings when in reality (1) the period was fueled by spending tied to the housing bubble; and (2) the world had been moving away from retailers like JCP for many, many years, and showed no signs of changing direction (it’s worth noting that despite a roughly 30% decline in sales for the company as a whole in the most recent year versus a decade ago, the Home department has fallen from ~22% of the company’s sales to ~12% of the company's sales over the same period). I used this data to convince myself that even in a “bad” scenario – which I defined as failure by Ackman / Johnson – the company would eventually return to financials that looked something like the JCP of the early-mid 2000’s (and even better if they were able to close some of the cost gaps between themselves and competitors like Kohl’s - KSS). With hindsight, that was way too optimistic; the current results are a mile away from what I assumed they would be in this scenario.
The downward spiral of the company's promotional strategy that I discussed in that article was a reflection of a serious problem that I believe Ron Johnson appropriately diagnosed; however, finding a solutionto that problem ultimately proved easier said than done. As management noted at the time, their plan was to compete on product and presentation. I’ll leave it to the reader to visit a local J.C. Penney’s to determine how well they’re doing on those points relative to their competitors.
Management & Big Name Investors
In addition to faulty analysis of the underlying business, I was drawn in by big name investors: Bill Ackman (Trades, Portfolio)’s sizable stake in the company (along with Steve Roth) comforted me. To be clear, I still did my own research and walked away thinking that the equity looked attractively valued – but to pretend Ackman’s involvement had no impact in coming to that conclusion would be disingenuous. Being unbiased when you see a well-regarded investor calling for a stock to triple (or more) over the course of a few years can be difficult. I fell into the trap of accepting Mr. Ackman’s forecasts, most notably on margins and sales. I shouldn’t have been swayed by his expectations – and if I couldn’t come up with my own expectations, I should’ve avoided the stock. In the end, the error rests squarely on my shoulders.
As it relates to management, I drank the Kool-Aid here as well. It’s kind of funny to remember that when Ron Johnson was hired, the stock jumped nearly 20% the next day, adding more $1.2 billion to the company’s market cap (to which Bill Ackman (Trades, Portfolio) replied “The market is wrong; he's worth way more than that”); less than two years later, Ron Johnson was sent packing.
Warren Buffett (Trades, Portfolio) tried to warn me, but I didn’t listen:
“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.”
Reader “Varunfriend” mentioned this quote in a comment to one of my J.C. Penney's articles, at a time when it should have been clear to me that the investment thesis was seriously flawed (this was a few years in). If I listened to him, I could’ve saved myself a lot of money…
Conclusion
With hindsight, I was too quick to believe the new strategy would work, and also overlooked the risks associated with its implementation (I was in numerous stores with a lot of unproductive selling space due to construction over the past few years). I was also too quick to accept that the cost savings outlined by Mr. Ackman would be realized in short order, something that still hasn’t happened (as a percentage of sales, SG&A in 2014 was higher than in 2011).
Most of all, I put too much weight on the results over the prior decade which gave me a false sense of confidence. I believed the company could earn a few hundred million dollars a year even if the proposed changes didn’t work out, without really taking the time to test that assumption. Finally, I overestimated the downside protection on the balance sheet – which in combination with the prior point resulted in an underappreciated risk of permanent impairment of capital.
In the future, I plan on spending a lot more time asking myself a few questions:
(1) Is there reason to believe that the financial results for the prior decade were fueled by exogenous factors? If yes, how much of any impact did these factors have on the business?
(2) What basis do I have for assuming that past results reflect what could happen in the future?
(3) What’s the basis for my forward estimates – and are these numbers truly conservative?
I paid a pretty steep price for investing in JCP, with the losses in 2013 creating an eight percentage point headwind to my overall returns for the year. In addition, that math doesn’t account for the opportunity cost I paid relative to investing those funds in my next best idea.
I sold half of my position in late 2014, and will liquidate the remainder in the near future. Hopefully I’ve learned some important lessons that will help me to avoid a similar mistake next time around.
