Of all the most corporate failures in recent years, Sears (SHLD, Financial) stands out. This failing retailer hasn't collapsed into bankruptcy yet, but it is a fascinating story of how value investors can end up being misled.
I'm cautious of using the term "value trap" here because I believe this term isn't that useful when describing an investment situation. You can only really tell if a company has become a value trap in hindsight, and you can always argue that a company trading at a discount to its net asset value with a negative return on equity is a value trap.
However, this erodes the core principles behind value investing. Buying stocks that have fallen on hard times trading at a discount to book value (and usually achieving a negative return on equity due to temporary factors that have resulted in the opportunity being presented) is precisely what the godfather of value investing, Benjamin Graham, built a career on.
Sears is the classic tale of a stock that looked highly attractive to value investors several years ago but has struggled to pull itself out of a death spiral.
Real estate value
Sears has always been a real estate play. The company owned the majority of its stores and has unlocked a significant amount of value from selling off these holdings.
Between fiscal 2014 and fiscal 2016, the company received nearly $4 billion of proceeds from selling real estate. Then, between April 2016 and February 2018, the company generated $1.7 billion of proceeds from the sale of real estate and related assets.
In addition to real estate sales, the company has benefited from the disposal of other assets, such as its Craftsman brand for cash proceeds of $525 million in early 2017. Over the past six years, total assets sales have amounted to $8 billion.
In other words, the original value investment thesis for Sears was correct. The company had (remaining assets are just a fraction of this total) a strong balance sheet backed up by plenty of real estate. The real estate is so attractive that even Warren Buffett (Trades, Portfolio) got involved. This week it has been announced that Berkshire Hathaway (BRK.A)(BRK.B) provided a $2 billion loan to Seritage Growth Properties (SRG, Financial), the real estate investment trust spun off from Sears with 249 retail properties across the U.S.
What I find fascinating about the Sears story is that this is 100% a mismanagement situation. There was, as has been proven over the past few years, significant value on the group's balance sheet, but the income from the sale of these assets has been wasted. Yes, the Amazon effect has also been a contributing factor in the firm's demise, although Sears had an advantage over the online retailer with its owned brands such as Craftsman and Kenmore. The group's auto centers also provided an edge. These assets have all been wasted.
Finding traps before it's too late
Investing is not a precise science, but by looking at case studies of the past we can build a rough idea of how to invest for the future.
As I stated above, finding value traps before you end up investing in them is almost impossible, and I would not hold it against any investor who brought Sears based on the firm's balance sheet five years ago. It is just unfortunate the way events have unfolded. The business is not bankrupt yet, but it is rapidly running out of options.
What we can learn from this situation is the importance of having an experienced, trustworthy management team with skin in the game (CEO Eddie Lampert did, and still does have skin in the game, but he is a financier, not a retailer) at the head of a company that is trying to stage a turnaround.
Some value investors believe that it is enough to invest in a company only based on its financials, and it is enough to ignore management quality. This can work, but the Sears case study shows the risks of doing so. The company had the tools to survive at one point. Management has failed the company.
Disclosure: The author owns no share mentioned.
