Retail Cigar Butts: 'The Whole Culture Has Changed'

In a 2012 interview with Fortune magazine, investor Bruce Berkowitz (Trades, Portfolio) was asked about his investment in Sears Holdings Corp. (OTCPK:SHLDQ). Here’s what he had to say:

“The value of Sears [which trades near $60] would be over $160 a share if the land on the books was fully valued. You can look back at recent transactions and ask a question: How can Sears close stores and generate hundreds of millions of dollars of cash? It gets at the inventory. The liquidation value of its inventory approaches its stock price. Forget the real estate … The retail recovery is a potential upside. Regardless, you’ll see gigantic cash flows from the closing of locations, the pulling-out of the cash from inventory, work in process, and distribution centers. They’re not idiots when it comes to real estate. They understand that today’s standalone store can be tomorrow’s multi-use hotel / residential-retail center. I think Eddie Lampert will end up being one of a few unbelievable case studies on what it means to be a long-term investor.”

With hindsight, this clearly did not work as expected. The retail recovery never materialized. As shown below, Sears' domestic same store sales (comps) were consistently in the red (the company filed for bankruptcy in October 2018).

But that’s not the part of the story I think Berkowitz erred on (as he noted in the Fortune interview, he viewed that as potential upside, not his base case). Instead, I think the mistake was his calculation of the margin of safety. And that gets to something that Charlie Munger (Trades, Portfolio) said at the 2000 Berkshire Hathaway (BRK.A)(BRK.B) shareholder meeting about cigar-butt investing (buying stocks that trade at a discount to net current asset value) in today’s world:

“There’s another change. In the old days, if the business stopped working, you could take the working capital and stick it in the shareholders’ pockets. And nowadays, as you can tell from all the restructuring charges, when things really go to hell in a bucket, somebody else owns a lot of the working capital. The whole culture has changed. If you have a little business in France and you get tired of it, as Marks & Spencer has, the French say, ‘What the hell do you mean trying to take your capital back from France? There’re French workers in this business.’ And they don’t care. They don’t say, ‘It’s your working capital. Take it back,’ when the business no longer works for you. They say, 'It’s our working capital.' The whole culture has changed on that one. Not completely, but a lot from Ben Graham’s day. There’re a lot of reasons why the investment idiosyncrasies of one era don’t translate that perfectly into another.”

It's instructive to think about Charlie’s comments in the context of some struggling retailers over the past few years. Consider names like Sears, J.C. Penney (JCP), Bed Bath & Beyond (BBBY) and Macy’s (M), to name a few. At various points in the past five to 10 years, these retailers were pitched as value investments due to unappreciated asset values (real estate, working capital and so forth); in addition, they often came with a seemingly cheap valuation (usually a price-earnings ratio) relative to historic financial results.

Yet in every case I know of, the investment proved to be a dud. Each company mentioned above has seen its stock price fall by at least 75% over the past five years. And Munger’s explanation hits the nail on the head. The reason these investments do not work out is because they are too focused on the numbers as opposed to the realities of running one of these businesses.

At the end of the day, these investments essentially rested upon the idea of a timely liquidation. Assets being used in current operations can be sold, with the proceeds distributed to owners. But that outcome would require management to fire thousands of employees (Sears still had 264,000 employees in 2012), admit defeat and ultimately put themselves out of a well-paying job.

Unsurprisingly, few managers accept such a fate (especially managers without a significant financial interest in the long-term per-share value of the business). Instead, they slowly close stores generating inadequate returns – a list that grows over time. In addition, they lean on the best-performing boxes for cash that is spent in an effort to try to reinvent the business.

For Sears, that included investments such as the “Shop Your Way” rewards program. These efforts should not have been a surprise to shareholders. As Chairman Eddie Lampert noted in his February 2011 shareholder letter:

“We will continue to make long-term investments in key areas that may adversely impact short-term results when we believe they will generate attractive long-term returns. In particular, we have significantly grown our Shop Your Way Rewards program, improved our online and mobile platforms, and re-examined our overall technology infrastructure. We believe these investments are an important part of transforming Sears Holdings into a truly integrated retail company, focusing on customers first.”

Year after year, Lampert clearly stated in his letters that they would continue investing in an attempt to compete in “integrated retail.”

But in my experience, there are few examples where investments such as these ultimately led to a successful turnaround. Said differently, the ability of the business to keep generating some cash in the short term – which is usually part of the investment thesis – often proves irrelevant because the funds are misallocated. (I discussed this topic in a recent article titled “No Options at All.”)

Finally, even if any of this works (as a liquidation or as a turnaround), it can take many years for the efforts to bear fruit. When the rationale for an investment relies upon closing a gap to intrinsic value as opposed to continued value creation, time is of the essence. As a result, when all is said and done, that large margin of safety can prove quite slim – or nonexistent.

Conclusion

Before Munger's comments at the 2000 shareholder meeting, Warren Buffett said the following:

“Those sub-working capital stocks are just almost impossible to find now. And if you got into a market where a lot of them existed, you’d probably find wonderful businesses selling a lot cheaper, too. And our inclination would be to go with a cheap, wonderful business … if you found that kind of a group and did it as a group operation, and Ben Graham always emphasized a group operation because when you’re dealing with lousy companies but you expect a certain number to be taken over and all that, you’d better have a group of them. Whereas if you deal with wonderful companies, you only need a couple. But I think, if you see that period again, we’ll be very active. But it won’t be in those kinds of securities.”

Buffett’s thoughts on the subject are undoubtedly influenced by the constraints inherent in running a large operation. But it also reflects his evolution as an investor. He realized that a margin of safety can be applied more broadly than buying hard assets at a discount to their liquidation value. And as discussed above, this approach has its own pitfalls as well. In the case of retail, efficiently closing thousands of stores and firing hundreds of thousands of employees is a tough ask. The world may have changed in a way that makes the modus operandi of a prior era less effective.

Disclosure: Long Berkshire Hathaway B-shares.

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