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The Science of Hitting
The Science of Hitting
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Retail Cigar Butts: 'The Whole Culture Has Changed'

A look at Sears and others

September 03, 2019 | About:

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.


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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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.9/5 (13 votes)



Praveen Chawla
Praveen Chawla premium member - 2 weeks ago

I think it can still work if the right incentives are created for the managers. One industry is the cigarette stocks - PM, MO, BTI. They are managing declining core businesses but pay high dividend. Money is going into shareholders pocket.

The Science of Hitting
The Science of Hitting - 2 weeks ago    Report SPAM

Praveen - Agreed, incentives are very important in these situations. With that said, your ability to adapt in the cigarette industry (see pricing power) is much different than what you face in retail. Thanks for the comment!

Stephenbaker - 2 weeks ago    Report SPAM

What incentive exist in the cigarette industry that warrant an investment in tobacco companies? Dividends aside, why invest in a dying core business? There are plenty of companies and industries that pay dividends that are (a) not dying; (b) don't cause addiction, health problems and death by using their core products for their intended purpose; and (c) have honest management. Remember, these are the same companies whose management advised users for decades that cigarette smoking was not harmful to their health. Now that they have embarked into areas (in which they have no experience) such as vape, CBD, etc.. they will undoubtedly make the same representations as to these products. As a former MO shareholder who did very well with this investment throughout the 1980s into the 2000s, this is not an area I would ever want to again invest in.

Praveen Chawla
Praveen Chawla premium member - 1 week ago

Apart from the dividends these companies have vast distribution network.

Basically I look at the cigarette companies as the present value of future dividends + the optionality of a cannabis/vaping startup.

I acknoledge the moral issue but there are similar issues in varying degree with a lot of businesses. Look at the pharma companies and opioid crisis, pharma price gouging, weapon system manufacturers, fast food industry, soda industry, alcohol industry, fossil fuel industry.

Stephenbaker - 1 week ago    Report SPAM

Praveen, all due respect there is no moral equivalency between tobacco companies and pharma and other companies. The objective of pharma companies is treatment and cure of medical ailments. Other companies produce products either designed to provide societal benefit and/or that can be enjoyed in moderation. The objective of tobacco is addiction, followed by certain health decline if cigarettes are used as intended. How many casual cigarette smokers do you know of? The issue of whether to invest in tobacco companies is not a moral one (though there are increasingly more people who won't invest in such companies, whch reduces demand, all else being equal). Tobacco remains legal, but that does warrant an investment in a dying primary product. With regard to other products, they are completely unproven. Why bet on unproven products when there are plenty of proven products to invest in? Tobacco companies trade at cheap valuations for a reason. They will likely get cheaper.

Praveen Chawla
Praveen Chawla premium member - 1 week ago

Leaving aside the moral issue for which I have no good argument apart from saying it remains a legal product and society tolerates it because of the huge tax windfall. Alcohol industry has a similar moral dilemma. So does gambling, fast food etc. to lower degrees. Where do you stop? Is there a bright line?

Tobacco smoking may be a dying product but it seems to have a long runway to eventual demise and it does throw off a lot of cash. Market prices are irrelevant if you are willing to hold forever.

Revenue per share for MO is still growing. The barriers to entry are huge because of the regulatory issues as well distribution. I also fully expect tobacco vaping and cannabis to be huge markets. Vaping per say is not very harmful and its 90% better thBoth these product lines are fully aligned to the distribtion advantage of tobacco companies as well as political/ regulatory know-how.

Stephenbaker - 1 week ago    Report SPAM

I don't have a medical or chemistry degree but common sense dictates that inhaling foeign substances is not healthy. Gambling, fast food and alcohol can be, and most often are enjoyed in moderation. Not sure about the long runway for cigarettes; there is a rapidly growing list of places you can't buy them or use them. Why would anyone today smoke their first cigarette? The answer is ignorance, and betting on ignorance is usually a bad bet. The only thing we know about the tobacco business is history will not repeat itself. Management knows one thing - cigarettes. They've lied to their users about lack of health hazards in the past - what makes you think they won't lie about new products?

Praveen Chawla
Praveen Chawla premium member - 1 week ago

Of course all drugs have some side effects and Nicotine and alcohol are drugs. However most of the harm for tobacco comes from combustion and vaping does away with combustion, so logically its a much safer way of delivering nicotine into the body via the pulmonory route.

Moderate consumption of alcohol is OK but its well known that between 10 - 20% of the population is "alcoholic" i.e., they cannot stop at moderate consumption. This leads to widespread misery for themselves and their families and early death. This problem is at least as big as tobacco smoking and is growing.

Attached is a chart showing the revenues of the largest tobacco companies. While volumes is going down they are making it up with price increases. So I think the business will contiue on for a couple of decades.


Stephenbaker - 1 week ago    Report SPAM

Praveen, we'll have to agree to disagree. Cigarettte companies generated success by addicting people to nicotine under false pretense of it not being harmful to one's health. Cigarettes are almost 100% addictive. I'm truly surprised you buy into the notion that vaping is "safer" , whatever that means.

Praveen Chawla
Praveen Chawla premium member - 1 week ago

Nicotine - which is the addictive substance in cigarettes is not very harmful, per se. If there is a safer way to deliver it (like vaping), I am for it. You can't wish Nicotine away as you can't wish Alcohol away (they tried it in 1920's). The best we can do it tax it highly and regulate it tightly. Other wise criminals move in to meet the demand and the industrial security complex. Same goes for Marijuana, Opiates etc.

Stephenbaker - 1 week ago    Report SPAM

The medical field would strongly disagree with your comments about the harm caused by nicotine. Kindly provide scientific documentation for your opinion. Otherwise, I'll trust those who know better. Going back to the original point of this discussion, the fact that something is taxed and regulated does not make it a good investment.

Stephenbaker - 1 week ago    Report SPAM

Not to beat a dead horse, but The CDC has said this:
"Vaping exposes users to many different substances for which we have little information about related harms – including flavorings, nicotine, cannabinoids, and solvents. CDC has been warning about the identified and potential dangers of e-cigarettes and vaping since these devices first appeared. E-cigarettes are not safe for youth, young adults, pregnant women, or adults who do not currently use tobacco products."

Praveen Chawla
Praveen Chawla premium member - 2 days ago

Here is an article which might introduce you to the subject of nicotine harm reduction. I am not saying that Nicotine Vapaing is 100% safe but its a lot safer than Cigarettes, so a welcome innovation. My opinon is that you cannot wish the societal need for nicotine away - many people need it just like caffeine.


Stephenbaker - 2 days ago    Report SPAM

Praveen, the second line in the article you cite states "...nicotine itself is not very harmful". If you buy that then there is entirely no use in having an intelligent conversation about this issue. Best wishes.

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