How Charlie Munger Followers Could Have Avoided The Folly At J.C. Penney

| About: J.C. Penney (JCP)

One of the first lessons that investors can learn from studying the shared wisdom of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) Vice Chairman Charlie Munger is this: it is not all about the numbers. It is also about psychology, behavior, and stories. This is a notable contrast from someone like Professor Benjamin Graham, who was a much more numbers-focused guy. Graham did not spend much time differentiating between whether a company earned its profits from well-branded soft drinks or pet rocks, but rather, focused on the numbers. With Graham, cheap was cheap. Munger spends more appreciating the general arc of a company's trajectory, and he often explains why we should pay attention to seemingly esoteric elements such as behavior and psychology trends when making an investment decision.

Because I encourage investors to follow a "buy and monitor" approach, and because I have often talked about Charlie Munger's wisdom in the abstract, I wanted to look at J.C. Penney's (NYSE:JCP) ouster of Ron Johnson through the lens of someone who pays attention to what Munger says about psychology.

One thing that Munger has mentioned in his discussions of basic human psychology is the notion that customers like to get a deal. If a necklace is worth $50, there's no excitement generated by slapping a $50 tag on it. However, if you stock a $100 price tag on it and announce a "this weekend only sale" that gives customers a ½ price discount on the necklace, that $50 necklace suddenly seems like "a deal." There is no cleverness to this principal. It's basic Marketing 101. No wonder J.C. Penney's earnings per share went from $1.59 per share in 2010 to a loss of $2.10 per share in 2012.

And Kohl's (NYSE:KSS), in contrast, gets it. It floods the e-mail inboxes and mailboxes of their customers with discounts and limited offers. It has stickers all over their stores announcing deals and bargains. If it wants to sell you something for $70, it is going to have a $130 sticker somewhere on the item that lets you know you're getting $60 off. This artificial stimulation of making customers feel like they are getting a deal works. It explains why Kohl's has been able to use their high cash flow to reduce share count and grow earnings by 13.5% annually since 2003 while J.C. Penney management took the company into the ditch.

Not only did CEO Johnson make decisions that directly violated this basic psychological impulse to find a deal, but he made the decision without testing it in select markets before rolling it across all stores. That's just plain hubris. When you are going to do something that goes against years of conventional wisdom and violates the basic psychological impulses of customers to feel like they are "getting a deal", there should be some kind of trial run to see if such a counterintuitive move could work.

But here is the good news for us as investors. When we pay attention to the kind of behavioral factors that Munger talks about, we can find good investments as well as avoid/get out of bad ones. For instance, once I realized that the old CEO of Kraft (KRFT) cared more about empire building than creating shareholder value by taking a huge tax hit to sell Digiorno and destroy shareholder wealth by issuing shares to complete the Cadbury purchase, I realized there was a company on the other side of the transaction doing something intelligent. Nestle (OTCPK:NSRGY) acquired a perfectly growing and profitable pizza subsidiary, and it did not take me too long to figure out that, valuations being equal, I'd much rather acquire shares of Nestle than Kraft based on current management's allocation policies.

That's what happened with J.C. Penney. When you see management doing something that violates common sense -- effectively killing clearance sales and heavy discounting -- you can steer yourself clear of investments like J.C. Penney and find companies that do adhere to common-sense discounting principles like Kohl's.

This is why I tend to gravitate more towards Munger than Graham. It's about being alert and seeing how basic human traits come out. When you see Irene Rosenfield at Kraft selling Digiorno for over $3 billion and paying over $1 billion in taxes to do it, you should start questioning management's motivations and competencies. When you see Ron Johnson at J.C. Penney violating common sense by removing clearance sales and heavy discounts without running a successful trial run first, you should consider getting out of J.C. Penney and running into the arms of Kohl's. Of course, Kraft has the benefit of strong underlying business to tolerate such management abuses. J.C. Penney shareholders aren't that lucky. These are the kinds of things you have to watch out for when the phrase "buy and monitor" comes up. A little common sense and a spoonful of Charlie Munger's wisdom could have avoided this mess entirely.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.