What's Wrong with Eddie Lampert's Strategy at Sears?

I don't want to pile on the Sears Holdings (SHLD) boo-fest that happened across all financial media on Thursday morning - but I thought I'd share a few thoughts I had about Eddie Lampert, and what I think are some mistakes he might have made recently. These are mistakes that are certainly similar to the kinds of things individual investors, myself included, do to sabotage themselves every day.

What we have seen from Sears Holdings, Eddie Lampert's primary holding and the stock that was supposed to be his investment vehicle as he built a Warren Buffett-like empire, has been nothing short of dismal. The shares are now about 50% below the high that they hit back in May, primarily because the actual Sears and Kmart stores are doing terribly. They are suffering from weak sales, weak earnings, and, frankly, stores that no one could be excited about visiting.

But you already heard that from pundits across the globe on Thursday. What I was thinking about was how Eddie Lampert's experience can illuminate some of the problems that individual investors often have, problems deeply rooted in our psychology.

There are two things that I think have been significant about the Sears Holdings story since Eddie Lampert got on board. Certainly, he almost immediately increased the value of the company dramatically by harvesting the value of the real estate below the Sears and Kmart stores, and no one can take that away from him.

But in terms of operating the company, beyond that first burst of value creation, there are two things that I think are significant.

The first, is that Eddie Lampert didn't just buy Sears because he thought it had undervalued real estate, harvest that value, and move on. He thought he could turn around the company itself.

That, to me, is a bit of a warning sign. It strikes me that this is the same kind of problem that individual investors often have, when they assume that their skills and expertise in one area mean that they are naturally going to be skilled and expert investors.

What do I mean? Well, Eddie Lampert is, even given this current problem at Sears, clearly a brilliant value investor. He knows how to identify bargains, he knows how to use financial engineering of all sorts to harvest value, he knows how to get great returns on the public and private markets.

Does that mean he's a guy who can turn around a struggling retail giant? Well, that's still an open question.

I've made similar kinds of mistakes more than once myself. They often occur after I have an experience that I think validates my investing acumen. I have come across tiny stocks that seem brilliantly positioned, in areas where I have just enough knowledge to get myself in trouble, and I've invested in them. Often, it hasn't worked out, but I find myself buying those shares - to psychoanalyze myself just a little - because I get puffed up by a successful trade or investment and think, "I'm brilliant! If I like this new stock it must be great!"

I'm not saying that Eddie Lampert is nearly as swayed by emotion as the typical investor, or that he's as much of an idiot as I've proven to be at times, but it continues to look to me like his belief that he could bring any kind of operating savvy to Sears, and manage the stores in a different way without worrying about standard metrics like same store sales growth, might have been a bit of hubris. He's a brilliant guy, by all accounts a strong-willed guy who has been able to bend many situations to his will. He negotiated his own release from kidnappers, for crying out loud, but that doesn't necessarily mean that his ideas for managing a retail dinosaur are going to work.

This psychological problem in individual investors has generally been described as "overconfidence" - it's possible that other issues are coming into play for Eddie Lampert as well, like "cognitive dissonance," which as I think of it is the inability to process conflicting information - in this case, his close relationship with Sears, his heavy investment in the company and it's future, and the confidence that he has the right plan makes him unable to see the skeletons of Montgomery Ward, Jamesway, or Ames, and realize how difficult (I'd say "doomed") his challenge is, especially with a weakening consumer market.

The other significant psychological barrier that Lampert seems to me to be running into, and again it's one that's quite common for me, is simple obstinacy. This is related a bit to cognitive dissonance, in that you want to stay on the same track with what you feel should be working, and you ignore warning signs that you're going the wrong way.

In my case, this would be akin doubling down on falling stocks because I still keep in my head the original conviction I had that they would be excellent investments - one example of this is Chico's (CHS), I bought shares ages ago, at much higher prices, and averaged down a few times because I believed that the problems they were having were temporary. If so, they were "long-term" temporary, and only continue to worsen - so in my case, I built an image of Chico's in my mind that said it was a strong grower for the long-term, and even though that growth case started breaking down, with plenty of evidence for that breakdown coming out every quarter, or sometimes every month, I kept putting more in. Ooops. Now I'm stuck with the evidence of my mistake in my portfolio every day.

When we talk about Sears and Eddie Lampert, I wonder whether something similar is coming into play, particularly with his aggressive share buybacks - all of which, in the past year, have clearly now been very badly timed. While Sears has been doing badly by all traditional metrics, it has been generating some very good cash flow, and one of the things that Lampert was supposed to bring to the table was an ability to reinvest that cash flow into much better growth opportunities. That's what made his running Sears a great idea, his ability to allocate cash flow for better long term results.

And that's what made people say that he would be the "next Warren Buffett" or that Sears Holdings would be the "next Berkshire Hathaway." Looking back on his history, it's clear that Warren is an excellent allocator of capital and a great investor, but there isn't much evidence that he is great at running a textile mill (which is what Berkshire was when he bought it). His brilliance was not his ability to turn around a dinosaur in a dying industry, it was to (eventually) realize that the textile business was dying, harvest as much cash from it as he could, and move that money into something much more valuable - in his case, insurance companies.

And this is where I really have a problem with Sears and the current Eddie Lampert plan, at least as I interpret it. While its recent offer to buy Restoration Hardware is intriguing, the fact remains that, so far, all of Sears' excess cash has been reinvested in Sears shares through very aggressive stock buybacks. And that investment by Lampert has been a massive money loser over the past year as Sears shares have crumbled.

So, does he really have a plan to really harvest the value of Sears, or is he continuing obstinately to believe that he can restore it to it's former glory as the leading retailer in the country? Or is it something in between? I'd be happy to hire him to chop up a dying firm and get the most money possible from it, but I'd be very reluctant to hire him to turn around a complex operating business - even experts in the retail turnaround field, like Julian Day (who incidentally made his reputation at Kmart, now a part of Sears Holdings) don't necessarily find fast or certain success in doing this every time, and in Day's case the jury is still out on Radio Shack after about a year and a half of his turnaround leadership.

I find it refreshing that Eddie Lampert seems, at least on the surface, to face some of the same psychological barriers as I do in investing, and I hope that I can think of the plight of Sears the next time I'm talking myself into doing something foolish in a situation that I don't fully understand.

Just to close this out on a friendlier note, it is very possible that the Eddie Lampert brilliance is poised inside the moldering shell of Sears, just waiting to pounce out. I don't know what the company's plans are, or how it will do in the future, but I do understand that as a long-term investor in a very short-term world, there are going to be times that Lampert looks foolish and takes unwarranted criticism, just as Warren Buffett has on many occasions when he's at least temporarily on the wrong side of a trend (as was the most recent case with his USG Corp. (USG) purchases). I might be guilty of that here.

Value investors and contrarians are often portrayed as foolish by the investing punditocracy because of the short term movements of their portfolio as they try to envision a success that may be five or ten years away, so what look like mistakes might appear better in the future. For the sake of the investors who put their faith in Eddie Lampert to built the next great value investing empire, I certainly hope that's the case here.

Full disclosure: I do own shares of CHS as of this writing (unfortunately), but not of any other stock mentioned in this article.

Comments

[shld-long]

Travis,

Any reason why Bruce Berkowitz doubled down on SHLD in his FAIRX mutual fund? Also, why did Bill Ackman buy a 5 million share stake in SHLD. Bill Ackman always does his research. Look at the windfall he has made during the decline in MBI and ABK. I can't imagine Ackman made a $600M bet on the "cult of Lampert/ESL" only to watch his investment free fall.

Also, Lampert is not acting alone. He has a talented board of Directors and he is building an all star executive team. Every month we hear about another high profile addition to the SHLD executive team. Every article makes it seem like Lampert is picking out next year’s women’s clothing line or designing menswear in his free time.

Finally, I invest in Lampert and SHLD because he went "all in". No base salary, no stock options. His compensation and livelihood is directly correlated to the performance of SHLD. Instead of applauding his accountability to the company, we come up with theories about psychological problems. You tell me how many other CEOs have their entire net worth in a company… (Other than Buffett of course)

[anonymouse]

I don't think Lampert is thinking that with RSTO he can turn around Sears. I bet he is thinking more along the lines of "As part of SHLD, RSTO can be worth a lot more than it is since I can transfer real estate and products around. But in the worst case scenario, I bought a half-decent retailer for really cheap... suckers!"

Most who bring up Buffet and BRK seem to forget--or worse, they never knew--how long it took for Buffet to finally dispose of the textile business assets.

[shld-long]

RSTO is a distribution play. I love how analysts try to rationalize how RSTO's ttm sales would not move the needle for Sears. Sears is a distribution platform, it only needs the products. RSTO success may have been limited by its lack of scale. The RSTO real estate is probably worthless (expensive leased stores) and no point in keeping around.

[drex davjs]

Then Bill Ackman must be an idiot, too. And Berkowitz.

The stock got ahead of itself, but there's a lot of value. Here's my take.

In the earnings make up of Sears, there are profitable and unprofitable stores. Lampert has been pricing (gross margins) for profitability. I think he's stress testing the stores. The profitable stores are going to stay, the unprofitable ones are going to go.

I think he may have understood that in doing this, the share price would drop. May have even done it on purpose to get more shares at a price he wanted. He certainly has been gobbling them up.

I think you pick up restoration hardware, put it into your profitable stores, sell off your unprofitable stores. you're now getting cash flow from real estate sales, and you've gotten rid of the drag on earnings from the unprofitable stores. so you're spitting off cash, boosting your ROIC and EVA and transforming your unprofitable stores which are sitting on valuable locations into cash.

i see so much value in sears. people might be getting impatient with him. but there's value there and he's not going to sit around forever without unlocking it.

i think he's been stress testing these stores of ROIC potential, and he'll keep what's "good", and divest what's "bad" while upscaling the Sears experience. With Land's End, Restoration Hardware, Kenmore, and Craftsman . . . heck, that's a formidable lineup.

[an.observing.guy]

Your last (2) paragraphs stole my thunder. You are definitely big picture. I would say Eddie is drooling over a few more bargain priced prospective upscale nuggets to add to his mega-platform, popularly priced upwardly mobile stable of stores. I'm behind you Eddie...