Second-Guessing a Sears Position

This is one of those times when I just don’t know what to say. Perhaps it’s my relative inexperience, perhaps its just human nature. But the market is tanking, I am losing money and I can’t help but second-guess my past decisions.

It is important not to make emotional decisions, but to tell you the truth it is hard to tell if the decisions I am making even are emotional. By that I mean, it’s tough to know whether I am rationally changing my own perceptions, or whether I am allowing the pundits that pervade the news sources from which I get my information to sway my opinion.

I know not to let fear or greed influence my decisions, but how do I know if they are? I know to let the market be a tool, not a guide, but it is hard to rely solely on my own interpretation of available information. After all, how arrogant must I be to assume I am right while everyone else in the market is wrong? Bottom line: this is the type of environment when investing is most aggravating.

Of course the biggest losses have come from the financials. Those are the easiest to brush off too, since it was much more of a macroeconomic phenomenon than a company-specific one effecting these losses. It is the individual picks that cause the most distress.

For me, the one individual stock for which this frustration is most pronounced is Sears Holdings (SHLD). I’m not really sure what to think about this investment anymore and at times I struggle with the question of whether my original purchase of the stock was an emotional one, or one based on a rational consideration of the facts.

The question is justified. Ever since Business Week asked in November 2004 if Eddie Lampert was “the next Warren Buffett,” folks started jumping on the SHLD bandwagon. Maybe that was reason enough for me to stay away. But I didn’t. I jumped right alongside them. Now, it seems, they are all jumping off that bandwagon. Why? Let’s talk about that.

A year ago, the theory was that Lampert would use Sears as a vehicle by which to invest in other businesses (a la Warren Buffett and Berkshire (BRK.A) ). Folks debated this issue, but the theory that Lampert saw the company as merely a turnaround lost out to the competing theory from the bulls who had more faith in Lampert’s investment prowess. As such, the story went, whether or not the retail business really grew (Lampert claimed he wanted it to nonetheless) was not of top concern, since the plan was to merely use the cash flow from Sears’ current operations to make better investments outside the company.

But now, it seems, the retail business is so bad that it isn’t even generating that cash flow! So Lampert is left with no cash to invest, at precisely the time when the market might be creating the best bargains. Remember, this is a company directly competing with Wal-Mart (WMT), not an enviable position in which to be for anyone.

In addition, everyone thought Sears’ real estate assets were a hedge against the performance of the company’s retail operations. Ha. What does the market for commercial real estate look like these days?

The plan appeared to be working because Lampert did, to his credit, do a great job cutting costs and boosting profitability. So even as sales lagged income rose. But the benefit of cost cutting is limited by the company’s sales. Don’t get me wrong, Eddie Lampert is certainly one of the most successful hedge fund managers in recent years and obviously a very bright and astute businessman. I love the way his shareholders’ letters are written and the obvious parallels we can draw between them and Berkshire’s. But that doesn’t change the fact that he must begin by making sure the utterly lousy retail business he is burdened with doesn’t completely fail.

Part of me feels foolish for even writing about this. It has been written about to death. And 99% of that writing is motivated purely by the hope that Business Week was right. Nobody knows at this point if the company will survive long enough to turn in to a new Berkshire. But we hope it will.

Note the word “hope.” This is an emotion. And if I bought SHLD “hoping” that it would become something huge then I was greedy, because there was not a whole lot of evidence indicating it would be. There reasonable speculation, but no solid evidence that would afford the margin of safety that I should have demanded. There was a lot that could have gone wrong that I should have considered, but I didn’t because I let the dollar signs blind me. Ah, hindsight.

I think the lesson from all of this is the following: Emotional discipline is the number one most important factor affecting investment performance. Warren Buffett has been successful because he has that emotional discipline. I think he would have passed on Sears Holdings, even as great a guy as Eddie Lampert is. But just as it is so difficult to change one’s personality, if we don’t already have emotional discipline we can’t expect to obtain it easily. And this might just make some type of structured investment philosophy that disallows the influence of emotion preferable.

Disclosure: Long SHLD