I have been mulling over one of the seeming paradoxes of investing: Stocks that are trading in the cheapest quintile according to book value go on to outperform the other four quintiles combined by 2.5% annually over the subsequent twenty-year measuring period. It is this insight, coupled with the construction of client portfolios following this principle, that made Benjamin Graham a millionaire quickly and earned him the nickname “The Dean of Wall Street.”
And yet, Peter Lynch also stumbled upon an important insight–stocks that fall more than 50% in a three-year period go on to underperform the S&P 500 by almost five points annually over the coming decade. This insight was one of the gems of his work “One Up On Wall Street” and explained why most of his successes at the Fidelity Magellan Fund came when he purchased companies trading in the vicinity of the then-existing fifty-two week highs.
So what should we do to this information? The answer is the same as every other question: “It depends.” But I will add this: Declines of 50% or more in the integrated oil industry, or a similar decline from a large-cap pharmaceutical that is experiencing lucrative drugs going off patent, is part of the ebb and flow of the industry and likely represents a value investing opportunity rather than a signal of the end times.
Companies facing technological obsolescence with a key product, or a retail stock falling out a favor, is a much more worrying trend–especially when those 50% declines are actually accompanied by 50% declines in earnings.
This brings me to Sears Holdings (SHLD), the retailer that has been in perpetual decline since the early 1990s. It occupies a special place in my studies of the past quarter century, as a portfolio featuring Sears in 1993 came to include automatic positions in Sears Canada, Allstate, Discover Financial, Land’s End, and Morgan Stanley (I’m not including the recent Seritage REIT, as that is a purchase option on a pro rata basis rather than an outright plain vanilla stock spinoff.) Even as the core business of Sears entered a state of collapse, the aggregate total returns that include that spinoff went on to outperform the S&P 500 Index by 1.5 percentage points per year.
Although the company could theoretically squeeze out another spinoff like the Power Tools division, the retail giant has now reached the point where I believe prospective investors will eventually see their investment shrivel towards $0 with a final ending in bankruptcy.
The balance sheet at Sears is one of the worst I have ever studied: There is $3.8 billion in total debt, and $3.1 billion of that is due within the next five years. Even when Sears was relatively thriving–its most profitable year in the past eight was $300 million–the current debt obligations are still 12x a best case scenario of return to profitability. And Sears has $300 in interest that it needs to pay within the next five years, which would put the debt above $4 billion if it gets refinanced since Sears is currently reporting losses. And the interest rates will likely be higher, due to the general economy’s raising rates and the increased risk profile at Sears.
The company has half a billion in rentals that it is contractually bound to pay even if it closes down stores, and those rental obligations don’t end until 2021. If I had spent my life working at Sears, I would start getting worried about the underfunded pension as Sears has stopped funding it adequately–it owes its retirees $6 billion, and now has only $3.6 billion in funding (outside of the airline and auto industry, this is the worst pension level of funding that I have studied since Goodyear Tire).
In the company’s annual report, it speaks optimistically about plans to lower costs by growings its mobile sales platforms with the anticipation that more Sears goods will be purchased online. I am not optimistic that this strategy will succeed. I was recently looking at Dewalt Power Tools on the Sears website, and I found that: (1) Amazon sold the exact same product at the same price or lower under the brand new offerings; (2) Amazon included “used” offerings that are much cheaper than the new listings, and the sears.com did not offer something comparable; and (3) Amazon Prime users can get their hands on this tool in two days as part of their annual subscription fee, whereas a Sears user would have to pay in the neighborhood of $20 to get this equipment.
Don’t read me wrong–when I criticize Amazon, it is over valuation–as the online retailer is a very formidable foe for a late mover to make a dent by clawing back some of the market share that would seem to be naturally theirs. Others can disagree, but I do not think sears.com will make the anticipated gains against Amazon that seems to be a necessary condition of growing sales. When the company brags about 16% annual gains in online sales, the base is so low that $39 million in sales doesn’t put much of a dent in the hemorrhaging that is taking place in the physical retail locations.
Here is a crazy statistic that gives you an idea of how poorly the physical retail locations have been performing at Sears: The company has cut its store count in half over the past ten years–from a little over 3500 to a little over 1600–and the same-store sales at existing locations have still declined 11% in the past year. That is a conjunction with a 15% cut in the prices of its goods. If you shutter your worst-performing stores, cut the costs of your existing merchandise, and still see double-digit annual sales declines in generally good economic conditions, you are a business staring into the abyss.
The escalating amount of losses indicate that Sears will need to borrow extensively in the short term, meaning the company will either face massive share dilution a la Bank of America or Citigroup during the financial crisis or will need to somehow find a way to stuff even more debt onto its balance sheet. When it was losing $200 million two years ago, the firm was positioned to borrow every year and take a decade to right the ship.
The losses have escalated to the point that I am not sure indefinite borrowing can continue. It lost $800 million last year, and is slated to lose $700 million this year. If it issues stock, the existing shareholders will get diluted by 25%. If it adds balance sheet debt, I shudder to think of the interest rate that will be required by the creditors.
It has been a large fall for Sears, which traded at $190 per share as recently as 2007, and now finds its stock price in the mid $20s. This isn’t “a sale.” The book value of the stock is only $5, meaning the current price is almost five times book value. The pension is deeply underfunded, the annual leases and rentals are high, the interest payments alone are a third of a billion, the debt is over 10x the recent best year’s cash flow, the mobile growth is a pipe dream, the same-store sales are declining by double-digits even with double-digit price cuts, and massive share dilution or continued high-debt overleveraging awaits the immediate future. If I owned it, I would sell it and put it in Johnson & Johnson or Hershey at current prices. If I were contemplating it as a prospective investment, I would quickly move on to the next issue.
Originally posted 2015-09-26 20:12:09.