Circle of Competence

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I read an article called “Sears majesty to hedge-fund dust” at the behest of a reader on the gurufocus message boards, and I have to say it is one of the most uninformed and incomplete articles I’ve ever read. There are so many misguided and shallow statements that it’s hard to know where you’d even start to refute the allegations. Before you read my refutation, please read the article for context. Please read my refutation through before commenting.

I’ll start with a quote from the article, and continue on down from there:

“But as all readers of this site well know, things sure changed in 2007. Many of the hedge fund strategies that paid off like slot machine jackpots in the previous two years, such as huge heavily leveraged bets on subprime mortgage paper, came up lemons last year.”

Leveraged bets on subprime mortgage paper? What on God’s green earth does subprime mortgage paper have to do with ESL Investments? While this reporter basks in the failure of many hedge funds last year that were doing things extremely far removed from what ESL does, I question if he actually looked at any other ESL investments outside of Sears and Citigroup. If he did, then it’s a classic red herring argument fallacy; he is using irrelevant information that doesn’t have anything to do with the argument at hand.

“In reality, what has been happening with both Kmart and Sears during the Lampert era was that the operating expenses for both entities have been cut to the bone, in order to free up the billions that Lampert would use for hedge fund speculation at ESL.”

Hedge fund speculation? This statement had to be the most egregious of the bunch. Lampert was “freeing up billions” to reduce Sears’ debt, make over a billion in capital expenditures, and buy back shares for Sears at advantageous prices. I’d hardly dub that “hedge fund speculation.” Here’s what Eddie spent the money on last year alone:

“Finally, our cash flow generation remained strong as we generated $1.6 billion of operating cash flow in 2007, which exceeds the $1.4 billion generated last year. We ended the year with $1.6 billion in cash, as we deployed $4.3 billion in 2007 as follows:
• $2.9 billion for share repurchases;
• $600 million for net reductions of debt;
• $580 million for capital expenditure reinvestments in our business; and
• $220 million contributed to our legacy pension obligations.”

Here’s another gem from the article:

“Somewhere along the line, America got the idea that the buck generated from financial services, from manipulating money, from passing it from hand to hand, was equivalent, or even superior to (after all, you come home with a lot better smelling clothes after a day on the trading floor compared to a day at the steel mill) the same buck made actually making and sustaining something - such as the great brand Sears once was. “

Just another terrific statement: The great brand of Sears is being destroyed by evil profiteers like Eddie Lampert. This kind of populist grandstanding really grinds my gears, because you can’t just pretend like profit-motivated capitalism doesn’t exist. While I agree that financial engineering doesn’t create anything, that’s simply not what Eddie is doing, as we just saw from the cash uses. From reading this article, you’d think that Lampert came in with Michael Milken’s junk bonds and pulled off a hostile LBO on Sears so he could sell off all of its assets to pay down the debt. Capitalism is change, and Sears is no longer the respected retail brand it once was. Get over it.

ROI

The real tragedy is that people still don’t get what Mr. Lampert’s strategy is, what he’s actually doing over there at Sears. The economic concept called return on investment. Why is it such a crime that he chooses to invest dollars where he’ll find a compensatory return? Reducing debt, buying back shares, reducing pension fund obligations; those are the surest returns right now, as Lampert has pointed out time and again.

This reporter insists that Lampert is “bleeding Sears dry.” What he’s actually doing? He’s putting the most money where the highest returns are. Right now, those returns are simply not in the brick and mortar retail business. Might they be in the future? Sure. They’re working on it. As a side note: There is a computer system Sears uses that tracks every little piece of information, inventory piece, and dollar in Sears’ stores. Gee, guess who is the number one user? Lampert. Imagine Eddie waking up one day:

“Oh, geez, if I just stopped bleeding Sears dry for hedge fund speculation, all that money could revive the brand! Then our same store sales would go back up! It’s just that easy!”

People need to wake up and read what he’s writing and hear what he’s saying instead of pushing their own shallow views upon the situation. The once-powerful Sears brand was on the decline when Eddie got there, and he’ll try his mightiest to reverse that but there has to be a return on dollars invested. A corporation is run on the behalf of shareholders; not management, customers, or the employees, as the reporter seems to imply. While neglecting those last three will not benefit your shareholders, I promise you that much, the shareholders are the ones with capital at risk, and thus where the focus of the corporation lies.

In the meantime, how’s he doing for his shareholders? In 2003 the stock price was $14. The current price is $95. That’s a return of 47% annualized over the holding period. Even if you didn’t get in until mid 2004 with the stock in the 70’s, you still would have made 2.5x your money by the beginning of 2007, and could have sold for a mint. So I’d say he’s done pretty good for the shareholders, regardless of what current critics say.

For Eddie Lampert to choose to withhold dollars for their highest return is his choice as by far the largest shareholder, and additionally, Chairman of the Board. It’s his (and his partners’) capital at work. Why don’t we ask these people who write so critically to put up their capital and turn the Sears boat around? We’ll see what they’re writing then. Until then, I leave you with some common sense from Eddie on investing in stores vs. investing elsewhere:

“Let’s look at a hypothetical example. Imagine that we invested $200 million to remodel or improve 100 stores, or $2 million per store. If the store profitability after that investment is exactly the same as before, then the $200 million investment generates 0% in return. By simply keeping our money in cash, we could have earned anywhere from 3-5% over the past several years, which is better than the 0% return in this case.

The related question then becomes: why can’t you find ways to invest in your stores that generate an acceptable return? That’s exactly the problem we have been working to solve and we will continue to work until we solve it. Until then, we will seek to be responsible with our shareholders’ capital and to make decisions based on the results of the portfolio of tests that we have in process at any point in time.”

Disclosure: I own shares of SHLD.