Is Sears the Next Berkshire Hathaway?

Submitted by Sizemore Investment Letter as part of our contributors program

I originally penned this articled in December 2011.  Given Sears stock action in the year that has passed, it’s worth another read.

A well-respected value investor buys an old American company in decline, promising to restore its fortunes.  Alas, the recovery never comes.  The economics of the industry have changed, and the company cannot compete with younger, nimbler rivals.  The company ceases operations, but the value investor holds onto the shell to use as an investment vehicle.

Could this be the future of Sears Holdings (Nasdaq: $SHLD) under Eddie Lampert?  Maybe; maybe not.  But it was certainly the case for Warren Buffett’s Berkshire Hathaway (NYSE: $BRK-A).

Unless you’re a history buff or a dedicated Buffett disciple, you might not have known that Berkshire Hathaway was not always an insurance and investment conglomerate.  It was a textile mill, and not a particularly profitable one.  It was, however, a cash cow.  And after buying the company in 1964, Buffett used the cash that the declining textile business threw off to make many of the investments he is now famous for, starting with insurance company Geico.

So, when hedge fund superstar Eddie Lampert first brought Kmart out of bankruptcy in 2003, the parallels were obvious.  With its debts discharged, the retailer would throw off plenty of cash to fund Lampert’s future investments.  And even if the retail business continued to struggle, Lampert could—and did—sell off some of the company’s prime real estate to retailers in a better position to use it.  Lampert sold 18 stores to the Home Depot (NYSE: $HD) for a combined $271 million in the first year.

That Lampert would use Kmart’s pristine balance sheet to purchase Sears, Roebuck, & Co.—itself a struggling retailer—seemed somewhat odd, but his management decisions after the merger seemed to confirm that his strategy was cash cow milking.   Lampert continued to talk up the combined retailer’s prospects, of course.  But his emphasis was on relentless cost cutting, and he invested only the absolute bare minimum to keep the doors open.  Sears Holdings didn’t have to compete with the likes of Home Depot or Wal-Mart (NYSE: $WMT). It just had to stay in business long enough for Lampert to wring out every dollar he could before selling off the company’s assets.

The strategy might have played out just fine were it not for the bursting of the housing bubble—which killed demand for the company’s Kenmore appliances and Craftsman tools—and the onset of the worst recession in decades.  With retail sales in the toilet (and looking to stay there for a while), there was little demand among competing retailers for the company’s real estate assets.

It’s fair to blame Lampert for making what was, in effect, a major real estate investment near the peak of the biggest real estate bubble in American history.  But investors  frustrated by watching the share price fall by more than 80 percent from its 2007 highs have no one to blame but themselves.   Anyone who bought Sears when it traded for nearly $200 per share clearly didn’t do their homework.  They instead were hoping to ride Lampert’s coattails while somehow ignoring the value investor’s core principle of maintaining safety by not overpaying for assets.

Lampert is a great investor with a great long-term track record, and there is nothing wrong with paying a modest “Lampert premium” for shares of Sears Holdings.  If you like Lampert’s investment style but lack the means to invest in his hedge fund, Sears may be the closest you can get.  But at $200 per share—or even $100—the Lampert premium had been blown completely out of proportion.  The same is true of Buffett, of course, or of any great investor.  As the Sage of Omaha would no doubt agree, there is a price at which Berkshire Hathaway is no longer attractive either.

This brings us back to the title of this piece—is Sears the Next Berkshire Hathaway?

I would answer “yes,” but not necessarily for the reasons you think.

Everyone assumes that Buffett’s decision to buy Berkshire Hathaway was a typical Buffett stroke of genius.  Nothing could be further from the truth.  In fact, Buffett revealed in an interview last year that Berkshire Hathaway was the worst trade of his career.

 

If you cannot view the video above, please follow this link: “Buffett’s Worst Trade“ 

We like to think of Warren Buffett as the wise, elder statesman of the investment profession, but Buffett too was young once and prone to the rash behavior of youth.  He had been trading Berkshire Hathaway’s stock in his hedge fund; he noticed that when the company would sell off an underperforming mill, it would use the proceeds to buy back stock. Buffett intended to sell Berkshire Hathaway its own stock back for a small, tidy profit.

We’ve all been there, Warren.

But due to a tender offer that Buffett took as a personal insult, he essentially bought a controlling interest in the company so that he could have the pleasure of firing its CEO.  And though it might have given him satisfaction at the time, Buffett called the move a “200-billion-dollar mistake.”

Why?  Because Buffett wasted precious time and capital on a textile mill in terminal decline rather than allocate his funds in something more profitable—in his case, insurance.  Berkshire Hathaway will still go down in history as one of the greatest investment success stories in history.  But by Buffett’s own admission, he would have had far greater returns over his career had he never touched it.

So, in a word, “yes.”  Sears probably is the next Berkshire Hathaway.  And investors who buy Sears at a reasonable price will most likely enjoy enviable long-term returns as Lampert’s plans are eventually realized.   But Mr. Lampert himself will almost certainly come to regret buying the company—if he doesn’t already.

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