Caldor Investment Mistake: Learning from the Past, Part 3

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Caldor Investment Mistake: Learning from the Past, Part 3

I wish I could tell you that it was easy for me to stop making macroeconomic forecasts, once I set out to become a value investor. It’s difficult to get rid of convictions, especially if they are simple ones, such as which way will interest rates go?

In the early-to-mid ’90s, many were convinced that interest rates had no way to go but up. A few mortgage REITs designed themselves around that idea. Fortunately, I arrived at the party late, after their investments that implicitly required interest rates to rise soon, fell dramatically in price. I bought a basket of them for less than book value, excluding the value of taxes that could be sheltered in a reverse merger.

For some time, the stocks continued to fall, though not rapidly. I became familiar with what it was like to go through coercive rights offerings from cash-hungry companies in trouble. Bankruptcy was not impossible… and I burned a lot of mental bandwidth on these. The rights offerings weren’t really good things in themselves, but they led me to buy in at a good time. Fortunately I had slack capital to deploy. That may have taught me the wrong lesson on averaging down, as we will see later. As it was, I ended up making money on these, though less than the market, and with a lot of Sturm und Drang.

That leads me to my main topic of the era: Caldor. Caldor was a discount retailer that was active in the Northeast, but nationally was a poor third to Walmart and KMart. It came up with the bright idea of expanding the number of stores it had in the mid-90s without raising capital. It even turned down an opportunity to float junk bonds. I remember noting that the leverage seemed high.

What I didn’t recognize that the cost of avoiding issuing equity or longer-term debt was greater reliance on short-term debt from factors — short-term lenders that had a priority claim on inventory. It would eventually prove to be a fatal error, and one that an asset-liability manager should have known well — never finance a long term asset with short-term debt. It seems like a cost savings, but it raises the likelihood of insolvency significantly.

Still, it seemed very cheap, and one of my favorite value investors, Michael Price, owned a little less than 10% of the common stock. So I bought some, and averaged down three times before the bankruptcy, and one time afterwards, until I learned Michael Price was selling his stake, and when he did so, he did it without any thought of what it would do to the stock price.

Now for two counterfactuals: Caldor could have perhaps merged with Bradlee’s, closed their worst stores, refinanced their debt, issued equity, and tried to be a northeast regional retail player. It didn’t do that.

The investor relations guy could have given a more understanding answer when he was asked whether Caldor was having any difficulties with credit lines from their factors. Instead, he was rude and dismissive to the questioning analyst. What was the result? The factors blinked and pulled their lines, and Caldor went into bankruptcy.

What were my lessons from this episode?

  • Don’t average down more than once, and only do so limitedly, without a significant analysis. This is where my portfolio rule seven came from.
  • Don’t engage in hero worship, and have initial distrust for single large investors until they prove to be fair to all outside passive minority investors.
  • Avoid overly indebted companies. Avoid asset liability mismatches. Portfolio rule three would have helped me here.
  • Analyze whether management has a decent strategy, particularly when they are up against stronger competition. The broader understanding of portfolio rule six would have steered me clear.
  • Impose a diversification limit. Even though I concentrate positions and industries in my investing, I still have limits. That’s another part of rule seven, which limits me from getting too certain.

The result was my largest loss, and I would not lose more on any single investment again until 2008 — I’ll get to that one later. It was my largest loss as a fraction of my net worth ever — after taxes, it was about 4%. As a fraction of my liquid net worth at the time, more like 10%. Ouch.

So, what did I do to memorialize this? Big losses should always be memorialized. I taught my (then small) kids to say “Caldor” to me when I talked too much about investing. They thought it was kind of fun, and I would thank them for it, while grimacing.

But that helped. Remember, value investing is first about safety, and second about cheapness. Cheapness rarely makes something safe enough on its own, so analyze balance sheets, strategy, use of cash flow, etc. This is not to say that I did not make any more errors, but this one reduced the size and frequency.

That said, there will be more “fun” chapters to share in this series, because we always learn more from errors than successes.

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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