In December 2012, I sang praises to J.C. Penney Co.’s stock. This summer my firm sold it at a loss. In this article I would like to put salt in the open wound and talk about what I learned from the J.C. Penney fiasco.
I don’t think buying the department store chain’s shares was a mistake. Investing is a probabilistic adventure: You assess upside and downside probabilities of a potential investment, and if at the end the balance is significantly favorable, you pull the trigger.
Uncertainty is the nature of investing. Let me illustrate. Suppose you were offered a coin-flip game: Heads you win $10, and tails you lose $1. It makes complete sense to play this game; the expected return (probability times outcome) is overwhelmingly in your favor. So if you flip the coin and get tails, was playing the game a mistake? No, of course not.
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In the case of J.C. Penney, the story was fairly straightforward. The company had been neglected and undermanaged. Old management was fired, and brilliant new management was brought in. New management developed a plan for completely redesigning the stores, giving them a real face-lift, upgrading merchandise and turning J.C. Penney into one of the best-looking stores in the mall.
The new CEO, Ron Johnson, had been instrumental in creating Apple’s stores and was a very well-respected retailer. At the time Johnson was executing on his plan — remodeling stores as J.C. Penney continued to bleed money — this is what I wrote: “The best thing about Penney is that the bar for success is set very low. Since he took over, Johnson has taken out $900 million in costs. Sales per square foot should rise with every redesigned store. If Penney achieves the pre-Johnson level of $150 per square foot and gets to keep $700 million of cost cuts, its earnings power will be $3 to $4 per share. If sales per square foot come back to the 2007 peak of $170, earnings will jump to $6 a share.”
We thought there was a very high likelihood — 70 percent or so — that Johnson would be successful; if so, the upside would be threefold or more. If he failed — a 30 percent chance — the downside was probably 40 percent or so. The risk-reward scenario was very attractive.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process (see PDF presentation here), as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.