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Bargain Hunting at J.C. Penney

ARMED WITH fancy, Nobel Prize–winning equations and Greek terminology such as beta, portable alpha, neutered theta and sigma-squared delta (okay, I made up the last two), an army of consultants evaluates mutual fund and hedge fund manager performance on a monthly and quarterly basis, ignoring the fact that in the short run stock movements are random and require no skill to capture. As investors zero in on the short term, they dump stocks that are expected to do little or have declined. But if you can bear short-term underperformance, long-term opportunity is created — I call it short-term pain arbitrage.

J.C. Penney Co. is a classic short-term pain arbitrage stock. There is a lot of uncertainty about what the retailer’s sales will do in the near future, but in the long run it looks like a very attractive investment.

A little more than a year ago, hedge fund manager William Ackman took a significant position in Penney stock. I don’t know if he had to resort to blackmail, but somehow Ackman pulled off a miracle: He persuaded Ron Johnson — the genius behind the Apple stores — to quit his job in Cupertino and become CEO of run-down Penney.

In the first quarter of 2012, Johnson unveiled a strategy to transform each Penney’s department store into a shopping mall with 100 small, branded shops. Each specialty shop will have a unique feel and be owned and run by Penney, but they’ll all be designed in collaboration with the brand owners (which are footing part of the remodeling expense). Everyone who has seen pictures of the prototype store in Plano, Texas, says it is amazing.

Johnson is also introducing at Penney those little things that made Apple stores so unique: Next to Disney and Carter’s shops, Penney will have Legos and iPad tables for kids waiting for their mommies to shop, while it will provide couches and coffee bars for the impatient husbands. So far, Penney has only introduced ten shops, but it will bring in 30 shops a year over the next three years, and by August 2013, 40 percent of Penney stores will have been redesigned.

U.S. consumers have an insatiable need to feel good about parting with their money. We don’t necessarily know it, but we want to be deceived: We want to buy things on sale; we want to feel like we took advantage of the retailer. The old Penney was the master of this game. It would inflate initial prices, then run sales. In fact, to overcompensate for its unexciting stores, Penney ran 500 promotions a year — 1.4 promotions a day. Serious brands did not want to be a party to this gimmickry, so Penney mostly sold its own, lower-quality brand.

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