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 dont think buying the department store chains
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.
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
Apples 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.
Johnson failed. Well, we are not 100 percent sure he failed
he was fired before he had a chance to prove himself.
But there is another sublesson we learned: Dont
underestimate U.S. consumers desire to be deceived by
coupons and sales. Part of Johnsons strategy was to have
honest, everyday-low prices. That did not fly with American
consumers. They wanted prices to be raised and then discounted.
After the CEO was fired, stories started to leak out that he
was a visionary but not a good manager. He canceled
multibillion-dollar brands without consulting with the board.
Also this is clear now Johnson should have tested
his pricing strategies first, maybe in a few stores in one
market, rather than rolling out a new, completely different
pricing strategy all at once.
When Johnson was fired, we sold the stock. Our bet was on
Johnson. Myron (Mike) Ullman, who replaced Johnson, was the old
CEO who had slowly but surely guided J.C. Penney into
irrelevance for years. With Johnsons departure our wisdom
on the upside and downside was gone. In fact, the downside
started to look deeper.
Johnson came from Apple, a company that does not believe in
making incremental decisions. If you make leaps, as Apple does,
you had better be right or you might be dead at least,
you had better be able to afford to be wrong. This leads to my
real reason for reopening the J.C. Penney wound. I want to
visit a topic rarely discussed by investors: position sizing.
How do you determine the correct percentage of a portfolio to
allocate to a single idea? We believe position sizing should be
driven not by reward but by risk. J.C. Penney had a terrific
upside, but it still had a 40 percent downside, with a
meaningful 30 percent probability. However, when we sold the
stock at a loss, the impact on the total portfolio was less
than 1 percent.
In the past our position sizing was driven by intuition.
J.C. Penney made us rethink that. We turned position sizing
into a fairly rational and well-defined process. Each company
in our portfolio gets a rating for the quality of its business:
the size of its moat, the strength of its balance sheet, how it
fits in its industry. We assess its management in two
dimensions: how good it is at running the business (building
moats around it) and at allocating capital. Last, there is an X
factor, where we judge business cyclicality, complexity and
transparency (banks, for instance, would never get a high score
there). Then we balance the totality of these factors against
the cheapness of the stock: Should we take a starter position
or a full position?
We arrive at a fairly disciplined decision about how much we
should allocate to the stock. This way our portfolio will
always tilt toward higher quality and risk is minimized, not
just through valuation (providing a margin of safety) but
through quality as well. There is a place for J.C.
Penneylike positions in the portfolio but not too
As Warren Buffett put it: Rule No. 1: Never lose
money. Rule No. 2: Never forget Rule No. 1.