As a value investor, you are likely to come across many struggling companies when doing research. These tend to be the ones trading at low Price/Earnings ratios due to pessimism about the future, so will frequently appear in stock screens. Some will inevitably have the attention of an activist investor who believes they can turn the business around, and in the process produce outsized returns for shareholders. It is easy, as an individual, to believe their assertions and they will often have a good track record to back them up too. But it doesn’t always go to plan as was the case with JCPenney (JCP), and it is an interesting case study to review so that hopefully investors don’t get caught out in this same trap in future.
For those that haven’t followed this story in the news, it started when activist investor Bill Ackman of Pershing Square Capital took a position in JCP and took a seat on the board. JCP had been struggling with sales falling year after year, especially during and after the recession. It had many problems, including that most of the items it sold were discounted by as much as 70% from RRP. Ackman installed a new management team that was supposed to turn around the struggling retailer by rethinking the strategy. You can view the Pershing’s presentation here. I recommend reading it, as it sets out a good argument for how they will turn the retailer around and why they believe it is possible.
Some interesting facts that they highlight as examples of waste to be cut at JCP:
- Netflix, consumed 20% of corporate internet bandwidth during work hours
- The average employee made 1,000 clicks on youtube per month
Reading the presentation, Pershing seemed to have a lot going for it – they installed a management team with a proven track record in successful retailing which was headed by Ron Johnson, who had successfully designed Apples retail stores. Additional to that, management invested their own wealth in the company, aligning their interests with shareholders. Investors could be forgiven for believing that this turnaround was a sure thing.
Ron Johnson, the new CEO, redesigned the stores to hold less stock, and house boutique sections for specific retailers. Instead of the majority of merchandise being discounted, it was instead sold at the reduced price from the outset, which meant stock now wasn’t sitting out for weeks beforehand without selling before ultimately being discounted. In theory these were sensible changes, but they resulted in a sales decline of 25%, and JCP reported almost $1bn in losses.
The problem was that it had alienated its current customers, who liked the large discounts apparent on the products they bought, they enjoyed hunting for bargains and feeling like they were getting a good deal. But JCP also simultaneously failed to attract newer customers to replace them. While Ron Johnson was clearly very capable of designing retail stores he had failed to identify with the core customer and that was fatal.
Another criticism is that too many changes were rolled out at once. The whole identity of JCP was essentially torn up and rebuilt from scratch. Couple that with the fact that Johnson hired many of his former colleagues from Apple into the management of the company, and it was too much of an overhaul.
What can we learn from this
The most important lesson is one that is as old as the hills, Buffett has quoted it on numerous occasions.
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”
This means that even the best managements cannot succeed in a business that is doomed to fail. JCP is operating in an environment with intense competition where it has no clear advantage over rivals. By being a discount retailer they are not only competing against the likes of Wal-Mart, but also online retailers which have the advantage of lower costs due to low store operating costs.
Knowing the business had bad economics, management tried to effectively change the business and its customers, but this is like trying to turn around an oil tanker, it takes a long time, if it’s even possible at all. Investors were effectively betting on a different, new company, succeeding rather than a company better utilising its competitive advantage. This is high risk and far removed from the principles of value investing.
So when considering that next turnaround situation that could be a 5 bagger, think carefully about the business and if it has an inherent competitive advantage that a new management can exploit. This ‘moat’ becomes all the more important when a business is struggling and why Buffett puts so much weight on it. And clearly you need to avoid any company, like JCP, with a competitive disadvantage.
Disclosure: JCP – no position