Investment Styles: How dirty do you get your hands?

Posted on February 6, 2008 by David Laidlaw 

Different investment professionals have radically different approaches concerning their degree of involvement with the investments that they choose for their clients. Most wealth managers and planners outsource the security selection to mutual fund and hedge fund managers that pick the underlying securities in the end clients’ portfolios. At the other end of the spectrum, private equity managers and activist investors often take active roles in the management of the target company. Our firm follows a middle course and actively chooses individual stocks based on our fundamental research, but we do not care to be involved in the day-to-day management of the company’s operations that we buy for our clients.

We believe our skill set is suited to this middle course. Our analysis of the markets through time and our investment discipline focus on certain financial characteristics. We add value through concentrating our clients’ investment in those companies that sell for a discount to what they are theoretically worth given an expected growth rate. However, we rarely believe that we could run an actual company better than its existing management. We limit our involvement to purchase and sale decisions and voting proxies regarding issues that come before shareholders for a vote.

Quite a few managers often make the leap from our style of investment to a much more activist role. They convince themselves that they have chosen investments so well that they therefore have an ability to run their investments better than the existing managements. Unfortunately, these forays are often unsuccessful because the qualities that lead to superior investment management performance are different from the qualities that lead to operating success in a tangible business.

Edward Lampert’s purchase of a Sears and Kmart is a classic example of the pitfalls that are possible when investment managers get their hands dirty running businesses. Sears and Kmart were and are retailers struggling to compete against Wal-MartCostco andTarget. However, Sears owned valuable real estate and had a few successful brands such as Craftsman Tools, Kenmore Appliances and Lands’ End clothing. After purchasing Sears, the stock soared to $190 per share in early 2007 from the mid $20s in 2003 as Lampert cut costs and began monetizing assets through real estate sales. The acquisition would have been brilliant if he had stopped there and completely restructured the companies and liquidated all of their assets.

Instead, Lampert continued to operate Sears and Kmart and results faltered. Poor locations and previous cost cutting have hurt sales as same store sales declined 4-5% when they reported 3rd Quarter earnings in November. Net Income plunged to $0.01 per share during that quarter from $1.27 per share during the 3rd Quarter of 2006. The company also warned last month that its 4th Quarter earnings for the period ending February 2nd will be about $3.00 per share which is significantly lower than the $4.40 predicted by analysts.

Running a successful retail business takes an astounding amount of execution to offer compelling merchandise, price the wares competitively, invest the right amount in store upgrades and finally motivate employees. These skills do not normally match the temperament or training of the vast majority of investment managers even if they are brilliant portfolio managers such as Edward Lampert.