Realized vs. Theoretical Gains

There’s a big difference between a company I am researching and one I have actual money on the line with. Perhaps I am flawed and need to intensify my emotional state when I research. But, I think the more likely explanation is real money intensifies the analysis/emotion. It’s one thing to see a historical operational hiccup, subsequent recovery, and determine “I can live through that.” It’s quite another to live through the hiccup and wonder whether the recovery will happen.

Similarly, it’s quite easy to say “This company is way too cheap!” I strongly believed Nordstom, Inc. was too cheap in August when the stock sold off in conjunction with Macy’s results. So I bought.

But here’s the problem: Nordstom faces structural headwinds, may or may not be innovative enough to grow its business long term, and has a lot of fixed costs embedded in the business. Therefore, if things unravel at Nordstrom they could unravel quickly.

So, why did I buy? I bought because I discussed the brand with a group of women who provided me with some comfort about Nordstrom’s brand equity. Moreover, I pay enough attention to retail to know the management team is attempting to transition the company to a modern retailer (unlike Macy’s). Further, I interviewed employees that told me the culture at Nordstrom is the best in the industry. Finally, the Nordstrom family (a) owns a large block of stock, (b) tried to take it private two years ago at near 2x my purchase price, and (c) committed to returning ~$5Bn to shareholders over the next 5 years (vs. a ~$3.9Bn mkt. cap at the time). Note – Family is italicized above because I think there’s a lot more pride on the line when the store bears the name of major shareholders than there is in most situations.

The “opportunity” presented itself because Nordstrom has not executed well over the last 3 quarters. I believe Blake Nordstrom’s death (Blake was a Nordstrom family member, co-President, and largely responsible for running Nordstrom Rack) was a very difficult event for the family/organization and sometimes life gets in the way of optimal business performance. Part of my belief stems from reading about Blake. Moreover, when I spoke to investor relations the woman I spoke to choked up a bit when I offered my condolences. Given everything above, I believe the market sees a potentially broken business with headwinds and I see a business that is facing headwinds but isn’t broken (though the business quality is clearly deteriorating from what it once was).

Despite the risks, I made the bet and was ready to collect dividends, watch share repurchases reduce the dividend obligation, and collect subsequent increased dividends (dividends per share would increase as shares outstanding decreased assuming the dividend payout remained the same). I “knew” the risks I took/am taking. I understand there is a path to failure in this investment. But, at the price I purchased the equity I thought the market was emphasizing the failure potential too much and missing a lot of the good the entity has going for it.

Shortly thereafter, the stock increased almost 40%. At that point, the decision to hold became a bit more difficult. The risk of failure also felt more acute because now Mr. Market was pricing in a more rosy scenario. Importantly, risks that lived on a spreadsheet or in a writeup now actually presented potential loss of real money and the odds had changed. At this valuation, the proposed share repurchases don’t accomplish as much. Moreover, the business risks haven’t changed. That said, if Nordstrom can accomplish their goals there is still quite a bit of value in the entity. Therefore, I decided to sell half my position to reduce some portfolio risk (Nordstrom was a ~5% portfolio weight at cost).

On the other hand, my second largest position (13% current portfolio weight) is in cable companies (Charter and Comcast). These have meaningfully appreciated. However, I haven’t even considered selling either because I fundamentally believe in owning broadband infrastructure for the long term. Thus, it would take a pretty egregious price to have me sell either position at this point. NOTE – I am not saying to buy cable company stocks right now! Nothing here is investment advice.

So, while a spreadsheet may produce similar IRRs for those two investments, the experience of owning the assets is quite different. The obvious response to what I am writing is “Retail investors should require a higher IRR to enter positions than cable company investors since there is less business risk in a cable company.” First, I agree. But more importantly, the right behavior/stomach is necessary to realize the theoretical IRR. And, that behavior can be difficult to handicap until the asset resides in an investor’s portfolio.

Generally speaking, I’ve found assets purchased because of valuation are much more difficult to hold because there is usually some element of business risk attached to them. Consequently, my focus has morphed to higher quality businesses trading at reasonable prices. However, I can’t help but look at my perception of mispriced assets. After all, I am trying to buy more value than I am paying for.

That said, the real gains are made from holding. And holding business risk is a lot tougher than it looks on a spreadsheet. Which is probably why the opportunity exists for those that are (a) right and (b) selective on price.

Recommended Reading

https://www.nytimes.com/2019/10/23/style/nordstrom-family-department-stores.html

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