Street Capitalist: Event Driven Value Investments

Eddie Lampert has released his 2010 Sears Holdings (NASDAQ:SHLD) chairman’s letter and I thought I’d highlight a few points that I thought were interesting. Over the last few years, Lampert has been hit harsh criticism from the business press, mostly because they perceived that he was failing in his turnaround at Sears. Mostly, I think a turnaround has happened, but its evidence is more visible on a financial level.

I visited Sears stores a couple times last summer and was not impressed, the stores aren’t as nice as competitors Walmart and Target, the employees did not seem as knowledgeable, and there wasn’t a great selection of inventory available. These kinds of observations may cloud an analyst’s judgement when looking at Sears objectively. Indeed, the results over the last year have been pretty good:

Today we announced our financial results for our 2009 fiscal year. I am pleased to report that we delivered both stability and progress, resulting in roughly $1.8 billion of Adjusted EBITDA, an improvement of more than $200 million over 2008. While this may be surprising to some, it isn’t to me. The dedication of our associates and leadership team led by Bruce Johnson and the diversity of the Sears Holdings business portfolio—Sears Full Line stores, Kmart stores, our Home Services business, Sears Auto Centers, Outlet Stores, Hometown Stores, the Kenmore, Craftsman, DieHard and Lands’ End brands, our majority interest in Sears Canada, and our online business properties including sears.com—have allowed us to successfully manage through the economic and financial crisis of the past two years.

Edward Lampert: Sears Holdings 2010 Chairman’s Letter

If you look back at Sears over the last few years versus competitors, you will see that Lampert decisively cut capital expenditures and investments in store expansion while most others gluttonously spent their way into the crisis. Competitors were forced to abruptly change their course and slash spending, inventory, or restructure/file for bankruptcy. Sears was nimble enough to evade most of the fallout from the financial crisis:

In 2009, we kept expenses under control and stayed focused on our vision and strategic, operational, and financial goals. We were both prudent and opportunistic in spending money and in allocating capital at a time when many others had to make major adjustments.

Early in the year we amended and extended our revolving credit facility through June 2012. In one of the most difficult financing markets in recent memory, we found significant support from numerous financial partners led by Bank of America, Wells Fargo and General Electric, and we executed one of the largest revolving credit facilities in the past couple of years. Our substantial asset base and our strong cash flow management were important factors in this successful deal. When people take a close and objective look at our company, our strengths are not difficult to see.

Sears was not totally unscathed by the crisis though. Store closures in retail are a reality, especially during downturns:

On a less positive note, we regret the closing of roughly 60 stores in 2009. Most of those stores have underperformed for some time and, despite focused efforts to improve them, we felt that we could no longer afford to wait for those stores to turn around. With expiring leases, we have been able to reduce our money-losing stores while at the same time generating cash from the liquidation of inventory and the monetization of some of the stores that we closed. We continue to evaluate our store portfolio, over 2,200 Kmart and Sears Full Line stores combined, and experiment with new and different ways to serve our customers and avoid additional store closings. Like any retailer, we would expect that our store portfolio will require continuous evaluation and transformation as we strive to have every store contribute to the creation of future value.

In the middle of last year, I responded to an errant published story that repeated unfounded claims from a Wall Street analyst regarding the cash impact of our store closings. As I explained, in most cases, when we close stores we generate cash, net of any cash required for severance and other store closing expenses. The GAAP accounting losses arise from the markdown of inventory, write-off of fixed asset balances, associate severance and any remaining payments on leases that expire in the future. Our ability to close stores is in no way hampered by any cash requirements. Instead, our preference is to operate stores profitably and to transform unprofitable or marginally profitable stores into money makers by evolving our formats to better meet the needs of the communities in which we operate. We know that when we operate our stores well, we have the ability to serve our customers well and to make money.

What’s important to note here is the fact that Lampert looks at stores as investments. Every store requires some level of capital investment and so they need to be judged from a perspective of how much return on cash they generate. Some stores will be posting good numbers, others may post negative ones. Lampert appears to take an experimental approach to store investment, where capital expenditures vary by store and concept. By doing this, in theory, he should be able to see what works and then adopt that more widely.

The biggest problem for an investor looking at retailers is properly gauging management. Management teams sometimes become consumed by their own egos that they engage on ruinous store expansion campaigns, financed by debt, at the top of the market. We know that Lampert isn’t like that, so the key is to discern whether he is deploying capital in the right ways. Given his share buybacks into the crisis, it looks like he has been doing well. That same type of capital allocation is not happening at competitors:

While we continued to repurchase shares during the economic crisis because the value was attractive and because we had significantly lower leverage than others in our industry, many of our competitors suspended their repurchase programs to appease credit rating agencies only to resume them again after their share prices recovered significantly.

We can understand rating agency caution surrounding economic events, the retail environment, and the potential for things to get worse. In our case, it turns out that our performance far exceeded many observers’ expectations and we hope to receive credit for this performance in the form of higher credit ratings and more balanced analysis.

Rating agencies play an important role in how investors allocate capital by “qualifying” debt for certain investors. By overrating companies and securities, rating agencies can lead to systemic issues and investor losses. Similarly, by underrating companies they can lead to lower growth, less risk taking, and less job creation. Simplistic analyses, which automatically prefer capital investment to share repurchases as a use of cash that “benefits“ bondholders, ignore the fact that negative or below market returns on invested capital are as harmful to creditors as to shareholders.

When we inquire why our ratings are not higher than some competitors with credit metrics that are weaker than ours, one factor cited is that some analysts prefer their business models. Meanwhile, we have a higher market capitalization and less debt than many of these competitors. We increased our earnings, while many others have seen their earnings decline. We have a diversified business portfolio and a significant revenue base and scale. Obviously, we don’t agree with all of the critical qualitative conclusions and the quantitative metrics speak for themselves.

We do some things differently than others, and we have certain beliefs that differ from theirs. Our culture is owner-oriented, because we have owners who serve on the board that governs the company. We believe that ownership makes a difference, especially when owners have significant financial interests in the company and a long-term perspective. Instead of this raising concern, rating agencies should welcome and value owners with a demonstrated track record of long-term value creation and conservative capital policies, even when some of the capital allocation preferences differ from those that others believe lead to higher long-term credit performance.

The criticism Lampert lodges at ratings agencies is pretty valid. Ratings agencies largely do not reward sharp capital allocation skills. They will view it as a positive when a company suspends its share buyback program as its stock price crashes, even though (as we learned from John Singleton) that is precisely the best time to buy. Such behavior reinforces bad practices among executives and ultimately destroys shareholder wealth.

Lampert goes on to talk about growth strategies for Sears. He plans to expand the already successful Land’s End brand, domestically and internationally. Others include Sears’ online initiatives like the Sears My Gofer plan. One I found interesting was their plan for franchising auto centers:

Sears Holdings Corp. today announced the launch of a new strategic initiative for the Sears Automotive business. The Independent Sears Auto Center franchise program offers automobile dealers the opportunity to operate licensed Sears Auto Centers, bringing the Sears brand, buying power, distribution network, systems and corporate support to automotive aftermarket businesses. Coleman Auto Group of East Windsor, New Jersey, is the first dealership to take advantage of this opportunity and will open a Sears Auto Center in March 2010.

Sears Auto Centers Introduce Franchise Business (PR Newswire)

The franchise business is often a good one, because of the high returns on capital. It is easy to see from the numbers given:

Franchises must pay an initial fee of $30,000 for the franchise and $3,000 a month in brand license fees for the first year and $2,000 monthly thereafter. A service license fee of 2% of prior year revenue is charged after the first year, and franchisees contribute 3% of net revenue to a marketing fund to support national advertising and activities.

Several thousand auto dealerships in the U.S. have lost their franchises as auto makers have consolidated amid efforts to become profitable.

“There is a lot of very good talent in rejected Jeep, Chrysler, Dodge, Saturn, Pontiac and Saab dealers that already have the facilities in place, the manpower and years of experience to help Sears sell their products,” said Bruce Coleman, president of the Coleman Auto Group dealership in East Windsor, N.J., and a partner in what will be the first Sears Auto Center franchise.

UPDATE: Sears Begins Franchising Of Its Auto Centers (Dow Jones)

At the end of his letter, Lampert recommends Thomas Sowell’s book Intellectuals and Society, here is the Amazon description:

The influence of intellectuals is not only greater than in previous eras but also takes a very different form from that envisioned by those like Machiavelli and others who have wanted to directly influence rulers. It has not been by shaping the opinions or directing the actions of the holders of power that modern intellectuals have most influenced the course of events, but by shaping public opinion in ways that affect the actions of power holders in democratic societies, whether or not those power holders accept the general vision or the particular policies favored by intellectuals. Even government leaders with disdain or contempt for intellectuals have had to bend to the climate of opinion shaped by those intellectuals.

Intellectuals and Society not only examines the track record of intellectuals in the things they have advocated but also analyzes the incentives and constraints under which their views and visions have emerged. One of the most surprising aspects of this study is how often intellectuals have been proved not only wrong, but grossly and disastrously wrong in their prescriptions for the ills of society—and how little their views have changed in response to empirical evidence of the disasters entailed by those views.

He reflects on the government intervention in financial markets over the last year or so, questioning its logic and contrasting it with his own conservative leaning views on business and regulation. Those ideas fit in line with his book recommendation last year, The Road to Serfdom by F. A. Hayek:

An unimpeachable classic work in political philosophy, intellectual and cultural history, and economics, The Road to Serfdom has inspired and infuriated politicians, scholars, and general readers for half a century. Originally published in 1944—when Eleanor Roosevelt supported the efforts of Stalin, and Albert Einstein subscribed lock, stock, and barrel to the socialist program—The Road to Serfdom was seen as heretical for its passionate warning against the dangers of state control over the means of production. For F. A. Hayek, the collectivist idea of empowering government with increasing economic control would lead not to a utopia but to the horrors of Nazi Germany and Fascist Italy.

Now the question is, does Lampert’s letter change my mind on Sears? At current levels, no. The company is held by many savvy investors and has a great capital allocator at its helm, but still resides in a cutthroat sector where I’d rather look for a larger margin of safety that isn’t so dependent on its chairman. Still, I like to watch the company and study its turnaround for insights when examining the larger universe of investment opportunities.

As most of you know, Eddie Lampert’s investment vehicles ESL Investments and RBS Partners have substantial stakes in three businesses: Sears Holdings (NYSE:SHLD), AutoZone (NYSE:AZO), and AutoNation (NYSE:AN).

(HT: Matt Miller) On January 11, his investment vehicles filed three SEC Form 4 filings, detailing an interesting transaction

Sears Holdings

ESL Institutional Partners, L.P. (“Institutional”) distributed these shares of common stock, par value $0.01 per share, of Sears Holdings Corporation (“Shares”) to its general partner, RBS Investment Management, L.L.C. (“RBSIM”), in an in-kind pro rata distribution for no consideration. RBSIM then distributed these Shares to its members in an in-kind pro rata distribution for no consideration.

RBS Partners, L.P. (“RBS”) distributed these Shares to its partners in an in-kind pro rata distribution for no consideration.

ESL Investment Management, L.P. (“ESLIM”) distributed these Shares to its partners in an in-kind pro rata distribution for no consideration.

These Shares include 3,565,316 Shares distributed by RBS in an in-kind pro rata distribution for no consideration, 244,153 Shares distributed by RBSIM in an in-kind pro rata distribution for no consideration and 15,678 Shares distributed by ESLIM in an in-kind pro rata distribution for no consideration. As a result of these distributions, Mr. Lampert directly holds Shares in which he previously had an indirect interest. The distributions did not change Mr. Lampert’s overall pecuniary interest in securities of Sears Holdings Corporation.

Sears Holdings SEC Form 4

AutoZone

ESL Institutional Partners, L.P. (“Institutional”) distributed these shares of common stock, par value $0.01 per share, of AutoZone, Inc. (“Shares”) to its general partner, RBS Investment Management, L.L.C. (“RBSIM”), in an in-kind pro rata distribution for no consideration. RBSIM then distributed these Shares to its members in an in-kind pro rata distribution for no consideration.

RBS Partners, L.P. (“RBS”) distributed these Shares to its partners in an in-kind pro rata distribution for no consideration.

These Shares include 792,882 Shares distributed by RBS in an in-kind pro rata distribution for no consideration and 48,659 Shares distributed by RBSIM in an in-kind pro rata distribution for no consideration. As a result of these distributions, Mr. Lampert directly holds Shares in which he previously had an indirect interest. The distributions did not change Mr. Lampert’s overall pecuniary interest in securities of AutoZone, Inc.

AutoZone SEC Form 4

AutoNation

ESL Institutional Partners, L.P. (“Institutional”) distributed these shares of common stock, par value $0.01 per share, of AutoNation, Inc. (“Shares”) to its general partner, RBS Investment Management, L.L.C. (“RBSIM”), in an in-kind pro rata distribution for no consideration. RBSIM then distributed these Shares to its members in an in-kind pro rata distribution for no consideration.

AutoNation SEC Form 4

These transactions all appear to be doing the same thing, taking major holdings of ESL/RBS and giving them to investors in their funds. The reasons for doing such a transaction can vary. Think back to when Warren Buffett decided to unwind his partnership. He liquidated assets, paying a small dividend, and also distributed shares of Berkshire — which he was chairman of. For an investor in his partnership, they could either keep their faith in him and hold on to their Berkshire shares or sell. You all know how that turned out.

For Lampert, there could be other reasons too. Some funds that take controlling stakes and then decide to wind down find it more efficient to distribute out large holdings rather than sell them onto the open market. Or, it could be a way to give investors in the fund an opportunity to be extricated from having such large holdings have a dominant influence on returns. This will be a situation to watch for any Sears, AutoZone, or AutoNation holder.

The people over at Advisor Perspectives have a great interview with Bruce Berkowitz of the Fairholme Fund which touches on his thoughts regarding Sears Holdings (NASDAQ:SHLD), Leucadia (NYSE:LUK), and Berkshire Hathaway (NYSE:BRK-A). These are three investor favorites all which ran into pessimism by the investor community over the last two years or so.

I thought I would excerpt some of the interview (full interview PDF)

Is deflation – particularly with respect to asset prices – eroding the margin of safety at Sears Holdings?

Deflation eroded the margin of safety, in that real estate values came down as the housing market was destroyed. There is a significant correlation between the housing market and Sears. The answer is yes.

On the other hand, Eddie Lampert was quite astute in the way he handled capital allocation in the last couple of years. In hindsight, you can say it was a mistake for him to buy stock at $150 to $170 – it was a different environment. But by creating a company such that there is significant free cash flow being generated, the company has a huge number of degrees of freedom. If deflation was causing a decline in value and Sears’ shareholders overreacted or very smart people start shorting the stock, then the company has more than enough cash to buy all the shares that Lampert and I don’t own – and together we own over 60% of the company.

It was a real win-win situation, in that I believe it was a temporary condition, but he configured the company for adversity. If you count how much cash he generated in the last few years you will see it. Sometimes it is a little hidden, for example because he had to fill a gap in a pension fund liability because the market turned south and the rules required him to put more money in. He’s also paid off a nice chunk of debt. The company does not have a lot of debt. He has bought back a ton of shares.
If you add up all the money used to do that, it’s a significant amount of free cash.

Berkowitz goes on to talk about Leucadia, which is in some circles described as a mini-Berkshire.

Is the value in Leucadia National affected by the tightness in the credit market? Do they have access to capital at attractive rates, and if so why have they not been more active?

Yes, they have been affected by tightness in the credit markets, but they have access to lots of money. With the right idea they have no issues with access to capital. We would loan money to Leucadia. In this environment, it may not be a lack of ideas; it may be an unwillingness to share. Clearly this environment killed cheap money. Could they still get money on reasonable terms? Absolutely.

You have to have a little blind faith with Leucadia, like with Berkshire Hathaway. You can’t predict what they will do. You measure what they have versus what you have to pay for it, and make a determination as to whether you will get the future for free. Of course, you have to assume the future is going to be good.

Leucadia is difficult for me to peg right now. I think with the way the company is structured now, the investment attractiveness depend on your view of the macro and the timing of it all. I do think though that the company will at least be able to preserve its wealth because of its capable managers, whereas other companies may stumble.

Finally, there is a great bit about the Burlington Northern acquisition and whether it was a good deal for Berkshire Hathaway:

We interviewed Bruce Greenwald, the Director of the Heilbrunn Center for Graham & Dodd Investing at Columbia University in November. He was less than impressed with Berkshire Hathaway’s decision to buy the balance of Burlington Northern they do not already own. You own a good deal of Berkshire Hathaway, what is the value investor’s case for using Berkshire Hathaway stock to buy this company?

Last year I sold all my Berkshire and then I bought back what we now own. Last year I said that you have to take Warren Buffett at his word that he will do a couple of points better than the S&P going forward. And he did. That’s not bad at all. But I believe that we are still of the size where we could do a bit better. But that is absent some type of cataclysmic event – and then we faced this cataclysmic event, which allowed Berkshire to put tens of billions of money that was earning less than 1% to work, to earn 10%.

I can’t see how Burlington Northern was a great deal. The greatness of Berkshire is its deployment of float and profit. They are deploying other people’s money in terms of float – premiums on insurance policies that don’t have to be paid out for years and years. If you are going to use part of that float to pay for an investment, you have to make sure the investment is going to make good money. With Burlington Northern, if you adjust for a buyer with cash and don’t think much more about it, then it was not a great deal. But if you bought it using cheap debt and good chunk of other people’s money and you were highly confident that the company would give you a cost-plus return over a decade, then it’s a good investment.

Borrowing money is a sure way to die. But if you are buying toll booths and roads and regulated industries – pipelines or railroads or electric utilities, where you know you are going to end up with some type of cost-plus pricing – you are going to do very well, given that the actual equity you have in it is low.

It’s like buying a house with a low down payment. If you judge the return after expenses, after taxes, and on the profits on shareholder equity, the return can be two to three times what it looks like to an all-cash buyer.

Be sure to read the entire interview (click here to read more) it is well worth your time and delves into the car rental business and Fairholme’s view on healthcare stocks.

(from one of my favorite films: Searching for Bobby Fischer)

In 2009, Charlie Munger recommended Malcolm Gladwell’s book Outliers which studiers outliers throughout history and discipline to find commonalities. One of the ideas professed by Gladwell is a 10,000 hour rule, where if you want to master something you must practice it for at least 10,000 hours. Gladwell uses the Beatles as evidence of this rule, pointing out that their time in Germany was spent constantly performing live which helped them gain the mastery needed to become great musicians when playing concerts and on TV.

The folks over at Study Hacks find that in chess, to become a grandmaster, you do not just need to spend 10,000 hours practicing chess. You must also spend those hours doing the right kind of work or deliberate practice.

1. It’s designed to improve performance. “The essence of deliberate practice is continually stretching an individual just beyond his or her current abilities. That may sound obvious, but most of us don’t do it in the activities we think of as practice.”

2. It’s repeated a lot. “High repetition is the most important difference between deliberate practice of a task and performing the task for real, when it counts.”

3. Feedback on results is continuously available. “You may think that your rehearsal of a job interview was flawless, but your opinion isn’t what counts.”

4. It’s highly demanding mentally. “Deliberate practice is above all an effort of focus and concentration. That is what makes it ‘deliberate,’ as distinct from the mindless playing of scales or hitting of tennis balls that most people engage in.”

5. It’s hard. “Doing things we know how to do well is enjoyable, and that’s exactly the opposite of what deliberate practice demands.”

6. It requires (good) goals. “The best performers set goals that are not about the outcome but rather about the process of reaching the outcome.”

If you’re in a field that has clear rules and objective measures of success — like playing chess, golf, or the violin — you can’t escape thousands of hours of DP if you want to be a star. But what if you’re in a field without these clear structures, such as knowledge work, writing, or growing a student club?

…It seems, then, that if you integrate any amount of DP into your regular schedule, you’ll be able to punch through the acceptable-level plateau holding back your peers. And breaking through this plateau is exactly what is required to train an ability that’s both rare and valuable (which, as I’ve argued, is the key to building a remarkable life).

This motivates a crucial question: What does DP look like for fields that don’t have a tradition of performance-optimization, such as knowledge work, freelance writing, entrepreneurship, or, of course, college?

The Grandmaster in the Corner Office: What the Study of Chess Experts Teaches Us about Building a Remarkable Life (Study Hacks)

For any investor seeking to become better, deliberate practice is essential. The key is figuring out what deliberate practice should consist of in investing. Most of us read newspapers and blogs daily. This helps keep up to date with what is going on in the world. But is that enough? I am not too sure.

I think that taking a more active approach with news reading would be helpful. Recently, the Wall Street Journal ran an article about how David Tepper bought Bank of America stock at its low. A good exercise would be to actually sit around and try to reverse engineer that investment. Eddie Lampert has said that in college he reverse engineered many of Warren Buffett’s investment. This kind of activity would not only increase your understanding of investing but also build a model for you to look at if you ever find a similar investment.

Other investors strive to read one 10K a day. This can help build your circle of competence, but I believe it has some shortcomings. A more targeted approach with 10Ks will be more beneficial than simply jumping from reading about Exxon to reading about Bank of America. You should define goals where you are mastering knowledge of a specific industry or area of the market.

Maybe you want to learn the billboard/outdoor advertising business. Instead of looking at just Lamar Advertising (NASDAQ:LAMR) you would look at Clear Channel Outdoors (NYSE:CCO) as well. If you want to master restaurants, you would maybe start at a fast food company like McDonalds (NYSE:MCD) which is the best in its class. Then seek out Chipotle (reputed to have the best economics in the fast food business) and branch out so that you build familiarity with the industry which will help you evaluate lesser known companies like Steak N Shake (NYSE:SNS).

Feel free to use the comments or e-mail me with suggestions for implementing deliberate practice in investing.

Great write up of it at Compounding Machines. Be sure to read the whole thing. I’m a huge Eddie Lampert fan but have never invested in Sears. It certainly looks interesting at this price and is one situation I’m looking into.

Eleanor Laise, at the Wall Street Journal, has a good article about the recent troubles at the Fairholme Fund a couple of days ago. I’m not invested in the Fairholme Fund, but I really like the work that they do. For much of the year, they managed to dodge the credit crisis by refusing to invest in complex financials and sold their energy holdings around the top. Both of these moves would be a recipe for market beating returns, but eventually as Mr. Market’s depression spread to the entire market, funds that were concentrated in equities like Fairholme were hurt as well.

After outperforming a badly listing market by losing just a few percentage points in each of the first three quarters of 2008, the $6.7 billion mutual fund dropped 24% in the last three months of the year, lagging behind the Standard & Poor’s 500-stock index by two percentage points.

Mr. Berkowitz used his cash hoard to snatch up beaten-down shares, but new holdings like defense companies Northrop Grumman Corp. and Boeing Co. have fallen. Longer-term stakes like investment company Leucadia National Corp. and retailer Sears Holdings Corp. also were hit.

Some Fairholme investors are losing faith. In November, Fairholme experienced its first monthly outflow in more than three years, with investors pulling about $7 million from the fund, according to fund tracker Lipper Inc.

Mutual Fund Fought Off Bears but Now Is Clawed (WSJ)

Laise’s article is actually pretty balanced. Sometimes I think that journalists and the public are quick to cast a stone at managers who hit small bumps like this, but she devotes a good amount of the article to Bruce Berkowitz’ views on the fund.

One thing I’ve noticed is that value investors can have a hard time when managing the money of others. Inherently, value investors are going after areas of the market that no one else is touching. The problem with this is that such decisions can make their investors question their ability. When the markets are panicked, investors can panic too. This is particularly bad for a fund like Fairholme, where the level of concentration increases volatility.

If investors get really panicked, they’ll force withdrawals from funds and sometimes force selling. There are a few ways to get around this (borrowing, cash cushion) but often, it always looks bad when investors are pulling out of an investment vehicle. It’s times like those when fund managers should be vigilant and keep their investors calm.

Laise’s article only touches on it, but Berkowitz responded to the withdrawals by holding a great conference call. For much of the year, during the credit crisis, we’ve seen companies get on and hold these emergency conference calls to calm the fears of their investors. And almost every time, these conference calls are utter wastes of time. They end up trying to place the blame for their current woes on parties besides themselves — be it the government and their market intervention, or demonic short sellers.

Berkowitz didn’t do that. Instead, he spent most of his time on the call going back and forth with people who’ve invested in the Fairholme Fund. What investors received was great – frank discussions about the companies that were invested in and his perspectives on what went wrong this quarter. Rather than play the blame game, he said that Fairholme’s performance was due to a couple mistakes.

1. Misreading the management of a couple companies.
2. Buying too early.

Even Warren Buffett sometimes finds himself in situations like that (staying in Coca-Cola too long, buying to early during this most recent financial crisis). I don’t think that the occasional misread of a company’s management will end up killing a portfolio. Most investors are sufficiently diversified to protect against that. I don’t believe that the fund’s short term performance will be any indication of how it will perform in the longer term. Value investors aren’t trading daily and as a result, should probably be judged with a longer time period.

Throughout the call, Berkowitz was incredibly reassuring to investors. He spent a lot of time talking about specific holdings with the fund’s investors.

I liked the questions about Sears Holdings (NYSE:SHLD). Sears has taken a lot of hits in the press lately about the poor performance of its stock and the continuously turning turnaround. But now, if you look at what Eddie Lampert has done, maybe his decisions weren’t too bad. While most retailers were spending cash on upgrading their stores, Lampert was more focused on allocating cash to generate high returns. With cash and spending tight, a company like Sears might be better positioned than others. The fund’s investment thesis in Sears was really based around the company’s liquidation valuation, not because other value investors flocked to it, or Eddie Lampert’s successful hedge fund career.

He also discussed Pfizer (NYSE:PFE) a company that the fund selected because of its free cash flow yield, new CEO, cost-cutting, and distribution network. Berkowitz envisions Pfizer as a pharmaceutical merchant bank. With Pfizer generating what looks like $14 billion in FCF TTM, that kind of capital could be deployed quite well to acquire other companies with more developed drugs. That would be incredibly useful to offset the loss of Lipitor.

If you read through the Fairholme Fund’s letters, you’ll see that they mainly look for factors like high FCF yields, a good moat, and a good balance sheet. These companies might be hurting right now because of Mr. Market’s depression, but it seems hard to argue that their long term prospects are bad. The wont need government intervention and should be able to thrive by engaging in cheap acquisitions right now.

Besides specific investments, Berkowitz mentioned on the call that he would be pushing 100% of his net worth into the Fairholme Fund. I don’t know of a more reassuring move that a fund manager could make, especially in a time when investors are particularly frenzied and the economic situation remains a bit bleak.

Jason Zweig’s latest column at the WSJ (Psyching Yourself Up to Let Losers Go ) tackles a tough issue for most investors – when to sell. Selling can be difficult for a variety of reasons, but a big factor is psychology. We don’t like to let go and give up things we’ve bought. Zweig provides us with a telling statistic:

Individual and professional investors alike struggle with selling. Berkeley finance professor Terrance Odean has found that investors are at least 50% more likely to sell their winners than their losers. Among the money managers surveyed by Cabot Research, a Boston consulting firm, fewer than 30% base their sell decisions on “extensive research.” The rest concede they basically sell by the seat of their pants.

To defend our portfolios from our emotions, Zweig offers us six techniques.

1. Use stop-loss orders

I’ve never been a fan of using a stop-loss order on a company’s stock. I know that Investors Business Daily advocates the use of selling whenever a company falls 10% and I think it’s too trivial of a rule. Zweig says that he doesn’t advocate the use of stop losses but prefers “stop look” orders:

Whenever a stock drops, say, 25% below what you paid, automatically review your original top three reasons for buying to see whether they are still valid. That will prevent you from selling without thinking first.

This is a pretty good idea. I practice the same kind of exercise myself. I don’t have any alerts set to tell me when about a drop of 25%, but I do check my company’s prices regularly. An easy way to get notified of drops in your companies can be done with Yahoo Alerts, you can get an e-mail or text message based up requirements you set (price drop/rise or percent drop/rise). Two of my holdings, Air Transport Services Group (NASDAQ: ATSG) and Steak N Shake (NYSE: SNS) have fallen a bit from my initial buying points ($1.70 and $10.00).

In each of these cases, I re-analyzed my investment thesis, to see if anything changed. With ATSG, the fall from $1.70 to below $1.00 was triggered by almost no news. DHL severing business ties with ATSG was already part of my investment idea- so I didn’t see a reason to sell. With SNS, my thesis hinged on Sardar Biglari getting onto the board and gaining control so that he could make the right decisions for the company. I decided that I would not sell till that thesis was properly tested.

2. Don’t Go Far Afield

Here, Zweig recommends buying an industry index if the company you purchased ends up having poor results. I don’t quite agree with this advice. It all seems a little bit like decisions made by an investor who doesn’t know what they’re doing who is trying to catch a trend (and may be too late).

The only time I think that this is valid is when you’re investing in an industry with good economics but where the individual players might be too hard to pick. I’m thinking of Buffett’s investments in pharma with companies like Sanofi Aventis (NYSE: SNY), GlaxoSmithKline (NYSE: GSK), and Johnson & Johnson (NYSE: JNJ). The difference with Buffett’s investments in pharmaceutical companies is that he still was not buying an ETF, he bought just a few of the players in that industry. An ETF will usually have many more holdings and carry the risk of over diversification.

3. Shop Before You Drop

Zweig’s next technique is a bit better-

Ask yourself: Which stock or fund would I most like to own? Then view your losers as a source of funding to reduce the amount of cash you would otherwise need to raise

Sometimes I think that selling losers can be good, especially if you’re purchasing a better buy. Maybe a new opportunity has presented itself with a higher return or the margin of safety in your losing investment has narrowed.

4. Re-price it.

Here, the idea is to take your original purchase price and divide it by 10 and compare that price with its current price. A simpler method might be to look at the price you’re seeing right now and compare it to your conservative estimate for the company’s margin of safety(the spread between the current price and the company’s intrinsic value you in your eyes). If you’re buying companies at what you think are 50% discounts, you’ll see a wider margin of safety. It will then be up to you to decide if anything has changed.

If the margin of safety has narrowed to a point where maybe the capital could be better used elsewhere, then you should.

5. Follow your sales.

This is some of the best advice in the column.

Using an online portfolio tracker, monitor the returns of all the stocks you sell after you sell them. Studying the aftermath of your mistakes will enable you to learn which you sold too soon and which too late. You cannot improve what you do not measure.

I try to do the same. On my Google Finance page I keep all of my stocks, even after selling them. I like to see what they’re currently doing and learn from my mistakes and the company’s mistakes. By doing this, you expand your circle of competence. It makes me think of a quote from Edward Lampert in Fortune Magazine.

[The] idea of anticipation is key to investing and to business generally. You can’t wait for an opportunity to become obvious. You have to think, “Here’s what other people and companies have done under certain circumstances. Now, under these new circumstances, how is this management likely to behave?” The plays my father designed for me helped me learn to think ahead. Lots of days I asked him, “Why can’t we just invite kids over and play a game?” In order to do something well, he explained, you have to keep practicing and preparing.

And I think that’s one of the more important concepts to keep in mind when investing. You can often draw upon past experiences when making future decisions. The situation might not be entirely the same, but it’s incredibly useful to have that kind of knowledge filed away for future reference.