I’m hoping Paul, a Portfolio123 colleague of mine, doesn’t read this because I’m about to mention something he would likely find embarrassing. In the early 2000s, back when I was at Reuters, I interviewed him for a job as an analyst-blogger. I was intrigued when he told me his approach to finding stocks was to look for companies with “sustainable competitive advantages.” I had been lightly acquainted with him when we both worked at Value Line and he came highly recommended, so the interview was something of a softball exercise (and I suppressed the urge to laugh out loud). After I hired him, I promptly cured him of his addiction to corporate excellence.

In Search of What?

I didn’t hold Paul’s philosophy against him because I knew how easy it was (and still is) for many in the investment community to get lulled into innocently spouting it without realizing the implications of what they’re saying. Excellence is for billable-hour consultants, motivational speakers, seminar sponsors and non-fiction authors.

Is excellence for real?

Darned if I know. I checked up on In Search of Excellence, by Tom Peters and Robert Waterman, the 1982 title that was all the rage shortly after I got into the investment community. But its staying power seems to have been questionable. It has only 108 reviews on Amazon.com and 133 on Goodreads (which may or may not overlap). And although the Kindle version is fully priced ($13.99), if you want buy a hard copy through Amazon, you’ll have to settle for second hand copies priced below $2.00.

Still, the idea of excellence remains out there in the collective imagination of the investment community. We’re taught to love companies that grow, that are financially sound, that gain market share, that have pricing power, that have great management, that have . . . drum roll please . . . economic moats, etc. (How dumb a metaphor is the latter! Can you guess how many Medieval moat-protected castle-centered power bases survived? Answer: Zero!)

Yeah, although Peters and Waterman may be passé, excellence is still very much in among investors.

We’re Investors, Not Management Gurus

It looks like for the second post in a row, I’m going to have to invoke Shark Tank’s Kevin Oleary with a reminder that we’re here to “make money” (imagine the “o” being drawn out slowly). We cannot make money on excellence unless the stock can be purchased at a price that reflects market assumptions that the company is less than excellent. It’s OK if the market assumes pretty good, or decent. All we need is a gap between whatever the market assumes and what is real. That, essentially, is the basis for Joel Greenblatt’s Magic Formula.

By the same logic, we can make money on bad companies if the stock is priced on the basis of a market assumption to the effect that the company is horrifying or dreadful (or anything else so long as one can argue it’s worse than mere “bad”). And actually, if you observe the world long enough, you pretty much have to conclude that nothing stays the same. Everything changes over time. Accordingly, some of the stock-market money-makers can be found among shares of companies that progress from awful to merely mediocre.

Note, too, that with so many investors infected with the cult of goodness and devoting so much energy and resources to parsing definitions of excellence and differences between market assumptions of stupendous, excellent, great, very good, terrific and all that, I suspect we may find happier hunting grounds (e.g. less market efficiency) if we’re willing to jump into dumpsters and examine what’s there.

Revisiting the Retail Scrap Heap

Dumpster diving is exactly what I did in my 5/20/16 post exploring what I more politely described as Contrarian Retail Plays.

I was not playing a statistical revert-to-the-mean sort of contrarian game. I was playing a human version of it. Specifically I wrote:

“It’s not that I’m in love with lack of success. But the markets (consumer markets and capital markets) are such as to exert pressure for change and I wonder if it might make sense to invest in companies that know (whether or not they publicly admit it) that what they’ve been doing hasn’t been working. Either they figure out how to do better or they get replaced, at the HR level if done by the company or at the M&A level if done by the market . . . . Executives in can’t miss concepts whose earnings and stocks have been on a slow boat to nowhere can’t be complacent. They have to be hungry and/or desperate and those who don’t figure it out are apt to be shown the door maybe with a golden parachute or, in many cases, with a ripped parachute.”

Table 1 lists the 15 stock ideas I offered then and price performance since then based on screening idea I explained in the article (in sum, I look for below average returns and inventory turnover coupled with a hint of recent improvement, even if it’s very modes improvement), a screen I named “Crazy Retail.”

Table 1

Obviously, simply being an equal-weighted retail stock portfolio counted for a lot. While large-cap has been good in 2016, the measurement period was one in which smaller issues recovered some lost ground, and that helps performance of any stock group that is not weighted by market capitalization.

But that the stocks in Table 1 outperformed even this stronger benchmark, or even that they did not significantly underperform it, says a lot. Remember, these were pre-selected on the basis of having been fundamental corporate duds!

There’s also a market-news lesson here. Note that the retail ETFs outperformed the S&P 500, which is meaningful because each of the ETFs is weighted in a manner consistent with the S&P 500’s cap weighted approach. Back in May, the fact that the retail sector in general was very badly regarded in the investment community is what inspired the whole idea for this screen. So I can and do take credit for having made a good contrarian sector bet.

Updating The List

Only two stocks left the list; Destination XL Group (DXLG) and Tailored Brands (TLRD).

They are replaced by: Bon Ton Stores (BONT) and J.C. Penny (JCP).

Recently good share returns notwithstanding, I did warn readers back on May 20^th that some of these names could really be quite bad, so bad as to not even be worthy of contrarian investment. (I suggested the list could be more interesting as an idea generator for case-by-case follow up than the sort of buy-them-all approach I usually take with model-based lists).

Bon Ton Stores (BONT)

I’ve never had occasion to take an up-close-and-personal look at BONT. But my quick glance at the numbers suggests this situation may be perilous even by contrarian standards. When shares of a company with annual sales above $2.5 billion trade in low single-digits, that usually means the b-word is floating around in Mr. Market’s brain, and if you don’t know what the b-word means that alone is reason to steer clear here (hint; think a step below sub-prime borrower). An important indicator of survivability I’ve used in the past is whether the basic operation is reasonable profitable (sales minus cost of goods sold minus selling, general and administrative expense). If a company is OK there, and if a case can be made that the strategy is credible, then even the most onerous debt burdens can be and usually are restructured. This is the logic that motivated my bottom-of-the-barrel call on Rite Aid (RAD) a few years ago, when the Street was buying flowers for the funeral.

I have to tell you BONT is falling ever closer to operating-profit alarm. Its operating margin in the trailing 12months was a miniscule 0.30%, versus its own already-bad 1.96% five-year average. (Industry medians were 5.80% and 5.93% respectively.) Don’t even bother computing debt ratios; your calculator will likely report E-r-r or something like that. Suffice it to say the company’s ongoing survival depends on the benevolence and more important, faith, of creditors.

BONT is scheduled to report on Thursday. If the news is good, a nice windfall can be reaped (based on the idea creditors will try to work with the company). If not . . . I really don’t want to go there. What’s more likely? Often, though, the best investment opinion one can give is the one I’m giving here: If you need a good word from me to play this situation, then pass because frankly, I’m clueless. (Shh; don’t tell anyone I said that; folks like me are supposed to know everything.)

J.C. Penny (JCP)

I’m not a great expert on department-store merchant JCP except to say that as I sometimes walk through it, I have to use discipline to stay alert lest I find myself sleepwalking and bumping into people or fragile display items before I get from the parking garage entrance to the main part of the mall. But don’t write it off for that. I’m not a master shopper so what bores me may excite others: I’d rather spend an hour in J.C. Penny than a minute in WalMart (WMT), but that hasn’t hurt the latter one bit.

A quick glance at JCP’s numbers suggests a more tolerable risk situation. I would not go so far as to say operating earnings are well into the black, but over the trailing 12moths, they’ve been enough so ($892 million not counting the non-cash depreciation charge) to comfortably cover the $392 million in net interest expense. We can’t really ignore depreciation forever since it is a tolerable proxy for cash capital spending ($339 million in the case of JCP’s past 12 months). But at least capex is discretionary (so long as you do enough to prevent turning off customers) and fertile ground for discussion with creditors should negotiation become necessary.

Also noteworthy with JCP, we’ve seen some up-ticking, mild and meager up-ticking but up-ticking nonetheless which is a heck of a lot better than down-ticking. The company reported teeny-weeny year-to-year sales gains in six of the last seven quarters including the most recent one. The trailing 12 month operating margin was 2.19%. That was really bad compared to the industry median, but bliss compared to JCP’s 5-year average of minus 3.61. The debt ratio is awful, but at least I can compute it and get an actual number. At any rate, I’m more interested in liquidity than am in debt ratios in in that regard, JCP is still breathing.