Successful investing is all about figuring out what something is worth and then paying significantly less than that for it. If you can do that over and over again, you'll have found yourself a recipe for success.
It sounds easy, but of course it isn't. It takes a lot of hard work and patience to find situations where the market is offering up such juicy bargains.
I believe that there is one such bargain sitting in plain view today. This is a well-known company that I think offers investors the chance to buy a dollar's worth of assets for 25 cents. The evidence to support that valuation is quite compelling, but the question of when that value might be realized is difficult to answer.
The company I'm talking about is Sears Holdings (Nasdaq: SHLD).
Many people are familiar with the Sears story. Hedge fund manager Eddie Lampert gained control of Kmart in 2003 by buying up the company's debt and exchanging that debt for equity during bankruptcy proceedings. That was a home run for Lampert.
Then in 2004, Lampert had Kmart acquire Sears to form Sears Holdings. Investors were thrilled with this hedge fund star taking control of two large cash-generating businesses. A common expectation from outsiders was that Lampert would use Sears Holdings as a cash cow to make other investments, much like Warren Buffett has with Berkshire Hathaway (NYSE: BRK-B).
But over the subsequent decade, that hasn't happened. Lampert has instead tried to run Sears in its historical form as a retail operation. And that hasn't gone well.
In the early years, Lampert took massive amounts of the company's free cash and used it to buy back shares. Very little money was reinvested in the operating business -- and the business has suffered.
Revenue has shrunk steadily, which could be OK because there have been unprofitable stores closed. What really isn't OK, though, is what has happened to net income and cash flow.
Sears Holdings has gone from generating over $1 billion a year in cash flow to generating none.
And what must be very hard to look at for shareholders is the amount of money that was poured into share repurchases back in 2006 to 2008 when the share price was two, three or four times where it is today.
Given this company is generating no free cash flow at this point and seems to be in a death spiral, why in the world would anyone want to buy shares?
The answer lies in looking beyond Sears' income and cash flow statements and at its balance sheet -- because this is a story about undervalued assets.
The argument for owning Sears is that while the operating business is terrible, the value of the real estate the company controls through direct ownership and below-market long-term leases is worth much more than the current enterprise value of the company.
When looking at the balance sheet of any company that owns a large amount of real estate, it is important to know that generally accepted accounting principles (GAAP) dictate that real estate is valued at the lower of fair market value and cost.
For example, imagine a company that owns a piece of land in a city that was purchased 50 years ago for $50,000. Today, 50 years later, that land would likely be worth a lot more than $50,000. It might be worth several multiples of that purchase price.
However, GAAP would require that land be required at the lower of its current value or original cost. So if you looked at the balance sheet of this company, that land would be recorded at $50,000 -- while it might actually be worth several times as much.
That is what is going on with Sears Holdings.
The company is sitting on a huge amount of commercial real estate and valuable long-term leases from historical Sears and Kmart locations that is worth much more than the company balance sheet reflects.
The size of the real estate controlled by Sears through direct ownership or long-term and below-market leases is huge.
Sears Holdings is actually one of the largest commercial real estate organizations in the world. It just happens to be hidden inside of a struggling retail operation.
Significant Sears shareholder Bruce Berkowitz of the Fairholme Fund provides a telling story of the hidden real estate value of Sears in the slide below:
Simon Property Group (NYSE: SPG) has slightly less commercial real estate than Sears but a market capitalization of 8 times what Sears has.
General Growth Properties (NYSE: GGP) has 56% of the commercial space but three times the market cap.
Kimco Realty (NYSE: KIM) has 53% of the commercial real estate and also a larger market capitalization.
These comparisons are not apples to apples: Real estate is different by location, age and functional use. But I think it still provides a pretty solid piece of evidence that Sears Holdings has asset value far in excess of the current market valuation.
If Sears' real estate turns out to be worth just half of what Simon Property Group is valued at, it means that shares of Sears could be worth four times more than where they currently trade.
That is the type of bargain that you don't find every day.
Now the big question becomes, when does this real estate value get realized? When does Lampert shutter the struggling retail business and focus on the true value of the company?
The honest answer is, I don't know -- but I expect that if I were to buy some shares, sock them away and check back in five years, I'd be happy I did.
Risks to Consider: Any time a company makes a radical shift in strategy, there is plenty of execution risk. Moving Sears away from its historical roots and into the real estate business could involve plenty of bumps.
Action to Take --> Buy SHLD and be patient. At some point in time Lampert is going to put the retail business out of its misery and start extracting value from its real estate portfolio.