My experience with Ross Stores has taught some valuable investment lessons, including: be cautious with investments in apparel-retailing companies; buy with a large margin of safety; and, most importantly, acknowledge, rectify, and learn from your mistakes. Despite the difficulties of the apparel-retailing sector, I'm not willing to write it off altogether. I'm looking at Deb Shops, Kmart, TJX, and Intimate Brands. I invite your feedback.

By Whitney Tilson
October 2, 2000

In August, I published a column, Learn From Investment Mistakes, that analyzed Freddie Mac and why I sold it. Today, I'd like to discuss my mistake with Ross Stores <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ROST)") else Response.Write("(Nasdaq: ROST)") end if %>, which -- as I announced in last week's column -- I have now sold.

While one might think that all I do is stumble from mistake to mistake, that's not the case -- I simply spend much more time thinking about my errors than I do congratulating myself (and writing about) my best stock picks. Why? Philip Fisher said it best in his classic, Common Stocks and Uncommon Profits:

"While losses should never cause strong self-disgust or emotional upset, neither should they be passed over lightly. They should always be reviewed with care so that a lesson is learned from each of them. If the particular elements which caused a misjudgment on a common stock are thoroughly understood, it is unlikely that another poor purchase will be made through misjudging the same investment factors."

With that in mind, here are some of the lessons I've learned from my experience with Ross, as well as some general thoughts on sensible investing:

• Apparel retailing is one of the very toughest businesses. Don't invest in this sector unless you really understand it. I do, but I still make mistakes.
• While I think that carefully reviewing each company I own every few months or so is generally sufficient, this approach doesn't work for companies like Ross that lack meaningful competitive advantages and are in difficult industries that require flawless execution.
• It's hard to determine how well a retailer with hundreds of stores is executing. While a few anecdotes can be misleading, scuttlebutt is invaluable in most cases. Read message boards, talk to your friends, visit stores yourself, etc. Had I invested a little more time earlier in gathering scuttlebutt on Ross, I might have avoided the stock entirely, or sold months ago at a much higher price.
• The apparel-retailing sector is generally unattractive for long-term buy-and-hold investors (like myself), since knowing when to sell is often as important as buying at the right time and price. When I invest in this sector in the future, I'll be more willing to sell after I've doubled my money.
• Despite all of these negatives, the stocks of apparel retailers occasionally become wonderful bargains, as investors, in their haste to flee the sector, can significantly undervalue solid companies. A good example, in my opinion, is Deb Shops <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DEBS)") else Response.Write("(Nasdaq: DEBS)") end if %>, which I have been buying recently (discussed further below).
• Stealing the title of one of my favorite columns, Valuation Matters, I made a bet on Ross that didn't pan out -- the company has performed very poorly for most of the period that I owned the stock -- but I didn't lose any money. Why? Because I bought with a big margin of safety -- something that's always important, but it's especially critical in this sector. So many stocks today have no margin of safety whatsoever, yet na�ve (or perhaps cynical) investors pile into them, assuming a significant risk of severe, permanent loss of capital. It's understandable, given that the market -- at least until quite recently -- has been richly rewarding this behavior for quite a while, causing some to confuse brains with a bull market. But even if one survives the excitement of going over Niagara Falls in a barrel, it is still a dumb thing to do. And I believe the days in which reckless investing is rewarded are rapidly coming to an end.
• I didn't sell Ross because the stock had declined, I couldn't take the pain, and wanted to escape with my original investment intact. (Sounds silly, doesn't it? But studies show that this is precisely how most investors behave.) I sold because of the deterioration of the underlying business. If anything, the decline in the stock price made it a harder decision to sell since so much bad news is now reflected in the price.

Never let the market drive your buying or selling decisions. As Ben Graham wrote in The Intelligent Investor:

"The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment."

Warren Buffett echoed this advice, noting that "Mr. Market is your servant, not your guide."

• Publicly disclosing a favorite stock -- as I did with Ross -- entails the risk of getting egg on your face if it turns out to be a bad pick. That egg can be pretty tasty, however, if it helps you identify and rectify a mistake.
• There is no shame in making a mistake. Despite a great deal of research and analysis, I make plenty of them -- and so does every other investor -- because the future is inherently unpredictable. But there is shame in refusing to acknowledge a mistake and rectifying it.

The "rectifying it" part of the previous sentence appears obvious, but studies show that investors will hang on to their losing stock picks -- even when they know they've made a mistake and wouldn't buy the stock at the current, lower price -- because they don't want to admit their mistake. After all, if they sell, they can never recoup their losses -- the mistake becomes permanent -- whereas by holding on, there's always the chance, however tiny, that the stock could rebound to the point at which it was purchased (in which case, the stock is usually sold, even if that makes no sense either).

I have the opposite view. If I come to realize that I've made a mistake, then I prefer -- due to the tax benefit -- to have a loss rather than a gain on the stock. The real dilemma for me is when I am inclined to sell a stock that has appreciated substantially.

I'll let Philip Fisher have the final word on this topic:

"More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous."

Wanted: Opinions on Deb Shops, Kmart, TJX Companies, and Victoria's Secret/Bath & Body Works

I've come to appreciate the tremendous value of readers' opinions when evaluating retailers, so I would like to propose that we examine four other retailers that have caught my eye: Deb Shops, Kmart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KM)") else Response.Write("(NYSE: KM)") end if %>, TJX Companies <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TJX)") else Response.Write("(NYSE: TJX)") end if %>, which owns Marshalls and T.J. Maxx, and Intimate Brands <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBI)") else Response.Write("(NYSE: IBI)") end if %>, which owns Victoria's Secret and Bath & Body Works.

Deb Shops
Deb Shops is a national specialty retailer of fashionable apparel, shoes, and accessories for juniors (primarily girls aged 12-18) in both regular and plus sizes. The company operates 290 specialty apparel stores in 37 states under the DEB, DEB PLUS, and Tops 'N Bottoms names. Selling fashion apparel to fickle teenage girls has to be the toughest segment of this already-difficult sector. So why do I own the stock? Because the company has remarkably good economic characteristics, nice growth, and is unbelievably cheap. With a market cap of $151 million, $93 million in cash and no debt, the enterprise value of $59 million is approximately 3x trailing earnings (and with a tight balance sheet, it's trading at a similar multiple to free cash flow as well). At this absurdly low price, I think the risk-reward equation is very favorable.

Kmart
Few stocks are as unloved as Kmart's, but I've been pleasantly surprised by the Kmart in Great Barrington, Massachusetts. A close friend shared a similar experience at one near Santa Cruz, California. Might Kmart, with a new CEO at the helm, finally be turning itself around? If so, the stock, near its 52-week low, has a lot of room to rise. While most of the company's financial metrics look terrible, operating cash flow was up 89% in the first six months of this year.

TJX Companies (Marshalls and T.J. Maxx)
A number of readers who reported disappointment with Ross mentioned that they were instead shopping at Marshalls or T.J. Maxx (both owned by TJX Companies). I looked closely at TJX before buying Ross and, apparently, made the wrong choice. At today's price of 13x trailing EPS, TJX is probably not cheap enough for me, but it's worth a hard look.

For an excellent analysis of the two companies, read this post on the Boring Stocks discussion board by Colin Walters (known on the boards as playerofgames). After analyzing many factors, including return on assets, equity, and invested capital, inventory turns, flow ratio, topline and bottom-line growth, margins, cash conversion cycle, and valuation, he concluded that TJX was the better buy -- and bought the stock. You can read my reply as well. Colin, so far anyway, you wuz right!

Intimate Brands (Victoria's Secret and Bath & Body Works)
While Intimate Brands isn't cheap at 20x trailing EPS, the company has been a steady mid-teens grower, has excellent margins and returns on capital, strong and increasing cash flow, modest and declining debt, and has been buying back lots of shares.

Please post and/or email me your thoughts on these companies, and I will write future columns on them if I get enough interesting feedback.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected]. To read his previous guest columns in the Boring Port and other writings, click here.