When it comes to investing, one of my least favorite things is selling shares of a company I own.
My decision to invest in a company involves significant research aimed at helping me better understand the company, its financial statements, and its future prospects. Although there's a lot we can learn from our mistakes, it's still not easy to sell. When I buy, my intent is to hold the shares for as long as I can, hopefully forever.
For a while, I've been troubled by Gap's (NYSE: GPS) weak performance, but it wasn't until this discussion board thread that I started thinking seriously about selling. Last Friday, Zeke wrote an article discussing how Gap fares under our 4x4 sell criteria. (This informal rule recommends that we consider selling if a company misses four of our financial criteria for four consecutive quarters.) Based on the poll linked to that article, most of you agree we should sell.
However, for me these criteria are only a starting point. You have to look closely at the qualitative side of the ledger as well. For that I typically turn to the writings of Philip Fisher.
While a chapter of his book, Common Stocks and Uncommon Profits, deals with selling stocks, Fisher is generally loathe to pursue that course. In his words, "If the job has been correctly done when a common stock is purchased, the time to sell it is -- almost never." Fisher has three criteria for selling a stock. I'll address two of them tonight.
- "When a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favorable than originally believed."
1/31/98 7/29/00 Cash & equivalents $913,169 $327,860 Short-term debt $84,794 $859,448 Long-term debt 496,044 $1,022,871 (Amounts in thousands)Not a pretty picture. Cash is down roughly two-thirds. Total debt has more than tripled. Also, Gap issued $500 million of 10-year notes in fiscal 1998, so in hindsight, our purchase occurred just as Gap started accumulating debt.
If that's not scary enough, let's look at a couple of other debt-related items. The cost of Gap's ongoing construction projects was $120 million at the end of fiscal 1997. At the end of its most recent quarter, it had increased more than sevenfold to $876 million.
Let's also look at its off-balance-sheet debt, a figure found only in the annual financials. Gap's total minimum lease commitment was $3.1 billion at January 1998. At January 2000, this figure had increased to $4.6 billion. If you're not sure why I'm mentioning the rental payments Gap is making in the same breadth as long-term debt, check this Fool on the Hill column Rule Maker co-manager Rich McCaffery wrote in May.
I hate to beat a dead horse, but I will. During this same time period, Gap has been aggressively buying back stock. According to its most recent 10-Q, Gap repurchased $324 million of stock so far this year. To be honest, I just cannot comprehend how a prudent finance department would buy back that much stock while debt levels are increasing. I've discussed this issue with Bob Freeden, who covers Gap for Motley Fool Research. We both believe Gap will issue more debt by year's end.
When I penned the buy report, I mentioned two concerns that foreshadowed what's happened here:
- According to Gap's own assessment, the most critical factor in its profit growth is total growth in the number of well-placed stores. If the Gap division is unable to continue a nice trend here, and can't persist at driving its comparable-store growth ever higher, the company and its stock will hit trouble spots. We'll be watching those same-store sales growth rates, as well as new store developments in our Rule Maker daily reports in the months ahead.
- But, expansion has to be managed and measured. The company runs the risk of growing sloppily via its expansion into new channels of distribution and new markets (primarily international developments). There are established regional and national chains here in the United States and abroad that could whittle away its lead. Gap has to expand scientifically, aggressively, and well... conservatively.
In short, since our initial purchase, Gap has been hemorrhaging debt. AND, it's cash balance has fallen substantially. Gap's factual background, as Fisher calls it, is much less favorable.
On to Fisher's second reason for selling:
- "Sales should always be made of the stock of a company which, because of changes resulting from the passage of time, no longer qualifies in regard to the 15 points... to about the same degree it qualified at the time of purchase."
Point 6 - What is the company doing to maintain or improve profit margins?
I don't see a lot of positives in this area right now. Inventory levels are increasing faster than sales, Gap's cash conversion cycle has increased on a comparable-quarter basis for the last five quarters. Debt is up sharply, and the only time it's met our minimum 10% Cash King Margin target for a full year during the last decade was in fiscal 1993. Gap needs to show substantial improvement to turn things around, and I don't see that happening anytime soon.
Point 9 - Management Depth
One advantage to long-term investing is that we learn a lot about our companies and their business. I've come to realize that retail is kind of a one-man industry. In the case of Gap, that man is Mickey Drexler. As discussed in the Fortune article Gap Gets It, "There is no Gap formula hidden in some vault; there's only Mickey Drexler. "Mickey is omnipotent," says one former Gap employee, who asked to remain nameless. "We would all talk about that. We'd say, 'There's no heir apparent. There is nobody [at Gap] who is his equal. There is nobody who is near his equal.' "
While Gap may have other quality managers, it's hard not to equate Gap with Drexler and Drexler with Gap. They're almost synonymous. This is a characteristic I don't believe our other portfolio holdings share. For example, when Don Listwin left Cisco Systems (Nasdaq: CSCO), three of his four primary responsibilities were assumed by others who report to Chief Executive John Chambers. The only thing Chambers assumed was the marketing role... for now.
To make matters worse, Gap lost one of its top managers a little more than six months ago -- when Jeanne Jackson, who headed both the Banana Republic and Online divisions for Gap, left to become CEO of Wal-Mart.com, a unit of Wal-Mart (NYSE: WMT). Robert Fisher, head of Gap Brand, also resigned last October.
I asked Bob Freeden for his thoughts on Gap's executive turnover. Here's what he said:
"First, let's look at who left. The biggest loss was probably Jeanne Jackson. She was a huge loss because she was instrumental, as far as I can tell, in making Banana Republic what it is today. I'm not sure how great a loss Robert Fisher was. I think he was a leader during Gap's big rise, but I don't think he was the one with the ideas. When it became his baby, the brand cruised on its momentum, then started to lose it. So, his leaving (I don't think it was willingly) may not have been bad. Since his departure, the brand has improved somewhat, though August was atrocious."So, ultimately, we have a company that is largely dependent on one guy, with a few other spots of brilliance. They are trying to improve the quality of the rest of the management, but that will take time. I'm not terribly happy with the "Office of the President" for Banana Republic, but it doesn't seem to have hurt the merchandising and marketing.
My conclusion is that Gap's management depth isn't sufficient for it to be held by an investor favoring the approach of Philip Fisher. This, however, is not something that's unique to Gap; it's more a part of the retail industry as a whole.
When we purchased Gap, I didn't fully understand the retail industry and the way it differs from industries like high technology and pharmaceuticals, the ones I enjoy following most. Gap just doesn't qualify under my investment criteria. While it may be a good investment, I don't think it's a Rule Maker.
I'd like to close with one last quote by Fisher:
"Making some mistakes is as much an inherent cost of investing for major gains as making some bad loans is inevitable in even the best-run and most-profitable lending institution. The important thing is to recognize them as soon as possible, to understand their causes, and to learn how to keep from repeating the mistakes."I think we should sell our shares of Gap.