I don’t think that the value of AEO’s business is down 40% since last year; so, we can’t take action based on price cues. If the value of the business drops below our buy price or the current price, a sell is warranted. While some retailers are “crumbling,” AEO is far from dead right now.

You bring up a great point:

But then I stepped back from the numbers and thought about the macro environment of each industry (consumer discretionary, financial and home building and saw nothing but a huge blinking sign that screamed “value trap”.

Knowing how the economy is today, it’s easy to look back and say, “This and that should have been avoided.” The problem is that these sort of statements have to be made without the price action in mind:

JNJ’s business has not grown that much since last year’s $62 purchase; but, it seems to be brilliant in today’s market…based on the price action.

WMT was cheap at $42 last year, but looks so much better because the price is 25% higher. Sure it benefits from the recession as it pulls customers away from other stores; but, it also hurts because people – in general – will spend less. But, had you avoided all retailers – all consumer stocks – you missed Wal-Mart on the cheap.

The best way to judge AEO, WMT, or any business is after 3 or so years of owning it. Would I like to have purchased AEO only to see it sore 200% the following year? You bet! Regardless of recent price action, it was purchased on the cheap. If management can get the value growing again, AEO will likely provide a very handsome long-term return.

Trying to guess the macro can get you into a lot of trouble. Take a look at AEO below:

In September 1996 and October 1997, the price was exactly the same. Anyone who had purchased stock in October, November, and December of 1996 was likely sick in January – down some 73%. If Yahoo! had investment forums back then, they would be overrun by “I told you so” and “It’s going bankrupt” shennanigans.

You had two choices:

• ignore the news and buy an underpriced business; or,
• play the macro, sell (or skip it) and wait until the price rebounds.

The difference? The chart on the left shows the growth from October 1997 (assuming you waited for a rebound from the 9/1996 price) – a 24% annual return. You could have held from your 9/1996 purchase – a 22% annual gain. You could have purchased more at those lower prices – bringing your average cost down, say, 20% – a 25% annual gain. You could have sold for a 70% loss, and then reinvested when it rebounded to its 9/1997 level – a 9% average annual gain.

Every investment decision needs to be made in a 3- or 5-year timeframe. What will AEO look like in 5 years? It may be smaller than I had previously anticipated, but it should be larger than it is today. But if you play the macro, you’ll be buying precisely when everyone else is, and that negates the whole strategy.

So, we should discuss AEO next April when the annual report comes out. Let’s keep it on Fisher’s three-year list. But let’s not panic or celebrate based on one year of price movement.

Make sense?

Normally, I’d be right there with you on your approach, but these are not normal times. A company misses estimates by $0.01 and the stock plunges. Sometimes it comes back the next day, sometimes it keeps plunging. I agree that the macro is to a large extent unpredictable, but some things are really, really obvious. Home builders are not going to be growth companies for a long, long time. The American consumer is tapped out even if he doesn’t want to admit it and continues to be in denial for a while longer and financials are at best a black box right now and at worst ready to crumble as the housing market continues to crash.

What I do in light of this very dangerous environment is that I ask myself, “if this stock I’m considering buying right now were to lose %60 of its value the day after I purchased it, would I be delighted that now I can back up the truck?” If the answer is no, I don’t buy it, that simple. AEO looks absolutely great in the rear view mirror. It may very well recover nicely and even go on to be a great investment, but even at this reduced price, I fear it. It’s profit source, the American consumer, is in big trouble and it is in an industry with lots of good competitors. I think this is a case of a good or even great company who is in an industry that has gone from great to awful in a short time, with no recovery in sight.

JNJ and WMT on the other hand are good to great under any environment, specially JNJ. JNJ is the kind of stock you give your pre-kindergarten grand daughter for her college fund. Let JNJ drop 60% and I’ll be cranking up the provervial truck and renting extra trucks. I fully realize that I’m not a very sophisticated investor, but I can only work with whatever I have been able to absorb from the classic investors we all admire and with my own common sense. Thanks for the input, I will mull over what you say here as I always do everything you post.

It was hard. I remember I was tempted to buy BAC at around 37 and then again in the high twenties, but I couldn’t do it. I remember thinking, “you must be some kind of clinical narcissist to think you are smarter than Warren Buffett”. BAC is now on the way up again and I’m still happy that I didn’t buy it even at the bottom. Home builders? I don’t care if it is Bill Miller, that one truly baffles me. Finally there is Joe’s AEO. I looked at it again after this post and going by the numbers it is as good as some of my favorites, maybe even a little better, specially at the current price, but I still can’t imagine it. I can’t imagine the American consumer buying anything but the bare essentials for quite a while.

So this is what I don’t get. It just appears to me, that sometimes, great value investors don’t get their nose out of the SEC filings long enough to smell the coffee or hear the rumble of several banks, home builders and retailers crumbling. I know all three of these people are smarter than me by a magnitude of several and have forgotten more about investing than I’ll ever know, which probably explains why I just don’t get it.

A lot of people have e-mailed me about this so I am going to offer up a second performance post with more realistic numbers based on how I would have actually managed the portfolio.

Mark: I don’t like regulatory approval, but SEC comments/approval is generally simple. Fill out some forms, send them in, wait for comments. It is rare that the SEC would ever block a deal (unless there were fraud issues); so, I don’t consider SEC comments/approval to be a regulatory hurdle.

Do you usually enter a new position all in one shot? By that, I mean do you buy your whole 20% position as a single trade? It seems like you made that assumption here. What are your thoughts on DCA as the quotation price goes lower?

JC

Bill: You would get $1.25 per share, but give up the shares at $45. Here’s the way I look at it: You would get $1.25 a share, but deliver the stock at $45 if it closes at $46.25 before expiration (and you get called). So, the effective premium is $1.25 and your gamble is against the short-term. Will Adobe go above $46.25 before the August expiration?

Either way, you end up at a $45 sale price plus $1.25 per share.

Casey: Let me weigh the pros and cons of such a list. I really don’t want people focusing on the short-term; so, if I can up with a crafty way to do it, I certainly will.