NEW YORK (FORTUNE Magazine) - The mood was tense at the Bel Age hotel in West Hollywood, Calif., early last year. The top two dozen executives of Sears Roebuck & Co. were gathering for a strategy session with Eddie Lampert, then 42, the billionaire hedge fund manager who had just engineered an unlikely takeover of their venerable but struggling company.

The fact that the vehicle of his acquisition was discounter Kmart -- which Lampert had come out of nowhere to snatch control of during bankruptcy -- was only one source of unease. Once their presentations started, Lampert also began poking holes in virtually every idea.

Lampert, pictured here at the Sears in Yonkers, N.Y., is retooling the way the retail chain operates.

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"What's the benefit of that?" he asked again and again. "What's the value?" He shot down a modest $2 million proposal to improve lighting in the stores. "Why invest in that?" He skewered a plan to sell DVDs at a discounted price to better compete with Target and Wal-Mart. "It doesn't matter what Target and Wal-Mart do," he declared.

Eyes began rolling. Sure, Lampert was an alluring character: He'd built himself into one of the richest men in America, survived a bizarre and terrifying kidnapping, and somehow supercharged Kmart's moribund stock into a highflier.

But when the Sears team asked him to share his vision for their company, he brushed the question aside. The impression, says one attendee, was that "Eddie was going to pull cash out of Sears to invest in the next addition to his hedge fund." Lampert says that view comes with the territory: "The pushback I get is, 'He's a hedge fund guy.' Full stop. Some places, that can be a badge of honor. In others, it's almost a term of derision."

A year after the Bel Age meeting many of those Sears executives -- including the CEO, the CFO, and the chief buyer -- are out of the picture. Sears (Research) stock is up 30 percent, and Lampert is fully in charge. While his official title is chairman, he's operating much like a CEO, calling the shots on strategy, marketing, merchandising, and more.

"I'm not from a retail background, but I am a shopper," says Lampert, whose contained, sometimes shy manner is the last thing you'd expect from a big swingin' hedge fund guy. "I come to this with practical, logical ideas."

Eddie Lampert is the Steve Jobs of the investing world: He thinks differently, and acts differently, with extraordinary results. "He's the greatest investor of his generation," says fellow billionaire (and onetime mentor) Richard Rainwater, and Lampert has the numbers to prove it.

His hedge fund, ESL Investments, has delivered average annual returns of nearly 30 percent, after fees, since its 1988 launch, according to several of its investors, who include Dell founder Michael Dell, media mogul David Geffen, and the Tisch family. Geffen, who gave Lampert $200 million to invest in 1992 (when Lampert was just 29), says that had he not periodically taken money out for diversification, he would have $9 billion today. As it is, says Geffen, "I've made more money from Eddie than from all the businesses I've created and sold."

Lampert is wealthier than Warren Buffett was at his age. And his $15 billion fund has outperformed Buffett's Berkshire Hathaway during its 18-year span (though of course the bigger Berkshire is a heavier load to move). Unlike other hedge funds, ESL doesn't typically short stocks, or trade derivatives, or dabble in currencies, or use aggressive leverage.

Lampert buys cheap stocks and holds them for long periods (see "How Lampert Picks His Stocks"). He made his first big money in the 1990s with IBM and financial stocks like Wells Fargo, and became a billionaire by buying AutoNation and AutoZone, which have tripled and quadrupled in value, respectively, since he invested in them.

But the capper so far has been his coup with Kmart. In 2004 alone, the stock soared 300 percent, ESL's stake grew from $1.3 billion to $5.4 billion, and as a reward that year he raked in a reported $1 billion in fee income.

Now the question is this: Is Lampert's Sears acquisition another inspired work of genius, a stepping stone to Berkshire Hathaway -- like wealth creation for public investors? Or has he finally gone a step too far?

In a series of revealing interviews -- the first in-depth discussions he's had with any outsiders, including Wall Street analysts, since the Sears deal -- Lampert acknowledges that he has nearly all of his own money in his hedge fund. That means his personal fortune is also riding on the fate of Sears Holdings, as the combined Sears-Kmart is now called. After rocketing to $163 last summer, shares of Sears Holdings have dropped to a recent $121.

With same-store sales at Sears down 12 percent this Christmas season, the sniping among retailing purists -- for a time overshadowed by Wall Street's cheers -- is getting louder.

"These financial guys, including Eddie Lampert, have no idea who the customer is," says Britt Beemer, chairman of America's Research Group, a retail industry consultancy. Former Sears CEO Arthur Martinez calls the plunge in holiday sales at Sears "very troubling" and wonders how long Lampert can sustain such a poor showing.

If Lampert is blinking, he sure doesn't show it. His hedge fund owns 40 percent of Sears Holdings, a stake worth almost $8 billion and by far its largest position. (He takes no salary for his role as Sears chairman.) From ESL's tiny offices in an unremarkable four-story building in Greenwich, Conn., Lampert manages the $54 billion, 330,000-person retail giant by phone, e-mail, and videoconference. He regularly holds court in his spartan conference room, diagramming on a big whiteboard for Sears executives who tune in remotely. The key points on his agenda: Be willing to sacrifice sales for profitability. Ignore Wall Street expectations. Question everything.

Lampert, who is a white-knuckle flier, has been to Sears' headquarters near Chicago just six times. But chief information officer Karen Austin says Lampert is the company's No. 1 user of a computer-based tool to analyze sales, margins, and inventories by store, by region, and by merchandise group. A geek at heart, he spends hours at his Connecticut office drilling down into the data, zeroing in on whatever isn't making money.

His critics argue that judging a single item's profitability in isolation is unsophisticated -- that a retailer's menu of offerings is what's important, even if an individual item lags. Lampert disputes that. While Sears' December sales drop was disappointing, as he admits, year-end earnings, due out in mid-March, are expected to show improving margins.

That, in part, is because unprofitable items are disappearing from the stores. Sears recently stopped carrying traditional televisions, now offering only pricey flat screens. As for DVDs at Wal-Mart and Target prices, they're also a thing of the past. An in-store test showed that full-priced DVDs produce plenty of volume and a lot more for the bottom line. Eddie was right.

I THOUGHT THEY WERE GOING TO kill me," Lampert says. He's sitting in the conference room at ESL, almost exactly three years after his kidnapping. Lampert's operation has moved to a new building, and security has gotten tighter -- the beefiest receptionist in Connecticut sits behind the counter of ESL's small entrance area -- but when Lampert tells the full story of what happened to him that day in early 2003, the terror of it shakes him anew.

And there's also the irony: that if Lampert hadn't been kidnapped that day, he might not be the sole, undisputed king of Sears and Kmart now. If he hadn't been crossed by a potential business partner who took his absence as an opportunity to go around him, he might even have retired. To understand the saga -- the full tale that has not been told anywhere until now -- you have to go back to the start of the Kmart deal.

Just about everybody thought Lampert was crazy in 2002 when he began buying up Kmart debt at around 40 cents on the dollar after the retailer filed for Chapter 11. Crazier still, Lampert loaded up more as the price sank to 20 cents, eventually boosting his total investment to $700 million.

"To most people, Kmart looked like a pile of trash," says Al Koch of restructuring advisor AlixPartners, then Kmart's interim CFO. "We were told that this hedge fund guy had bought a huge portion of Kmart and wanted to get it out of bankruptcy fast. None of us had ever heard of him."

But Lampert knew exactly what he was doing. He'd spent hundreds of hours analyzing Kmart's financials and reached a simple conclusion: "Kmart's bankruptcy was avoidable," he says. To his thinking, the retailer had frittered billions on unproductive store improvements and excessive inventories. The prevailing wisdom held that Wal- Mart and Target were squeezing Kmart into oblivion by stealing its sales, and that Kmart had to fight back to maintain its dwindling market share. Lampert felt differently: that only by managing Kmart for profitability, not sales growth, could the discounter succeed. And if need be, Lampert could sell off Kmart's real estate, which had been valued at $800 million in a liquidation analysis filed in bankruptcy court. He was sure it was worth much more.

As 2003 approached, Kmart was hungry for more cash to keep operating, and Lampert considered bringing on a partner: Ron Burkle, a secretive California billionaire who had owned more than 6 percent of Kmart stock pre-bankruptcy and wanted back in. Lampert and Burkle considered several possibilities: that Burkle would buy some of Lampert's Kmart debt or partner with him to put additional funds into Kmart. "The company needed a lot of money," says Lampert. "And he had a lot of experience that could be valuable."

On Friday, Jan. 10, at about 7:30 P.M., Lampert left his office to meet his wife and mother for dinner at a nearby restaurant. He was anticipating a weekend full of phone calls and meetings -- the following Monday was a key deadline for Kmart's refinancing -- but as he walked to his car in the underground parking garage of ESL's building, four masked men grabbed him.

They pulled a thick hood over his head, shoved him into an SUV, and sped off. An hour later Lampert was sitting on a toilet in a motel bathroom, blindfolded, his hands and feet bound by plastic handcuffs. His abductors told him that they had been hired to kill him. It made no sense, but he wasn't about to argue. "One thing I was sure of was that I had to tell the truth because they knew everything about me," Lampert recalls. "They knew where I lived, how much I had paid for my house, who worked at my office, how much I was worth. If I bullshitted them, they'd know it."

He sat in that bathroom for 39 hours, awaiting who-knew-what. They gave him water and one meal (Popeye's fried chicken).

When they removed his blindfold so that he could eat, he kept his eyes down, even though they had masks on. "I was respectful," he says. They'd taken his wallet away but allowed him to hold a passport photo of his 5-month-old son that he'd wedged into his billfold.

When they demanded that he record a message to his wife, he complied. "I was in God's hands," he says. It was later reported that Lampert talked his kidnappers into believing that he would deliver $5 million to them if they let him go.

But the real story is a little different. One of the kidnappers foolishly used Lampert's credit card to order pizza delivered to a friend's house. When Lampert heard them talking about it, he saw an opening. Didn't they realize that the police were on to them now? Only if they released him would they have a chance to get away. Lampert, after all, had never seen them, so he couldn't ID them. But if they got caught with him as a captive -- or harmed him -- they would be in terrible trouble. Lampert says he did discuss a payoff with his captors, but nothing was decided on. "Ultimately they realized that it was better to let me go than to kill me," he says.

At 2 A.M. on Sunday the kidnappers dropped him at the off ramp of exit 3 on I-95. Even then he feared that they would shoot him, but they drove off. He walked a mile to the Greenwich police station. The cops apprehended the culprits within days. Ranging in ages from just 17 to 23, they had used the Internet to research Lampert and buy equipment for their caper. They later pleaded guilty. They are now in prison, and Lampert says he just wants to put the episode behind him.

"A couple of friends said to me, 'Stop. Get out of the business. Retire,' " Lampert recalls. "I thought about it -- not for a long time, but it was definitely a consideration."

A few hours after he arrived home, he says, he asked colleagues to call the key players in the Kmart refinancing and pass along a message: "I need to collect my thoughts. I don't need weeks. I need days."

He was stunned by the reaction he got: A few people suggested that he might have concocted the kidnapping story to buy time. Then he heard about Burkle. The day after Lampert's release, as he was recovering from his ordeal with his family, Burkle went to Jim Adamson, Kmart's then-CEO, and said he would be willing to put up the money the company needed, without Lampert.

When Lampert found out, he was furious at Burkle's apparent end run. "It jolted me back to reality," he says. Instead of retiring, he jumped back into the fray, elbowing Burkle aside -- and committing $110 million. Burkle says that Lampert misinterpreted his maneuvers, and that he acted only because one of Lampert's colleagues told him that ESL was not going to put any more money in. "We never would have gone in when somebody was kidnapped and tried to do a deal around him," says Burkle.

In any case, by the time Kmart emerged from bankruptcy in May 2003, a year ahead of schedule, Lampert had invested some $800 million. When his debt converted to equity, he found himself with a commanding 54 percent ownership stake.

WHEN LAMPERT WAS 14, HIS FATHER died of a heart attack at age 47. A lawyer, he nonetheless left the family, which lived in the middle-class town of Roslyn, N.Y.,

with virtually no savings. Lampert's mother took a job as a clerk at Saks Fifth Avenue.

Eddie worked in various warehouses -- stocking shelves, picking orders -- after school and on weekends to help support her and his younger sister, Tracey. "He was a child, and then suddenly he was a man," says his mother.

Eddie handled the pressure. He earned good grades, made time for soccer and basketball, won the scholar athlete award at his high school. He got financial aid to help pay for Yale, where he majored in economics and was inducted into Phi Beta Kappa and Skull & Bones.

"Even back then Eddie was intense," says Steven Mnuchin, his college roommate, who now runs Dune Capital in Manhattan and sits on the board of Sears Holdings. After college Lampert landed a job at Goldman Sachs, persuading Robert Rubin to let him join his risk-arbitrage unit.

The decision-making process he learned working for the future Treasury Secretary (now Citigroup vice chairman) -- envisioning possibilities and their inherent risks -- has shaped him as an investor, he says: "In investing, you constantly make decisions under conditions of uncertainty."

After four years the 25-year-old Lampert decided he didn't want to build his career inside someone else's money machine. In early 1988 he moved to Texas to work with Richard Rainwater, whom he had met in Nantucket a few months earlier. Rainwater gave him seed money to launch his own equity fund, which Lampert dubbed ESL. "Eddie works harder than anyone I've ever seen," says Rainwater.

He recalls that when he owned the Texas Rangers (with George W. Bush), he would take the guys from his office to the stadium on sunny afternoons to play baseball. "Eddie would come with us, but he'd be there with his papers spread out on the right-field stands."

Lampert cringes at Rainwater's portrayal. "Richard's office was like Grand Central Station," he says. "Richard would say, 'Joe Smith is coming to town. Let's all have lunch with Joe Smith.' I'd say, 'No, I have my work to do.' "

He split with Rainwater after a year and a half over a disagreement about his role. Lampert pushed to get involved in deals, but Rainwater wanted him to stay focused on buying and selling stocks. "It wasn't that I thought I'd do deals," says Lampert, who was 27 when he set out on his own, taking ESL with him. "But I was hell-bent on the principle that I should have the flexibility to do deals." He adds, "The irony is that I didn't do a deal until 15, 16, 17 years later."

That first deal was Kmart. During ESL's early days, Lampert was an ordinary passive investor. "I bought IBM two years after Lou Gerstner got there," he says. "They had an incredible services business, but most investors were focusing on the mainframe and PC businesses, so IBM's valuation was low. In four or five years, we made four or five times our money."

Starting in the late 1990s with Auto-Zone and then AutoNation, he became more active, attacking capital spending and playing a key role in replacing top management. He took heat from some critics, who charged that he was pursuing short-term fixes that could end up hurting the companies.

But the stocks of AutoZone and AutoNation continued to rise, and ESL still counts both among its core holdings. Lampert's tactics back then -- and critics' reactions to them -- would become a model for his future deals.

WHEN KMART EMERGED FROM BANKRUPTCY in 2003, Lampert quickly cut spending, reduced inventories, and halted what he calls "crazy promotions" to clear out merchandise.

"For the first year or so, we had declining same-store sales, but more stores made a profit. To some people, it looked like a plane that was going from 40,000 feet to 20,000 feet, and in five minutes from now, it's going to hit the ground. We said, 'We're going to land this plane.' And we did." The stock didn't just land, it soared.

By summer 2004, Kmart was solidly profitable and building a $3 billion cash pile. The retail novice was proving everyone wrong. The buzz on the Street was that Lampert planned to milk the company for cash, using Kmart's real estate as his secret cache.

Lampert exploited the moment.

In June he announced the sale of some 70 Kmart stores -- 5 percent of the base -- to Sears and Home Depot for more than $900 million. The figure was so high, Kmart stock zoomed on the news. Lampert's stake, acquired for $800 million, was now worth about $4 billion.

But Lampert had another card to play. His hedge fund had also quietly accumulated almost 15 percent of Sears over the previous four years. In selling 50 Kmart stores at a premium price, he'd spotlighted the weakness of Sears management. With Wall Street convinced that Kmart had gotten the better of the deal (Home Depot's purchases were deemed more strategic), Sears stock dipped.

That opened the door to phase two of Lampert's plan: to use Kmart to take over Sears. On Halloween weekend of 2004, Lampert and Sears CEO Alan Lacy sat down in Lampert's Greenwich home. Lampert prodded Lacy to sell him the company. After endless bad news -- sales declines, profit shortfalls, and 75,000 job cuts -- Lacy was exhausted. Kmart's $12 billion takeover was announced three weeks later.

Not long after, Lampert placed a call to Arthur Martinez, who had run Sears during a short-lived revival in the late 1990s. Martinez had recharged the company (and its stock) by reducing costs, imposing new financial discipline, and luring female shoppers with the "Softer side of Sears" campaign. Martinez had an office in Greenwich not far from ESL, and on a mild winter day he walked the few blocks over for a visit.

Lampert greeted him warmly, though the two had never met before. "Do you think I've done something crazy?" Lampert asked Martinez when they sat down. Martinez didn't answer him directly. "You have taken on the most complex retail integration task in history," he replied.

Martinez recalls that Lampert wanted to know how he had gone about changing a vast bureaucratic organization. "I told him that it was far harder than I thought it was going to be," Martinez says. He'd underestimated "the cultural challenge," he told Lampert, and should have cleared out the old guard more quickly. Says Lampert: "He was helpful. The changes he made didn't stick, so the turnaround stalled out."

Lampert got the message, though his strategic approach is not what Martinez's would have been. He replaced CEO Lacy, who was Martinez's successor, with retailing newcomer Aylwin Lewis, 51, a restaurant industry man and former president of YUM Brands (owner of Pizza Hut, Taco Bell, and Kentucky Fried Chicken) whom he had hired to run Kmart just before the Sears deal was announced.

"He's been on an incredibly steep learning curve," says Lampert of Lewis, with whom he talks frequently and e-mails constantly.

A few months ago, CEO Lewis recalls, he asked Lampert, " 'Where do you end and I begin?' Eddie said, 'Why do you have to know that? This is a partnership.' " Lewis is pragmatic. "You check your ego at the door," he says. "Eddie is a nontraditional leader. I've learned to be nontraditional."

Lampert found Sears a new marketing chief too, not by using a recruiter but by querying a tech world contact who steered him to IBM. Lampert, who admires the company for its cultural revival, asked Maureen McGuire, a 30-year IBMer, to meet him at his ESL office. McGuire recalls asking Lampert, " 'Why would you hire me? I have no retail experience.' He told me, 'That's exactly why I want you. I need somebody with fresh eyes.' "

Lampert's right hand at ESL, Bill Crowley, 48, is now his eyes and ears at Sears headquarters, typically spending three days a week there. "We don't use discounted cash flows out five years and weigh it against the cost of capital," says Crowley, whom Lampert installed as Sears' CFO and chief administrative officer. "We talk about how much money we are making right now, and how that can change."

At times it seems as if Lampert's only passion is in tightening the operations. (One experiment in expansion, new stores called Sears Essentials that put Sears brands like Craftsman, Kenmore, and DieHard into Kmart's off-the-mall locations, has already been scaled back after a subpar rollout.)

Says Morgan Stanley's Greg Melich, a bear on the stock: "You could find specialty retailers that have scaled down to something sustainable. But among general-merchandise retailers, there's no example of long-term success."

"The notion of spending money on the business -- I'm not opposed to it. I just want a return for it," Lampert says. That attitude has certainly helped free up cash flow: Sears Holdings ended 2005 with more than $3.5 billion on its books. But how is Eddie going to create long-term value? He offers no specifics. When I propose one popular speculation -- that if improved operations don't get the stock moving soon, he will begin selling off more real estate and maybe even Sears house brands like Craftsman -- he laughs, simply saying, "No." In other conversations he suggests that rather than unload the company's prime properties, he'd like to better exploit them -- he calls Land's End, for one, "a strategic asset." But he offers few details.

In other words, we just have to trust him -- as his hedge fund investors have. (He demands a five-year minimum commitment from them, and refuses to tell them what he's investing in.)

He points to three role models that together may say more about where he's going than any retail initiative he might float: Bob Rubin, who claims that the best decision-makers keep their options open until the last reasonable moment; Bill Belichick, the coach of the New England Patriots football team, who befuddles and outwits his opponents by constantly adjusting the game plan; and Warren Buffett, who turned from investor to business builder by acquiring operations at good prices and rearranging the cash flow, in many cases to invest elsewhere. "The entrance strategy is actually more important than the exit strategy," Lampert says.

Could Sears Holdings evolve into another Berkshire Hathaway? "One of the unspoken secrets about business leaders is that they often have no idea about where they're going to end up," Lampert says coyly. "I know the right direction. Whether we end up at the destination -- rebuilding Sears Holdings into a great company on many dimensions -- I don't know. But we're headed in that direction."

IN LATE JANUARY, LAMPERT TAKES ME for a walk-through of the Kmart in White Plains, N. Y., 20 minutes from his Greenwich office. He points out that he redirected the toothpaste display to the end aisle, and carps that the bath towel section needs classier signage.

His mother has joined us, and we sit down on Martha Stewart patio chairs in the outdoor-furniture section for a chat. "I never thought he would go into retail," Dolores Lampert says. "It's a very hard business. But it's a challenge, and Eddie likes a challenge."

She talks about how he'd been accepted to both Harvard and Yale law schools after college, and how crushed she was when he told her he was going to Goldman Sachs instead. "I didn't know what Goldman Sachs was," she recalls, adding: "I called my mother and I cried. I was hysterical."

I ask Dolores Lampert what Eddie's greatest insecurity is. She pauses, and almost chokes up, then replies, "This is a terrible thing to say, but it's that he won't live long enough to complete all his goals." His mother goes on, saying how Lampert writes his goals on a yellow legal pad, just like his father did before he died. "But Eddie won't die young," she says, not looking at him. "He'll probably live into his 90s."

Lampert is sitting quietly, watching us but involved in his own thoughts. "I want to be known as a great businessman," Lampert had told me earlier. With all he's accomplished, you might think he'd feel like one already. But Lampert has bigger aspirations, even if he's mostly mum about them. Sitting there in the Kmart with his mother, he agrees that he worries about dying young like his dad did.

"If you had asked me the question, I wouldn't have answered that way. But that is the right answer." And then he goes silent. Perhaps he is calculating the probabilities and, whatever they may be, thinking that he has no time to waste.

Also: How Eddie Lampert picks his stocks