: Okay. Thanks.

So, a little insight into their investment process there. I am still trying to locate Comb’s letter to his partners and will be sure to post it when it hits the wires. This is indeed huge value invest news and we look forward to keep readers up on the story in the coming weeks.

A few weeks ago, we talked Bruce Greenwald’s fantastic “Value Investing: From Graham to Buffett and Beyond” and the chapter and Walter and Edwin Schloss. We continue the second and final part of the series with this post.

“Edwin Schloss pays attention to asset values, but he is more willing to look at a company’s earnings power. He does want some asset protection. If he finds a cheap stock based on normalized earnings power, he generally will not consider it if he has to pay more than three times book value. “

We have noted in previous posts that when analyzing Schloss’ old holdings, there were some companies in the list that had never traded below 2.0x book. This finding, that Edwin Schloss, paid up a bit, jives with the data.

In my opinion, the key phrases in this quote: “Normalized Earnings” – Remember both Walter and Edwin Schloss like to go back at least 20 years in terms of financials. More often than not during that 20 year period there will be a couple of booms and busts (in terms of cycles). With that information in hand, you can look at where margins will fall in the steady state. I.E. You are not going to look at a homebuilder and use 2004 and 2005 volume and margin numbers to get a sense of normalized earnings power.

“When they begin to take a hard look at a new company, the Schlosses make sure to read the annual report thoroughly. The financial statements are important, no doubt, but so are the footnotes. They want to be certain there are no significant off-balance sheet liabilities. They look at the history of capital spending to see what conditions the fixed assets are in. A company that has a fully depreciated plant may be reporting higher earnings that a rival that has just completed a new factory, but if the rival has spent its money carefully, it is likely to have a more modern and efficient operation. Ten years of advertising expenses don’t show up on the balance sheet, but they do create some value for a brand, provided that the company knows how to exploit it. The Schlosses are looking for recovery potential. The stocks they buy have become cheap for a reason, and their success lies in their ability to form a sufficient accurate estimate of whether or not the market has overreacted.”

In my opinion, this is why the Schlosses can’t be called robots. They are not just picking statistically cheap stocks – they are looking for things the market may have missed or overreacted on. For instance, if a company has spent a significant amount of capital in the last few years their margins will be lower than an older company (depreciation schedules are different). This can cause companies to miss EPS numbers – something I am sure the Schlosses do not care about – when the market overreacts and the stock price falls over the “Schloss cliff” they are ready to pick it up on the cheap

Very good point about off balance sheet liabilities. For instance, a number of retailers carry very little corporate debt but a massive amount of operating leases which (in my opinion) need to be capitalized to get a better sense for the true leverage of a company

Remember – these stocks are cheap for a reason – your job as a value investor is to determine where the market is wrong.

“Because the Schlosses hold their positions on average for four or five years, they have time to become more familiar with the company. They continue to look at each quarterly report, but they do not obsess about day to day price swings or two-cents-per share earnings disappointments or positive surprises…Since everything about their approach orients them towards companies that are not in rapidly changing industries in which technological innovation may undermine value in weeks, if not days, they can afford to sit back and wait.”

Again, note the four to five year holding period.

As noted above, they care less about earnings misses.

Just like Buffett, the Schlosses tend to avoid technology. What I find interesting about this quote is if you look at the stock holdings of the Schlosses over the years there are a smattering of these sorts of companies (including bio tech). I’ll try to reconcile this in future posts.

“Still, when asked to name the mistake he makes most frequently, Edwin Schloss confesses to buying too much of the stock on the initial purchase and not leaving himself enough room to buy more when the price goes down. If it doesn’t drop after his first purchase, then he has made the right decision. But the chances are against him. He often does get the opportunity to average down – that is, to buy additional shares at a lower price. The Schlosses have been in the business too long to think that the stock will now oblige them and only rise in price. Investing is a humbling profession, but when decades of positive results confirm the wisdom of the strategy, humility is tempered by confidence”

In the book, the paragraph about the one noted above read: ”The disappointments or reduced expectations that have made it cheap are not going away any time soon…” This is so important: Too often investors will see a “Schloss Cliff” in a stock and start buying – it takes time for the market to digest certain information – why do you think the Schlosses hold for 4-5 year. In my opinion, current investors are far too impatient to try to mimic the successes of Walter and Edwin Schloss

I remember once reading that Walter will buy a small position to understand what it feels like to own a stock and then maybe own a 1/2 position after a certain time period – That gives me a lot of room to double up to make up as it were

“The decision to sell a stock that has not recovered requires more judgement that does selling a winner. At some point, everyone throws in the towel. For value investors like the Schlosses, the trigger will generally be a deterioration in the assets or earning power beyond what they had initially anticipated. The stock may still be cheap, but the prospects of recovery have now started to fade.”

This paragraph above is basically the deadly value trap that so many value investors struggle with. These value traps are almost always still cheap on any statistical basis – but either the business is deteriorating in some way not first anticipated or the margin of safety has eroded

Seth Klarman once wrote that when his thesis for an investment turns out to be wrong, he sells and re-evaluates. I hear similar sentiments from the paragraph above.

“The Schlosses run a diversified portfolio, but they do it without prescribed limits on the size of a position they will take. Though they may own 100 names, it is typical for the largest 20 positions to account for around 60 percent of the portfolio. They have occasionally had up to 20 percent of their fund in a single security, but that degree of concentration is a rarity. They are buying cheap stocks, we must remember, not great companies with golden futures…Diversification is a safeguard against uncertainty and an essential feature of the Schlosses’ successful strategy…Although they are not going to end up with a portfolio invested in one or two industries, they will overweight their holdings when they find cheap stocks clustered together in out-of-favor sectors. At times like these, they can pick the better companies within these discarded securities. If the price of a commodity such as copper has plummeted, then copper related stocks will be on sale…Companies with low costs that are not overburdened by debts are safe bets at these times, primarily because nobody wants to own them.”

Some great portfolio manager advice here: I’ve also noticed in running a portfolio that I will find cheap companies in one sector (for example, medical tech and defense are very cheap sectors right now). With that, my allocations will start clumping up – but because the investments I make (from an equity standpoint) run with very little leverage, I have confidence they will make it through to brighter prospects.

I might have mentioned this once on my other sites (or this one for that matter), but I once saw Carl Icahn speak about his strategy – he buys companies (via the debt) in beaten down industries – reduces leverage dramatically and wait for the cycle to turn – very similar to what Schloss is doing.

This diversification strategy is so Graham like – some investment will be terrible, but a few will be doubles and triples which more than make up for the losses.

So often the sell side looks 1 – 2 years in advance – If copper was dirt cheap, in some point in the future, it will become more valuable – as long as a company is not burdened by debt and can not burn cash flow (i.e. low cost), things will turn out alright.

Before closing up, my favorite quote from the chapter:

“It may also explain why the Schlosses do not disclose to their partners the names of the companies whose shares they own. In the main, they invest in unpresentable securities, stocks no one wants to brag about at cocktail parties or anywhere else.”

That is value investing to a tee – Unheard, unloved, hated names (with little debt remember).

For further reading on value investing with Walter and Edwin Schloss, please purchase the book. Or of course, check back for future value investing posts.

In 1996, Walter Schloss gave a lecture at the Behavioral Economics Forum at the Harvard Faculty Club in Cambridge, Mass. The speech, entitled “Why We Invest The Way We Do”, is a summary on how Walter and Edwin Schloss approach value investing at their investment partnership. This speech can be found here:

Walter Schloss and Value Investing: “Why We Invest The Way We Do”

Here are my notes from the speech:

Schloss does not approach investing as a science. His term “part art and part science with some boundaries.”

Walter and Edwin Schloss are not behavioral economists – they just buy cheap stocks: “…it’s just bargain hunting.”

As referenced before, Schloss decries the increased number of value investors in the field which makes finding value increasingly difficult

Believes in significant diversification which he knows many of his counterparts at other investing firms do not necessarily subscribe to

Ben Graham said: “We buy stocks like groceries not like perfume.”

Does not disclose stock holdings: They do not want competition. What is interesting, and something I have not thought about before: By telling other investors that you are long XYZ company, and XYZ company begins to fall, you, by disclosing your position and thoughts, may have set an effective floor on the holding thereby making it more difficult for you to buy it at a lower price.

Buying depressed stocks reduces their stress. Fantastic! Points to the fact that his low stress attitude has enabled him to manage the fund for 40 years.

Looks to protect on the downside, “and, if we are lucky, something good may happen.” Reminds me of the quote: “Focus on the downside and the upside will take care of itself.”

Again points out the problems with talking to management of ailing companies: “When we buy into a company that has problems, we find it difficult talking to management as they tend to be optimistic. ” Again points out that they are not the best judge of character so they are playing to their strengths here.

Pays out their realized gains at the end of each year. Average holding period = 4 years.

Incredible Quote: “We want to buy cheap stocks based on a small premium over book value, usually a depressed market price, a record that goes back at least 20 years…and one that doesn’t have much debt.”

Second Incredible Quote: “Price is the key factor in the purchase of a stock compared to what we think the company is worth.”

Does not manage large amounts of capital and so does not have the issues that big money managers have.

“If you are honest, hardworking, reasonably intelligent and have good common sense, you can do well in the investment field as long as you are not too greedy and don’t get too emotional when things go against you.”

As always, another incredible cache of information from Walter Schloss on Value Investing.

Many players in the value investing world regard Bruce Greenwald, value investing professor at Columbia Business School, director of research at Eagle Asset Management, and contributing author of Value Investing: From Graham to Buffett and Beyond as the definite resource on value investing. He is a valuable contributor to the development of student’s value investing acumen at Columbia and beyond. I think the man is absolutely brilliant and voraciously read whatever content I can get my hands on where I can learn from his thoughts.

One of Professor Greenwald’s great contribution to the value investing community is his book (along with Judd Kahn, Paul Sonkin, and Michael van Biema) “Value Investing: From Graham to Buffett and Beyond.”   In the book, there is an entire chapter dedicated to Walter and Edwin Schloss. I would like to take a number of quotes out of the book (this will be a two part series). I strongly encourage all, whether just out of college and learning or the very experienced among us, to read the book (I’ve read it three times). It is chalk full of knowledge. Without further ado, let’s get back to Walter and Edwin Schloss.

“Over the entire 45-year period from 1956-2000, Schloss and his some Edwin, who joined him in 1973, have provided their investors a compounded return of 15.3% per year…Every dollar a fortunate investor entrusted with Schloss at the start of 1956 has grown to $662 by the end of 2000, including all charges for management. A dollar investing in the S&P Index would have been worth $118.”

These are incredible numbers. 45 years of ~15% compounding turns $1 dollar into $662. It shows you the power of compounding

What I find interesting is that Schloss actually massively outperformed the market in the late 90s. This is quite a different experience to what any value investors dealt with in the late 90s

Note: These are returns to investors (i.e. the LPs). I have still not found the exact payment scheme Walter and Edwin used for their fund, but can you imagine the return to the GP? It’s out of this world

“Their office – Castle Schloss has one room – is spare; they don’t visit companies; they rarely speak to management; they don’t speak to analysts; and they don’t use the Internet. Not wanting to be swayed to do something they shouldn’t, they limit their conversation. There is an abundance of articulate and intelligent people in the investment world, most of whom can cite persuasive reasons for buying this stock or that bond. The Schlosses would rather trust their own analysis and their long standing commitment to buying cheap stocks. This approach leads them to focus almost exclusively on the public financial statements that public firms must produce each quarter.”

This philosophy/culture is so different than the ones I have been a part of over the past eight years. “What does the sell side think?”, “What does XYZ analyst think of this bond?”, “Have you spoken to management?” etc. Even the great Seth Klarman has said in interviews that he talks to the buy side and sell side for investment ideas. With that said, Walter Schloss has repeatedly said that he is not the best judge of people and hence he is playing to his strengths

Continuing that point, Michael Burry once noted that his investing style was HIS investing style. He did not go out to try to emulate Warren Buffett, Ben Graham, or some of the other greats. He picked and chose which practice / qualities worked for him, his temperament, his strengths, his weaknesses, etc.     We want to look at the “Schloss” framework through this lens. None of us are Walter or Edwin Schloss, but we can surely learn from them

“Ask either Schloss about his investment strategy and you will get the same succinct response: We buy cheap stocks. Identifying “cheap” means comparing price with value. What generally brings a stock to the Schlosses’ attention is that the prices has fallen. They scrutinize the new lows list to find stocks that have come down in price. If they find stocks is at a two or three year low, so much the better…The Schlosses are especially attracted to stocks that have gapped down in price – stocks where the price decline has been precipitous.”

The new low list is a fantastic place to identify undervalued fractional shares of business. Much behavioral finance articles have written extensively about investors over-reaction to bad news

Another place to look to is the new low Price / Earnings, Price / Book, etc. Harder to data to get your arms around, but can really bring up interesting values (for example a number of large caps are trading at the lowest multiples they have ever traded in their corporate history)

“When they find a cheap stock, they may start to buy even before they have completed their research. They have at least a rudimentary knowledge of thousands of companies, and they consult Value Line or the S&P stock guide for a quick check into the company’s financial position. Both Schlosses believe that only way really to know a security is to own it, so they sometimes stake out their initial position and then send for the financial statements.”

We have heard from Walter Schloss that he does indeed believe that owning a small position in a stock in par for the course for the partnership. I do this as well (allocating may 0.25% position in my portfolio to a prospective name). As you can emotionally separate yourself from the investment, you should be ok. Why do I do this? I like to see how the security moves with the market

I love how the articles states that he sends for the financial statements. Warren Buffett does the same thing (remember from above: the Schlosses don’t use the internet).   On most investor relations websites you can request financials and annual reports – seems like a legitimate use of the internet

On finding stocks less than 2/3 of working capital:

“But sometimes after 1960s, as the Depression became a distant memory, those opportunities generally disappeared. Today most companies that meet that requirement are either so burdened by liabilities or are losing so much money that their future is in jeopardy. Instead of a margin of safety, there is an aura of doubt.”

So true: I just ran a screen for companies trading less than book. A good number of companies came out. And then I added the criteria of minimal debt. 50% of the stocks were eliminated. Then I added the criteria: “Positive Earnings in any of the last three years.” Another 50% were eliminated. Slim pickings.

“If a company has a tangible book value of $15 per share, then even if its not earning money at the moment, the chances are good that the value of the assets will not drop precipitously. An investor paying $10 or even $12 per share has comfort in knowing that the assets are there to back up the shares. And in Schloss’ long experience, company’s whose shares can be bought for less than the value of the assets will, more often than not, either return to profitability or be taken over by another firm. All of this may take time; their average holding period for a stock is around four years. Walter has the patience to hold on. The underlying bet he is making is that over reaction by the market has offered him a bargain, and that given enough time will be rewarded…Though he tends to make his initial purchase before the stock has bottomed, and likes the opportunity to add to his position at lower prices, he also sleeps better at night knowing that if there is a cliff out there, his shares have already fallen over it.”

Note, the article points out “tangible book value” – We will have to remember that when we start building our own Walter Schloss value investing screen

Looks like the wheel house is anything less than 0.8x book

What is interesting: And bear with me for a minute – I once heard Carl Icahn speak on his investing strategy. Essentially what he does is buy the debt of a company at a deep discount to book value to gain control of a company’s equity. Post the bankruptcy, the company will be essentially debt free. And he knows that industry assets fluctuate dramatically in value over time. He buys when no one wants any asset in an industry and then sells the asset when everyone is clamoring for assets in that same industry. And since the company has no debt, he can just wait.

Again we note four year holding period.

The cliff analogy is incredible – I have found some of my best successes over the years with a company that has drifted lower over a couple years and then boom – some earnings miss, or other negative news, and the stock drop 15-25+%. To me, this nearly always feels like capitulation or even a portfolio manager “just having enough” with this particular security.   Emotional, anguished sellers are the ones I like best to buy from.

Next week we will continue our value investing series with the second part of the Value Investing: From Graham to Buffett and Beyond‘s look at Walter and Edwin Schloss and their value investing strategy.

One of the reasons I started a value investing blog on Walter Schloss, Irving Kahn, early Warren Buffett and other members of the Graham-Newman Corporation was my fascination on how rare their early investment style is still applied today. I think we can all agree that finding 2/3 net/nets as Ben Graham prescribed is difficult. That being said, far too often we hear about GARP or EV/EBITDA versus as asset based approach so effectively employed by Walter Schloss.

In 1985, Barron’s ran a story entitled “The Right Stuff: Why Walter Schloss is Such a Great Investor.” You can find a link to the piece in our value investing resources page. In this post, like one of our earlier Walter Schloss posts on the blog, I will be using bullet points to document my notes.

Interesting point about how Barron’s had not heard of Walter Schloss until Warren Buffett blew his cover in the ever famous “The Superinvestors of Graham-And-Doddsville”

Walter recounts how he got into the business. It is interesting to note that in this interview, he says “Graham was writing his book on the stock market, and I remember helping him with one chapter.” I never knew that part of the story – this is all before Schloss had enlisted.

Very heartily recommends The Intelligent Investor

Compares Ben Graham to an undervalued security: “It’s a funny thing about Graham. I think he was like an undervalued security, if you want to know. People said, ‘Oh, Ben Graham, he’s very smart.’ But then they’d go off and do their own little thing with computers, or whatever the popular thing was at the moment. They kind of forgot. They’d say ‘Oh, we like undervalued stocks,’ but then they wouldn’t buy them.” He then goes on to point out that Graham’s ideas made perfect sense to him.

Ben Graham’s philosophy on buying a diversified pool of stocks stems from the pain he experienced during the Great Depression.

At Graham Newman they followed “the idea of buying companies selling below working capital – at two thirds of working capital – then, when the stocks’ prices went up to match working capital per share, we’d have made 50% on our money. And the firm averaged about 20% a year on that basis.” Schloss, like I noted above, then goes on to note that during the fifties, those stocks started disappearing.

Why did these stocks trade at these levels previously? “They were mostly secondary companies; they were never the top grade companies. And they tended to be ignored by the public because they didn’t have any sex appeal, there wasn’t any growth – there was always trouble with them. You were buying trouble when you bought these companies, but you were buying them cheap. Of course, when you got them too cheap, they maybe ended up going down the tubes. So you try to be a little careful. But people don’t like to buy things that are going down.”

Philosophy: “Graham liked the idea of protection on the downside and basically, that’s what I do. I try not to lose money.”

When asked what he think the market will do, his response: “I’ve got no idea; your guess is as good as mine.”

Schloss on timing: “Timing is a very – everybody tries to do it, so I stay away from the game that everyone’s trying to do. If you buy value – and you may buy it too soon, as undoubtedly I do – then if it goes lower; you buy more. You have to have confidence in what you are doing.”

Again using five years as a yardstick. But notes their average holding period is 4 years.

Liked to stay under the radar.

On his investing style: “I am a passive investor. There are people who try to be very aggressive; they try to buy companies [Editor Note: Remember this is during the LBO Boom of the mid to late 80s]. We just buy the stock, and if it goes to what we think is a reasonable price, we sell it and move on to something else. Graham made the point in his book where he said, ‘You buy stocks like you buy groceries, not like you buy perfume.’ You’re looking for value.”

No ticker tape machine in his office – he tries to stay away from the emotions of the market. The market appeals to fear and greed – He doesn’t want to be a part of that.

Blames Warren Buffett for the uprise in value investing and how hard it is to buy cheap stocks.

Gives an anecdote about a stock that Schloss purchased for the fund and then the company was bought out shortly thereafter: “But the point is, if it hadn’t worked out that way, Stauffer was a really good company, and in a few years it would have worked out satisfactory. It happened to work out quicker, that’ all.”

Doesn’t like short term gains.

On the insert lists the rationale’s for a number of his stock picks:

“The downside is limited…so you buy it”

It isn’t exactly cheap. But it’s a good value.”

“Basically a good company and there will be another deal”

“It does have problems. I can’t say that enough.”

“The timber is worth a lot more than the market price.”

“You couldn’t replace it for what it sells for.” (On Texaco)

“A good value stock. They had a terrible break.”

“There’s no particular point selling it. I have a big profit.”

“It’s got a lot of cash flow”

Note that he was managing $45M in 1987

Notes that Graham returned a substantial amount of his limited partners capital when he couldn’t find cheap stocks in 53′.

On portfolio management: “The thing is, we don’t put the same amount in each stock. If you like something like Northwest Industries, you put a lot of money in it. But we may buy a little bit of stock, to get our feet wet, and get a feeling for it. Sometimes if you don’t own a stock, you don’t pay enough attention. Then also, we sell stock on scale. Sometimes we sell some, and then stock poops out on us, and then we’re stuck.”

Continuing: “Sometimes we get into situations where we really don’t sell at all. So we have more securities than I’d like to have, and yet, I feel comfortable owning them. Then, of course, you get a situation where you buy the stock, and it seems a good value, and it goes up a fair amount, and you like it better. You become a little more attached to it, and then you see some pluses that you may not have realized before.”

The quote above confuses me: Does he mean you like the stock because it has gone up or because you’ve done more work on it and got lucky with the price action?

Adjusted Working Capital = Current Assets – Current Liabilities – Debt

Again notes about management holding stock – seems to be very import to Walter Schloss

Talk about analyzing the balance sheet: “And of course a lot of companies have lots of assets tied up in plant and equipment. Well is it an old plant, or is it a new plant?

“You don’t have to just look at book value. You can look at what you think companies are worth, if sold. Are you getting a fair stake for your money?”

Talks about a “good company” and dubs it a “not a book value stock.” (For reference, the company was selling at 10x earnings, 5.5% dividend yield, 1.5x book, 15% ROE)

Here is a very interesting quote (probably my favorite in this article): When asked why “park money” in a stock: “If the market was very low, I’d say ‘Well, CPC probably isn’t a great stock to own. If the market is so cheap, you want something with a little more zip in it, or potential.’ In a market like ours, which is not very cheap – I wouldn’t say its way overpriced, because it isn’t; it’s in a more reasonable area-there’s more risk on the downside. CPC probably doesn’t have that much downside risk, and therefore I feel comfortable with it. If the market should collapse, we, then maybe we’d sell it, assuming we’d be getting that price, and buy something that’d gone down a lot.”

Notes how he doesn’t get involved in looking at earnings potential.

Why difficult to sell? Upward price movements feed on themselves …

On holding cash: “We’ve never really done that. We’ve always been fully invested. Which may be good, and may not be good – it’s psychological. I find I’m more comfortable being fully invested than I am sitting with cash.” …very different from a number of Value Investing Legends…

Note he doesn’t play in options, doesn’t write covered calls, doesn’t short stocks

Noted that Graham thought when there were no working capital stocks, the market was overvalued…Schloss does not that theory does not really apply anymore.

Schloss on the market: “I simply say, if there are not too many value stocks that I can find, the market isn’t all that cheap.”

Simply incredible. Stay tuned later in the week when we explore more value investing articles on Walter Schloss and start digging into some securities.

Irving Kahn was a fellow employee of Walter Schloss at the Graham-Newman Corporation. Kahn Brothers Advisors, LLC manages over $500M of institutional and private capital. From their website:

“Our chairman, Irving Kahn, got his start in value investing in 1930s while serving as Benjamin Graham’s teaching assistant at Columbia University. Over time, our investment philosophy has evolved from Graham’s original “discount to net asset purchase” model. We now target a many different types of companies including, in particular, businesses purchased at a discount to their private market, transactional or going-concern value. Still, in the tradition of Graham and Dodd, our investing discipline continues to stress three key words: margin of safety.”

And…

“We study companies and try to find undervalued securities… We’re absolute value investors focusing on asset values, book value discounts and low price to earnings ratios to normalized earnings. And we aren’t interested in so-called relative values — you know, something selling at 20 times earnings in an industry group with a 35 multiple.”

-Thomas Graham Kahn, “Outstanding Investor Digest”

Last week, Kahn Brothers & Co released their 13F detailing holdings as of 6/30/2010. Here is the filing:

Some quick points:

Kahn Brothers only bought one stock during the quarter: BP

Likewise, they only sold one stock during the quarter: USEC

The company did add to a number of positions as well as sell off a number of positions during the quarter.

You will note the median Price / Book for the fund is 1.3x. This compares to the S&P 500′s P/B of 1.98x. Obviously, value is playing a part of this portfolio.

In terms of industry concentrations – Simply put, there are a lot: 43% in Financials and 37% in Health Care.

Position concentration is also greater than you see in most 13Fs: The top 5 names make up 50% of the portfolio with the top 10 names making up nearly 75% of the total assets.

The largest percentage increase in holdings during the quarter was Patterson UTI Energy (still a relatively small position)

We know that Schloss and Graham both espoused significant diversification in holdings. That being said, we also know Schloss has recommended going up to 10% in a limited partnership setting. It looks like Kahn brothers is doing something similar, but with a little more concentration. We plan to bring you more coverage of Irving Kahn, Kahn Brothers and their 13Fs in the future.

Earlier in the week, I wrote a post listing the stocks Walter Schloss had owned during his time managing capital. One of the comments from that post made me do a little digging:

All I have been told about Walter Schloss is that he invests only in net nets. But from that list, it seems net nets are not the only companies he is looking for. I’m not an expert about Wells Fargo or Mc Donald’s but I don’t think these companies have ever traded at a discount to their net current assets (and for Wells Fargo net current assets is just insignificant in fact).

Maybe he uses other Graham techniques, like the 10 year PE, or things like that.

Pulling up the trusty Bloomberg, I confirmed that McDonald’s has never traded near its book value. And then I remembered reading about Edwin Schloss’ influence on his father and the subsequent stock selections of Walter and Edwin Schloss Associates.

This quote comes from one my favorite value investing books: Value Investing, From Graham to Buffett and Beyond. This book has a whole chapter dedicated to Walter and Edwin Schloss (this chapter is required reading for value investors imo). Here is the quote I found most interesting:

“Edwin Schloss pays attention to asset values, but he is more willing to look at a company’s earnings power. He does want some asset protection. If he finds a cheap stock based on normalized earnings power, he generally will not consider it if he has to pay more than three times book value. There are some durable companies in industries such as food, defense, and even plain old manufacturing, that sell for more than book value even when their share prices are depressed. Depending on his estimate of what the companies can earn, Edwin may still find the stock cheap enough to buy.”

Remember: Edwin Schloss joined the partnership in 1973 and the partnership closed in 2001. Edwin must of had a dramatic hand in capital allocation. And that explains why companies like McDonald’s are on that list. Does this relationship remind anyone of two other capital allocators out there? I do not have to tell my astute readers (because they have read it countless times before) the influence Charlie Munger had on Warren Buffett: Cigar Butts to Durable Competitive Advantages … i.e. Moats.

In future posts, I will spend a lot of time breaking down the Schloss chapter in Value Investing. For now though, let us dive into the implications of Edwin’s influence on the stock selection of the partnership.

For the longest time, I too was under the belief that the Schloss’ modus operandi was to buy stocks trading below their tangible book value. When I saw that list, I knew that couldn’t be possible. With that in mind, let’s look at I think the most important part of the quote above: “If he finds a cheap stock based on normalized earnings power, he generally will not consider it if he has to pay more than three times book value.”

Calculating normalized earnings is definitely more an art than a science. But I think one starting point, which Walter Schloss has repeatedly pointed out in past writings and speeches, is that you have to go back on 15 or 20 years of financials to understand a company. There may have been dramatic changes in processes or functionalities that may permanently augment margins, but net/net, the gross margins of a company, with a sustainable competitive advantage, are pretty sticky.

Let’s take a look at McDonald’s: Gross margins, since 1990, at MCD has ranged between 30-40% with an average somewhere around 35%. It has ticked higher recently, but to be conservative, let’s use 35%. SG&A as a % of revenue has been steady at around 10% +/- 1 or 2%. Gross margins less SG&A as a percent of revenue should lead you to EBIT margins (assuming D&A is wrapped into COGs). So using round numbers, MCD will run EBIT margins at 25% using our calculation. Lop off 2% for interest expense to get to EBT margins of 23%. Looking at the last few years, the company is doing $21-23 dollars of revenue per share which would equate to pre-tax earnings of $4.83-$5.30 less long term tax rate of 30% gets me to ~$3.5-$3.75/share in earnings. This backs into 17% profit margins.

Now this is definitely less than current estimates on the account of higher profit margins in recent years at MCD. Will these stick? I’m not sure. I just want to look at normalized earnings. What is a fair multiple for those earnings? 17x is fairly valued so I think MCD is fairly valued at $60-$65/share above. Remember, I said fairly valued. Would I buy MCD there? No – the stock would be cheap at 10-12x normalized earnings.

Obviously this exercise leads to allocating capital who’s current results are less than spectacular of previous years’ results. If a company is currently boasting gross margins of 8-10% and have historically printed 15-20%, then this exercise may turn up a few cheap stocks. The question you need to ask yourself: Is this a temporary problem or a permanent one? What is a value trap? It’s the aforementioned permanent problem.

I hypothesize: If you or I had the ability to 1) 100% correctly determine if a problem was permanent or temporary and 2) We had the temperament (and capital for that matter) to not blow out at the bottom, and instead add as stocks fell…well our results would be spectacular. I think if we set our minds working on problem #1 on a particularly depressed investment instead of whether the fed is going to raise rates, or whether their will be inflation or deflation, or if Greece is going to default, our results would be dramatically better. That is real value investing.

In January 2007, Walter Schloss sent Warren Buffett a list of stocks that he and the Walter & Edwin Schloss Associates partnership owned at one time or another. Here is the list Schloss sent:

Walter Schloss List of Stocks

At a Grant Interest Rate Observer Conference, Schloss was asked the turnover in his portfolio. His answer:

“I guess 20 or 25 percent per year. About every four years we turn over. We want to get long-term capital gains and when you buy a depressed company it’s not going to go up right after you buy it, believe me. It’ll go down. And therefore you have to wait a while for that thing to go around and it seems about, four years seems to be the amount of time it takes. Some take longer.”

Given that Schloss was running around 100 positions at any one time, that would mean, assuming a four year turnover, he would come up with 25 new positions. In the document he lists the stocks he owned in the 1990s. The partnership would have accumulated approximately 250 new positions in that time (all else being equal).

It is interesting to really look at these stocks. I am going to focus on those ones owned post 1990 as those are the ones that seem the most relevant. I am going to jot down some bullet points – If you see anything I am missing, please leave a comment.

Despite previous comments that he abhors debt, this list shows names like Downey Financial, Freddie Mac, and a few other financials. So financials were not a “full stop.” That being said, they are very rare on the list meaning they must have been pretty special situations for Schloss.

Industries really spam the gamut – Lots of basics, industrials, insurance, consumer products. Really everything.

Some of these companies are very high quality – Seems to me Schloss purchased them when they weren’t perceived as such: Schering Plough, Bristol Myers, Diageo, IBM, Disney, Barrick Gold, McDonald’s, Sherwin Williams, JM Smucker, Autozone, Kellogg

Some of these companies have filed (Reader’s, Bombay), but more have been taken out by another purchaser

He notates the document with “Old Holding.” – It would seem these are positions he owned post 1990 which he once owned before 1990. Cigar butt has come back alive for a second puff?

While I consider myself pretty well versed in market history, I have no idea what some of these companies are. I once read a quote that the best cigar butt investment is a company you have never heard of. I need to find that quote.

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This website is about value investing. Under no circumstances is this an offer to sell or a solicitation to buy securities discussed on this site. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise. Schloss-Value-Investing.com, its editor and/or related parties may have positions in companies discussed. All data, information and opinions are subject to change without notice.

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