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  • While this value investing blog is intended to focus on some of the original members of the Graham Newman Corporation, the news that Warren Buffett has named one of his successors to the CIO position for Berkshire Hathaway deserves its own post.  This is major news in the value investing world and I will try to bring you as much information as I can from various sources from the value investing community.

    To start, here is the full text from the news release:

    Omaha, NE (NYSE: BRK.A; BRK.B)—Berkshire Hathaway is pleased to announce that Todd Combs will soon be joining Berkshire as an investment manager.
    Warren E. Buffett, Berkshire’s CEO, commented “For three years Charlie Munger and I have been looking for someone of Todd’s caliber to handle a significant portion of Berkshire’s investment portfolio. We are delighted that Todd will be joining us.”
    Todd is 39 and has been managing Castle Point Capital for the past five years. Simultaneously with the issuance of our announcement, Todd issued a letter to the limited partners of Castle Point Capital announcing his decision to join Berkshire.
    Berkshire Hathaway and its subsidiaries engage in diverse business activities including property and casualty insurance and reinsurance, utilities and energy, freight rail transportation, finance, manufacturing, retailing and services. Common stock of the company is listed on the New York Stock Exchange, trading symbols BRK.A and BRK.B.

    So, obviously some pretty enormous news.  What have I been able to find about Todd Combs?

    Todd Anthony Combs graduated from Florida State in 1993.  According to Carol Loomis, Combs worked for Florida’s comptroller and then went on to set automobile insurance rates at Progressive (is he an actuary?).

    In 2002, Combs graduated from Columbia’s Business School.  Warren Buffett attended Columbia business school, studying under Ben Graham.  In addition, we know he has a soft spot in his heart for graduates from Columbia:  Buffett hired Ian Jacobs, also a Columbia graduate earlier in the decade to be one of his “project guys.”    It has been reported in the press that Ian went off to start his own fund in 2009.   I have not heard much about his since.

    Prior to starting Castle Point, Combs worked at Cooper Arch Capital which has since closed.  From the press release, we know that Combs started Castle Point 5 years ago. Castle Point was seeded by Stone Point Capital, a well regarded, for lack of a better term, private equity investor in financials and financial services.   Their website is down now (massive traffic?).

    Castle Point is a long/short hedge fund that is focused on financials.  It was formed in 2005.  According to Bloomberg, Combs was up 13.6% in 2006, 19% in 2007, down 5.7% in 2008, and up 6.2% last year.  It is reported Castle Point was running with $400M of capital recently.

    We know from various press reports that Comb was the third pick of Buffett and Munger with Li Lu turning down the position and an unnamed other manager also turning it down.  An interesting theory being floated around is Bobby Bierig  is the unnamed second person in the running – Bierig is Lou Simpson’s #2 at GEICO (and a former ESL employee) and will, according to sources in the value investing community, be leaving to start his own hedge fund soon.

    Nonetheless, Comb got the nod and our hats are off to him.  Good on you.  It remains to be seen what role Combs will actually play – will he manage just the GEICO book?  Will he be partioned off a couple of billion to see how he does?  We know Warren had 4 choices in mind – Li Lu, Combs, possibly Biergin and one more.  Combs will be stay in CT to run the Berkshire capital.

    We know that Combs was under EVERYONE’s radar.  Typical Buffett.  He has always said he wanted someone that wanted the job for the job itself: not the publicity or the money.  A search on Todd Combs from a few days ago would have turned up 2-3 results…now millions.

    You can find his 13F all over the web…but here are some other tidbits people have yet to stumble upon:

    We know Castle Point is located at 20 Horseneck Lane in Greenwich.  One Craig McBeth was listed as an analyst at Castle Point Capital (same address as above).   From looking at his Linked In profile, he is listed as a partner at Castle Point Capital and previously worked at Lehman Brothers (he graduated from Amherst in 2004).  On July 22nd, 2010 MB Financial held their 2nd quarter 2010 earnings call.  On that call, during the Q&A session, McBeth (listed in the as from Castle Point) asked a few questions of management.  Here is the relevant exchange:

    Your next question comes from the line of Craig McBeth of Castle Point Capital. You may proceed.

    <Q – Craig McBeth>: Hi. Thanks for taking the question. Just on the potential problem loans, possible to say how much of the increase in early stage DQs and also NPLs came out of that potential problem bucket from the first quarter?

    <A – Tom Prothero, Chief Operating Officer, Commercial Banking>: Most of the increase in the non-performers was out of the potential problem buckets from the prior quarters.

    <Q – Craig McBeth>: Okay. And I mean any of the charge-offs this quarter come directly from that bucket?

    <A – Tom Prothero, Chief Operating Officer, Commercial Banking>: We did have some charge-offs on the C&I side. The charge-offs that were – companies related to construction, real estate and housing. Some of those deteriorated very, very quickly and they bypassed the potential problem bucket.

    <Q – Craig McBeth>: Okay. And just on the real estate owned. I heard what you’re saying about the legal hang-ups in foreclosure process, but I think you also said you expect that OREO line to increase. Is that case going to be different than we’ve seen? It’s been just a few million each quarter recently.

    <A – Tom Prothero, Chief Operating Officer, Commercial Banking>: Well, we have several deals in the pipe, if you will, where we have negotiated a deed in lieu arrangement or deed in the box, and I do expect, some of those to come to fruition in the coming quarters, as well as loans that are just going to go through the regular foreclosure process that were getting close. So, I do expect it to continue to go up, probably at a higher faster pace than it has in the last two quarters.

    <Q – Craig McBeth>: Okay.

    <A – Tom Prothero, Chief Operating Officer, Commercial Banking>: And of course, we do continue to sell some other real estate every quarter, so there – what you’re seeing in the increase is net.

    <Q – Craig McBeth>: Right, right, okay. What I’d, I mean the sales should increase as things get into that bucket as well. Right?

    <A – Mitchell Feiger, President and Chief Executive Officer>: I’m sorry, I couldn’t hear your question.

    <Q – Craig McBeth>: The sales of real estate should, you can’t sell them until you own them, right?

    <A – Mitchell Feiger, President and Chief Executive Officer>: Correct.

    <Q – Craig McBeth>: So hopefully, those will increase in line with the gross change?

    <A – Mitchell Feiger, President and Chief Executive Officer>: Yes, we would anticipate that sales at some point would increase as well.

    <Q – Craig McBeth>: Okay, just one unrelated question, can you say what the fee income is today coming from debit?

    <A – Jill E. York, Vice President and Chief Financial Officer>: I can. I thought that question might be asked, its, hold on, one second.

    <A – Mitchell Feiger, President and Chief Executive Officer>: From which part – which part of — are you speaking of debit card interchange or what…

    <Q – Craig McBeth>: Yes, that’s what I was thinking of but I mean.

    <A – Mitchell Feiger, President and Chief Executive Officer>: Debit card interchange revenues.

    <A – Jill E. York, Vice President and Chief Financial Officer>: Yes, it’s about 5 million a year.

    <Q – Craig McBeth>: Okay. All right. Thank you.

    Similarly, on February 12th, 2010, Penson Worldwide held their 4Q 2009 conference call.  Again Craig McBeth asked management a number of questions:

    [Operator Instructions]. Your next question comes from the line of Craig McBeth of Castle Point Capital.

    <Q – Craig McBeth>: Hi, thanks for taking my question.

    <A – Phil Pendergraft, Chief Executive Officer and Co-Founder>: Of course.

    <Q – Craig McBeth>: Sorry, if I missed this, but just on Broadridge, I was hoping you could elaborate on the specific products that you wouldn’t support and just maybe why?

    <A – Phil Pendergraft, Chief Executive Officer and Co-Founder>: Yes, the – probably the biggest one is in the area of mortgage-backed TBA processing. I don’t know how familiar you are with that market. But

    <Q – Craig McBeth>: Not very.

    <A – Phil Pendergraft, Chief Executive Officer and Co-Founder>: It’s – it is very capital and it’s actually very cash intensive. And the – the return on the cash and capital allocated to support that business is sub-par. And – and so that’s a business line that we’re not in today. And that we really have no interest in expanding into. And that there is a portion of Broadridge book of business that is heavily focused in that area and that’s not a good fit.

    <Q – Craig McBeth>: Okay, and is that – can you size that?

    <A – Phil Pendergraft, Chief Executive Officer and Co-Founder>: It’s in that – that 15, 20. I mean in total it’s in that 15, $20 million delta between the current run rate and where we think we’re going to be, I don’t actually have the exact breakdown of what it might be or what that component is.

    <Q – Craig McBeth>: 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:

    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.”

    “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.”

    “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.”

    “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.”

    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.”

    “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.”

    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.

    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.”


    “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:

    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.