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.
Hi,
thank you very much for your instructive answer.
Hunter,
Why do you like the 17x earnings multiple?
Thanks
There is outlook profit interview with Edwin Schloss (I did get it from Outlook Profit but its no longer available)…It was a great one and he says he is not at all like Walter Schloss who buy only when the price is below Book Value..He also suggest book by Mary Buffet (1st Edition)
Thanks
Vishnu