Value Investing with Walter Schloss

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.