Value investing can be divided into two separate groups. One side focuses upon the sustainability of earnings and the efficiency in which the earnings are reinvested, while the other side focuses upon the value of the assets. Walter Schloss is a proponent of the latter camp.
Mr. Schloss started his own investment partnership after leaving Graham-Newman in 1955. The partnership was started with a modest sum of $100,000 which he raised from a small group of investors, including himself. By the end of 1984, Schloss and his son were managing approximately 45 million in assets. In 28 years, Schloss had earned his investors a compounded annual rate of 16.1% (after taking out 25% fees) vs. a compounded rate of 8.4% for the S&P which included dividends. The intent of this article is to provide an in depth description of the investment philosophy which allowed Schloss to dramatically outperform the major indices over many decades.
Assets are Safer than Earnings
Schloss believed that investors should attempt to limit their downside when investing. He felt the best way to accomplish this was to focus on the assets of a company rather than their earnings. The following quotes are from his letter on Factors Needed to Make Money in the Market: "Earnings can change dramatically. Usually assets change slowly." "One has to know more about a company if one buys earnings".
In my experience, the concept that assets outweigh earnings is an extremely contrarian investment viewpoint. Most investors focus on earnings and many are simply unable to purchase shares of a company which is currently losing money. Schloss felt that purchasing discounted assets provided a substantial margin of safety for investors; a notion that he learned from Benjamin Graham. He felt the value of the assets would eventually be recognized if any of the following conditions occurred: the earnings cycle turned, the assets were liquidated and distributed to shareholders, the company was bought out or the management decided to take the company private.
Schloss on the dangers of focusing on earnings for the ordinary investor from the 1985 Barron's interview: "Most look at earnings and earnings potential, well I can't get into that game. This is a little outfit here, to try to compete with big brokerage house analysts, with all their connections and all their information".
If we analyze the 28 year results from 1956 to 1984 provided by the Barron's interview, it appears than Schloss's stategy is validated. During that period, the small group of investors which put their faith and bankrolls into Schloss's fund, not only outperformed the S&P by nearly 8% per year on an annualized basis, they also experienced only six years where the S&P plus dividends outperformed Schloss on a year by year basis. It seems that the Schloss method not only reduces risk, it also provides outstanding returns! http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Walter%20Schloss/Walter%20Schloss%20-%20The%20Right%20Stuff%20-%20Barrons%20-%2002-25-85.pdf
Passive Investment Style
Schloss utilized a passive investment style. He seldom talked to the management of companies in which he invested. He felt that management was generally overly optimistic and listening to their positive view tended to taint the judgement of an investor. Instead he relied on Value Line and a the annual report of a company for his evaluation. Schloss expressed the belief that Warren Buffet was the exception when it came to evaluating management; very few people possessed his skills. Robert Olstein has expressed the same view on numerous occasions in regard to talking to management, although I am of the opinion that the view is not widely held among money managers.
Key Elements when Purchasing Stocks
1) Price is the key factor when purchasing stocks.
Schloss liked to cite Ben Graham's contention that "a stock well bought is half sold". Schloss felt that most stocks become compelling buys at some point so long as they dropped low enough to provide a margin of safety.
2) Price to book value is the key component in valuing stocks.
Schloss rarely purchased stocks which traded at a premium to book value. He felt that a discount to book value offered a margin of safety since most companies were worth at least the price of their assets minus their liabilities. Patient investors would be rewarded if they systematically bought such stocks.
3) Look for stocks which are well off their highs.
Schloss utilized Value Line's list of 52-week lows to find stock leads. However he took it a step farther. He liked to buy companies that were near multiyear lows; noting that sometimes a 52 week low still represented a double or triple off the stock's multiyear bottom.
4) Look for a stock which has at least a 20 year record.
Schloss liked to purchase companies that had a long history of doing business. The ability to survive over a long period suggested that they will continue to do business in the future. It also provided a basis to compare their current book value and earnings per share as well as the ability to view the typical cycle of the business.
Schloss frequently landed on out-of-favor cyclical companies or companies which had recently done something wrong. He would purchase them if he felt that their assets were strong and their long term business prospects were not damaged.
5) Purchase stocks with low debt to equity ratios.
Schloss preferred companies with low debt which provided investors with an additional margin of safety. He warned, "be careful of leverage; it can go against you."
6) Maintain a large diversity of holdings and stay fully invested.
Schloss differed from Buffett in those regards. He generally held about 100 different stocks and rarely was he less than 100% invested without regard to market valuation. He even adjusted his price to book standards upward during periods of high market valuations if a company was paying a good dividend and held a low price to earnings ratio; although he generally mistrusted earnings and relied on dividends as proof of profitability. Later in life he did admit that he would have gone to cash "if the market went crazy."
Personal Traits of Success Investors
Schloss felt that the following personal traits were essential in successful investing and choosing money managers:
2) Hard work
3) Reasonable intelligence
4) Common Sense
5) Emotional Control
Wisdom of Schloss
Schloss observed: "Timidity prompted by past failures causes investors to miss the most important bull markets". That is one of most insightful quotes about value investing which has ever been written. Too bad more people did not read that quote in late 2008 and early 2009. Fortunately for me, I heeded his advice!
The investing style of Walter Schloss fits perfectly for most individual investors and money managers, particularly ones who are able to buy smaller companies. It not only minimizes risk, it also offers the promise of outstanding returns. The style does not require any special talents or an extremely high IQ, merely an even temperment, a good work ethic, and a modicum of common sense.
Most investors, myself included, do not possess the the intellectual insight of Buffett to recognize durable competitive advantages on a regular basis. Nor do we have the talent to scrutinize income and cash flow statements to satisfactorily ascertain their veracity on a regular basis. Schloss provides us with a near infallible alternative by focusing on the assets of a company, rather than their earnings. By following his lead the average investor is afforded a huge advantage over his investment competition. The reason being that the average investor will always put undue emphasis on the current earnings of a business and disregard the value of the underlying assets. These assets are plainly visible on the balance sheet and/or the annual report. That phenomena has not changed since the early days of Walter Schloss nor is it likely to change in the next century. Thank you Walter for your wonderful lesson!
Articles on Walter Schloss:
Hand typed copy of his lecture at Harvard, may 16th 1996 for the Behavioral Economics Forum. http://www.schloss-value-investing.com/wp-content/uploads/2010/06/Why-We-Invest-the-Way-We-Do.pdf
Buffet comments from 2006 annual letter: http://www.foundryasset.co.nz/wp-content/uploads/2010/11/Warren-Buffett-on-Walter-Schloss2006.pdfCopy
1985 Barron's interview with Schloss: http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Walter%20Schloss/Walter%20Schloss%20-%20The%20Right%20Stuff%20-%20Barrons%20-%2002-25-85.pdf
Hand typed copy of Schloss's Factors needed to make money in the markets: http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Walter%20Schloss/Factors%2520needed%2520to%2520make%2520money%2520in%2520stocks%2520-%2520Schloss.pdf