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Rupert Hargreaves
Rupert Hargreaves
Articles (559)  | Author's Website |

Walter Schloss Explains Why Relative Value Is a Waste of Time

Some advice from Schloss from the archives

June 14, 2018

Relative valuation is the notion of comparing the price of an asset to the market value of similar assets, and it's wrong according to Walter Schloss, one of the superinvestors of value investing.

Schloss is one of value's most renowned investors. He worked with Benjamin Graham and went on to achieve returns of 21% per year for 47 years for partners when managing his own investment firm by investing in deep value equities.

Here's what Schloss had to say about relative valuation in 1974:

"I note in your Editor's Comment in your September/October issue, you quote Sidney Cottle as saying:

'Security analysis is the discipline of comparative selection. Since stocks are only under or overpriced with respect to each other, the process of comparison is going to identify over- and under-priced stocks with roughly the same frequency in good markets and bad.'

I'm not sure what you have said above is what Mr. Cottle means but I must say as a security analyst I take exception to this point of view.

I believe stocks should be evaluated based on their intrinsic worth, NOT on whether they are over- or under-priced in relationship with each other. For example, at the top of a bull market, one can find stocks that may be cheaper than others, but they both may be selling much above their intrinsic worth. If one were to recommend the purchase of Company A because it was COMPARATIVELY cheaper than Company B, he may find that he will sustain a tremendous loss.

On the other hand, if a stock sells at say, one-third of its intrinsic value based on sound security analysis, one can buy it irrespective of whether other stocks are over- or under-priced.

Stocks are NOT over-priced or under-priced compared to other companies but compared to themselves. The key to the purchase of an undervalued stock is its price compared to its intrinsic worth."

The problem with relative value is that it does not take into account each individual situation. If a company is trading at only five times forward earnings, in a truly efficient market, it is trading at this level because it deserves to, even if it may be a discount of 50% the rest of the sector.

Value on assets, not earnings

Valuing each company on its own merits alone was one of Schloss' fundamental skills, and when doing so, he didn't want to use earnings. Instead, the first place he looked for value was on the balance sheet -- among the company's assets. He explained why he favored this approach in a 1989 issue of Outstanding Invest Digest:

"Assets seem to change less than earnings. You could argue that assets are not always worth what they’re carried for. [Ben] Graham made an argument at one point that inventory was a plus, not a minus. In an inflationary period, having a big inventory might be very helpful. While in a deflationary period, a big inventory would not necessarily be good....If you have two companies – one with a plant that’s 40 years old, another with a new plant – both are shown on the books but the new plant may be much more profitable than the old one. But the company with the old one doesn’t have to depreciate it. So he may be overstating his earnings a little bit by having low depreciation.
...

Ben made the point in one of his articles that if U.S. Steel wrote down their plants to a dollar, they would show very large earnings because they would not have to depreciate them anymore. Would that be proper? Of course, he didn’t think it would be. But that means a company could really increase its reported earnings. And that’s only one of the reasons why Edwin and I aren’t wild about earnings. They can be manipulated – legally. If people are just looking at earnings, they may get a distorted view."

In other words, Schloss wanted to eliminate as much as possible the risk that he might mis-estimate a company's intrinsic worth.

If you calculate the intrinsic value based on positively adjusted earnings figures, you could end up with an optimistic estimate of intrinsic value eliminating any margin safety. This coupled with a relative valuation gives you nothing more than a tower of cards.

Disclosure: The author owns no share mentioned.

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website


Rating: 5.0/5 (2 votes)

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Comments

batbeer2
Batbeer2 premium member - 2 months ago

Hi Rupert,

Thanks for another article worth reading.

I'd argue that relative valuation makes perfect sense if relative performance is your goal (for most investors it probably is). Intrisic value is a more logical yardstick if you are looking for superior absolute returns. Then again if you're good enough at value investing (i.e. based on intrinsic value) you get satisfactory results on both counts.

Importantly, the converse is not true and the difference is exactly what could wipe you out.

Rupert Hargreaves
Rupert Hargreaves - 2 months ago    Report SPAM

Hi Batbeer2,

Thank you. I agree with you but I think another takeaway from these words is the flexibility of earnings and how this can result in misleading valuations, especially on a relative basis. Even the best investors will never be able to gain a truly accurate view of a company's figures so we have to lower the probability of succumbing to misleading numbers and widen our margin of safety by focusing on what we know (the balance sheet) and avoiding overly optimistic predictions. After all, you can make anything look cheap if you try hard enough.

Rupert

batbeer2
Batbeer2 premium member - 2 months ago

Yeah, the balance sheet is more fundamental. Economic dynamics aside, if you think of an earnings statement as nothing but the difference between two balance sheets then it is clear why the latter is more fundamental.

That is how I often approach earnings statements. They tell me how that balance sheet came to be. Together they paint a picture of the quality of the business and the accumen of management.

Having said that, the most intersting things (both risks and opportunities) are somewhere between the sheets.

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