Walter Schloss was one of the great value investors of the last century. Schloss learned how to find value under Benjamin Graham, who he worked with for a period early in his career. Schloss liked to buy stocks cheap and hold them, a strategy he followed right up until his death in 2012.
According to some reports, Schloss even helped Warren Buffett (Trades, Portfolio) get out of his deep value positions quickly when he closed his Buffett Partnerships at the end of the 1960s. Buffett reportedly called Schloss and asked him to bid for the whole portfolio, which he duly did.
One dollar invested in the Schloss Partnership at inception (1956) was worth around $650,000 by 2000. A similar investment in the S&P 500 returned only $150,000.
As a value investor, Schloss wanted to own companies that were trading at a deep discount to his estimate of intrinsic value, and not at a discount to each other, as he made clear in a letter to a financial publication in December 1974.
Schloss wrote his letter in reply to another analyst who had declared:
"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."
To which Schloss replied:
"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."
In his letter he went on to say:
"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."
Even though Schloss made this comment nearly 50 years ago, it has aged exceptionally well.
Valuing stocks is more of an art than a science, and as a result, there is no set template. Every company has its own unique qualities and bull-bear points. These issues cannot be streamlined into a single ratio or data point.
Warren Buffett (Trades, Portfolio) believes that an analyst can only truly calculate a company's intrinsic worth if they know the industry the business operates in well, and has a certain degree of certainty around its growth potential. When you have an understanding of the company, its sector and growth potential, you can estimate its cash flows far out into the future with a certain degree of confidence.
As some companies have much stronger competitive advantages than others, it stands to reason that these companies deserve a higher valuation than their low-quality competitors.
Detailed fundamental analysis is essential to reducing risk in investing, which means researching the intricacies of each business and calculating an intrinsic value based on these data. Using relative valuation is an attempt to streamline this process and arrive at an answer without having to put in the extra work. This may only lead to disaster.
As Schloss outlines in his quote above, relying on relative valuation may mean that you end up overpaying for terrible businesses and avoiding good businesses because they look more expensive than the rest of the market. That is not key to successful investing.
Disclosure: The author owns no share mentioned.
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