This article on Walter and Edwin Schloss’ Favorite investing strategies was written by Luis C. Sánchez. Luis is a lawyer and private investor in Bogotá, Colombia who focuses on net net stocks. He is an expert in corporate law and he passed the CFA Level I exam. He manages stocks for his personal account and for clients. Article image (creative commons) by Marco Verch Professional Photographer and Speaker, edited by the Broken Leg Investing.
The father and son investing team of Walter and Edwin Schloss deserve a place in the Value Investors Hall of Fame. Not only did they consistently beat the market for almost five decades, but they did so by keeping it simple.
When asked about their investment strategy, they always answered: “We buy cheap stock."
But, every value investor says that, right?
Well, the thing is, in their case, there was no doubt about it because their favorite investing strategies were net nets and low price to book value stocks.
Walter and Edwin Schloss’ investing prowess reminds me of the story of my family’s apple pie recipe.
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If It Ain’t Broke, Don’t Fix It
My great-grandmother was born near the end of the 19th century and lived for 106 years. I only have vague memories of her, but I keep one precious gift she left for the family: her handwritten cookbook.
Of all the recipes she threw in there, one stands out: the apple pie. It is just perfect, delicious, and all the family loves it.
Now, only my aunt actually knows how to follow that recipe, and she bakes that apple pie we all love every once in a while for special occasions. She has done so for as long as I can remember.
A couple of years ago, though, young family members questioned the recipe for health concerns. “Sugar is bad for your health," they said, so the apple pie shouldn’t have sugar. The recipe should be updated — some said: “upgraded."
At first, I said: “If it ain’t broke, don’t fix it. I mean, sure, sugar is bad for your health — if you have too much of it. But a piece of apple pie once in a while, won’t do you any harm.”
The older generation agreed with me — initially.
But as my young relatives kept talking about sugar related health-issues — mainly obesity, and diabetes — some of the initially reluctant older members questioned the recipe too.
A few days after the discussion, my aunt told me she had been thinking about it, and that as there were sugar “substitutes” available nowadays, she could just use one of them instead of sugar in the apple pie.
I didn’t want to be the only one in the family who supported “bad” habits, so I ended up joining the revolution.
“How bad could it be?” I asked myself.
I even asked my aunt to bake the sugar-free apple pie for my next birthday!
And she did.
That day, there were some expectations in the family — not because of my birthday, but because of the upgraded sugar-free healthy apple pie.
Someone served me a slice of apple pie. There it was, looking exactly like all the other apple pies I’d had before.
I grabbed a spoon and attacked that pie. There was something off about its texture, though. It wasn’t as soft as before. The pie didn’t just melt with the touch of my spoon. I was a little disappointed.
But it could still taste the same, right?
As I tasted that first bite, disappointment washed over me. I looked around the room as others who'd pushed for this change slowly chewed their bites. They wore similar dismayed looks.
With that one bite, the revolution died. My great-grandmother's recipe remains unchanged ever since.
Walter and Edwin Schloss’ story is about keeping the recipe unchanged.
Edwin Schloss’ Father Meets Benjamin Graham
Walter Schloss didn’t go to college. He went to Wall Street in 1934 to work as a clerk. However, he took some investing courses at night at the New York Stock Exchange Institute, where Ben Graham taught.
Attending Graham’s courses, he learned about value investing and got hooked immediately, although he didn’t have any money to invest.
When World War II came, Walter Schloss enlisted, and while he was still in the service he got a letter from Graham that said: “Have you a chance to come work with me?”
After a couple of years in service, in 1946, he started working for Graham at Graham-Newman, where he learned the recipe to beat the market. Warren Buffett worked there too.
The recipe was very simple: buy a group of deeply undervalued stocks, wait for the price to match the value, then sell, and repeat the process indefinitely.
Graham’s Recipe for Beating the Market
Graham lived through the Depression. For that reason, his investing strategies focused heavily on downside protection, not on profit potential.
To guard against losses, Graham’s first rule was to use very conservative valuation metrics. If a stock’s price was very low — even compared to the most conservative valuation metrics — then he’d be interested.
He called it the margin of safety.
Graham was very skeptical about business valuations based on past or future earnings.
Earnings are “manageable” to a certain degree, and future earnings are pure speculation. But assets are real, and their reported values are usually lower than their market values.
For example, at Graham-Newman, Schloss’ and Buffett’s work consisted of pouring through Value Line surveys and finding stocks selling for prices either below their liquidation values (i.e., the value of their current assets, minus all their liabilities — both short- and long-term, as well as off-balance-sheet — and preferred stock) or below their tangible book value (i.e., the value of their tangible assets, minus all their liabilities).
But stocks that were cheap even in relation to these very conservative valuation metrics had an “ick” factor to them. They were either lousy businesses or had poor management — or a combination of both.
So, obviously, to that extent, an investment in such companies was risky. The business could go bankrupt, or never recover at all, or there could be fraud in the reported numbers.
Well, Graham found that, although individually considered these companies looked troublesome, as a group they were not risky at all.
Consider companies selling for prices below their liquidation values: even if the business liquidated, Graham recovered his investment and even made a profit.
But the company could stay permanently undervalued, or have off-balance sheet liabilities that wiped out the equity.
For that reason, Graham diversified extensively, owning more than 100 stocks at a time. Around 30% of his stocks wouldn’t work out, but even then he’d make a profit.
Graham averaged 20% returns annually for more than twenty years just buying tons of net nets and selling them when they reached their liquidation values. He called it “a foolproof method” to beat the market.
The downside was protected, indeed, but the profit was quite spectacular as well.
Puts the lie that you have to take on more risk if you want higher returns!
Walter Schloss Follows the Recipe
Graham retired in 1955, and Walter Schloss decided to start his own business with 19 partners and $100,000.
He liked stocks selling at prices below their liquidation values — also known as net nets — but eventually this kind of bargains dried out in the American stock market, so he turned to tangible book value instead which, in his words, was “a little lowering our standards, because book values have some good and bad features”.
But that doesn’t mean he changed the recipe at all. Low price to tangible book value is still a highly conservative valuation metric, as it relies heavily on asset values.
He just followed Graham’s recipe to the letter, buying a very diversified basket of undervalued stocks — up to a 100 different stocks at a time — and selling them for a profit.
In his first decade in business, he beat the market by a wide margin.
With Edwin Schloss, the Original Recipe Remains Unchanged
Edwin Schloss joined his father in the business in the ’70s, and he learned the recipe too.
By that time, asset-based valuation methods were already a thing of the past.
Following the publication of John Blurr Williams’ book The Theory of Investment Value (1938), analysts all around the world had come to the conclusion that the value of any business is equal to the present value of its future cash-flows.
This means that analysts had to rely on earnings forecasts to assess the value of any business.
Even Buffett had shifted towards this valuation method by then, trying to buy companies selling at big discounts to the present value of their future cash flows.
Buffett did wonderfully at this, of course. But Walter and Edwin Schloss didn’t mind. They stuck to what they knew. They kept the recipe unchanged.
Walter and Edwin Schloss didn’t trust earnings for the same reason Graham didn’t: they could be manipulated. Asset values, on the other hand, were more dependable.
Buffett referred to Walter Schloss in his famous article The Superinvestors of Graham and Doddsville as follows:
“He owns many more stocks than I do — and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.”
Leave earnings forecasts to the crowd. Walter and Edwin Schloss just liked the taste of cheap assets better.
Edwin Schloss: Expected Returns of Net Nets and Low Price to Book Value Stocks
Walter and Edwin Schloss did pretty well by sticking with Graham’s recipe, earning a 16% compounded annual growth rate (CAGR) over a 40-year span.
But can you and I expect similar returns in today’s stock market?
First, let’s talk about net nets’ expected returns. Not only well-respected value investors like Graham, Buffett, and Schloss testified to how powerful net nets are, but academic research also shows that a basket of net nets massively outperforms the market in the long term.
Oppenheimer studied a 12-year period starting in 1970. A basket of net nets outperformed the market during that period by a factor of two, for a 31% CAGR.
In 1981, Joel Greenblatt, Richard Pzena and Bruce Newberg published a paper that concluded that buying a basket of stocks at prices below liquidation value — i.e. net nets — had a CAGR of around 40% for the period studied (1972 to 1978).
James Montier, a renowned value investor, also published a paper on Japanese net nets, studying their performance from 1985 to 2007. During that period, the Japanese stock market returned a lousy 5% CAGR, while Japanese net nets gave an impressive 20% CAGR.
Although past returns are not predictors of future returns, the case for a net net strategy is solid enough as it is. However, you won’t find many net nets in American stock markets today. You have to look around the globe for them.
At Net Net Hunter, you can find shortlists of carefully selected net nets from around the world to fill your portfolio.
What Is Walter and Edwin Schloss’ Preferred Strategy?
Now, what if you want to invest only in the US and Canada, for example? You could load your portfolio with low price to book value (P/B) stocks, which just happen to be Walter and Edwin Schloss’ favorites.
Most studies that compare value investing strategies show that buying a basket of stocks at low P/B yields about a 13% CAGR. That’s not as impressive as net nets, but it’s still above average.
However, at Broken Leg Investing, we developed the Ultra strategy, which incorporates additional selection criteria for low P/B stocks that boost their performance to around a 20% CAGR.
Enter your email address below and we’ll send you information about the Ultra strategy and other great deep value strategies available today for individual investors plus a free copy of The Broken Leg Investment Letter.