This article on simple value strategies for big returns was written by Thomas Niel. Thomas is a private investor, a financial blogger and an accountant in Washington DC. Creative Commons photo by MichaelGaida, edited by The Broken Leg.
Learning more about the legends of value investing can inspire your personal investing strategy. While Warren Buffett achieved notoriety far beyond the value investing niche, there are several other Graham disciples who built impressive investing track records of their own. One of the most successful Graham disciples is Walter Schloss, whose life and career may be the most relatable to small value investors.
Schloss’s humble beginnings and Horatio Alger-esque life story are inspiring on their own, but his “old school” mechanical approach to investing gives small investors key insight into how to structure a deep value portfolio even in today’s ever changing market.
Schloss took the concepts laid out in Graham’s teachings and incorporated them into his own style, yet stayed close to the fundamentals laid out in Security Analysis. He did this so well that Buffett himself took notice, naming him one of the “Superinvestors” in his 1984 counter to the Efficient Markets Hypothesis titled The Superinvestors of Graham-and-Doddsville.
In this article, Buffett pointed to how numerous alumni of Graham’s — including Walter Schloss — had long-term track records that beat the market, arguing it was impossible for this to be pure luck.
From Floor Runner To Graham Protégé
Walter Schloss came of age at a time when a career on Wall Street could be more bootstrap than white shoe. Despite having only a high school education, he rose from the bottom of the financial world to become one of the first hedge fund managers.
In those days, getting your foot in the door of a Wall Street firm literally required “pounding the pavement.” Schloss started off as a floor runner — the young men who hustled from the brokerage house down to the exchange floor to send in orders and exchange stock certificates.
Around the time of Schloss’s start on Wall Street in 1934, the New York Stock Exchange expanded its continuing education program (The New York Stock Exchange Institute, later called the New York Institute of Finance). The Institute helped build up the competencies of Wall Street’s rank-and-file, most of whom lacked any formal education or certification in finance.
Schloss wanted to move up from the back office to an analyst role on Wall Street. After a potential employer told him to gain more education in order to get ahead, Schloss seized the opportunity and began taking courses at the institute.
Right Place, Right Time To Learn From The Best
Similar to Buffett, Walter Schloss first met Benjamin Graham in the classroom. During this time, Graham lectured at the NYSE Institute, teaching students about the investing theories he mapped out in Security Analysis.
The statistical approach Graham took to investing fascinated Schloss. Taking Graham’s course laid the foundation upon which he built his career as a value investing legend.
In a classic story of “it’s who you know, not what you know,” Schloss built up a relationship with Ben Graham via Graham’s brother, Leon. Leon was a broker, and Schloss had invested his life savings with Leon shortly before leaving to fight in World War II. Coming back to Wall Street after the war, Benjamin Graham offered Schloss an analyst job at his firm. In 1946, Schloss reported for work at Graham-Newman.
In the early 1950s, Schloss and Buffett worked together at Graham-Newman, scouring S&P manuals for undervalued stocks. The Graham-Newman partnership served as an incubator of future value investing talent, hatching the famed “Superinvestors.”
Graham-Newman’s decision to close up shop in 1955 opened the floodgates for a new generation of value investors to go out on their own. Buffett went back to Omaha to set up the first Buffett partnership. Walter Schloss also decided the time was right to go into business for himself. Gathering a coterie of investors, he set up his first (and only) fund — Walter Schloss Associates (later Walter & Edwin Schloss Associates) would manage money for 47 outperforming years.
Just like the Buffett Partnership, Schloss’s operation was skeletal: a one-man operation with little overhead, and marketing via word-of-mouth rather than through shameless self-promotion. While Schloss was operating in the center of the action (New York), he was still on an island of his own, carving a niche by scouring the deep value space.
The Walter Schloss Investing Playbook
Unlike Buffett, who has a more fluid investing approach, Walter Schloss preferred a “by-the-book” Graham-style method of identifying and investing in undervalued stocks.
As his son and business partner Edwin put it, “We try to buy stocks cheap.” The fund was market cap agnostic, looking at value wherever it found itself (large cap, mid cap, small cap). Given the difficulty of investing globally at the time, Schloss invested only in American stocks.
In 1994, Schloss wrote a list detailing the key factors needed to make money in the stock market. These may sound boilerplate to experienced value investors, but they offer key lessons for anyone looking to invest on their own:
- Price is the most important factor to use in relation to value.
- Establish your own valuation for a company.
- Use book value as your valuation starting point (avoid companies with high debt-to-equity).
- Have patience.
- Don’t buy on tips, and don’t sell on bad news.
- Be a contrarian, but make sure you are right in your opinion.
- Have courage and conviction in your investment decision.
- Stick to your investment philosophy.
- Don’t sell just because the stock popped; reassess your valuation and base a sell decision on the facts.
- Try to buy at multi-year lows.
- Your value focus should be on discount to book rather than earnings-based valuations.
- Listen to ideas from others you respect, but don’t buy on their opinion alone.
- Invest with your brain, not your heart.
- Always remember the power of compounding.
- Stick to stocks over bonds for long-term, inflation-adjusted gains.
- Be careful with leverage.
As seen from these key points, Schloss preferred stocks selling at a discount to tangible book rather than discount to peers. In Schloss’s mind, earnings were volatile, but for the most part tangible book remains stable.
By using book value as a parameter, investors can have sufficient margin of safety while they wait for a company to straighten itself out. A stock selling for 50% of book value can easily double back to par value if a string of losses turn into quarterly profits. A company selling at a high valuation built on growth models can easily crash when growth expectations fail to deliver.
He also was wary of high leverage, both in his portfolio and the companies he bought. A company may be selling at a large discount to book, but that matters little if bankruptcy wipes out the shareholders.
Schloss was also a big fan of high insider ownership, knowing it indicated management confidence in potential upside. However, Schloss rarely spoke with managers, only traveling to shareholder meetings if they were within a 20-mile radius. He shared Graham’s belief that speaking too much with managers taints your objective opinion of a company.
When assessing the quality of a company’s management, Schloss preferred integrity over smarts. As he put it in a 1989 interview with Outstanding Investor Digest:
“In a choice between a smart guy with a bad reputation or a dumb guy, I think I'd go with the dumb guy who's honest. Of course, you can't always protect yourself there, either. I guess the mistakes we've made are probably in those areas.”
These “rules of investing” were relevant in Walter Schloss’s day, and they remain relevant for today’s small value investor. Keeping things simple and sticking to a time-tested value approach can lead to big gains over the long term.
Schloss’s Mechanical Approach To Portfolio Construction
In his 1984 article, Buffett best summarized the Schloss method of asset allocation:
“He knows how to identify securities that sell at considerably less than their value to a private owner: And that’s all he does ... 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 is one of his strengths; no one has much influence on him.”
Schloss did not get “up close and personal” with the stocks he bought; he didn’t travel coast to coast to get insight from corporate managers, and he didn’t try to handicap every minute detail that could affect a company. Not that Schloss bought deep value stocks at random — he conducted general due diligence of a company’s financials, but he didn’t try to overthink his way out of an investment opportunity.
He spread his bets widely, sometimes investing just $10,000 into a stock. The fund’s portfolio typically consisted of around 100 stocks. Even with a highly diversified portfolio, Schloss regularly beat the market over the long run.
Schloss preferred to take small initial positions, buying more if the spread between trading price and intrinsic value continued to widen. Focusing on stocks with low leverage was an important part of this; the market can stay irrational longer than you can stay solvent, making it important to buy stocks that will avoid filing Chapter 11.
It is interesting to see the similarities between the Walter Schloss investing strategy and our approach at The Broken Leg: Walter Schloss knew it was tough to “predict the unpredictable,” but from his personal experience had the confidence to bank on the historical long-term outperformance of deep value stocks.
Super Returns From A “Superinvestor”
Walter Schloss’s longevity (he lived to be 96) gives us an idea of what a long-term deep value track record looks like:From 1956 to 2002, Schloss generated an annualized return of 15.3% (versus 10% for the S&P).
A key factor in Schloss’s long-term performance was the small scale of his operations; unlike other money managers who grow and grow (and grow), Schloss preferred to maintain a smaller capital base. At the end of the year, he would distribute realized gains to investors.
While the opportunity cost to Schloss’s personal bottom line may have been material, sometimes bigger is not always better.
Let Walter Schloss’s Old-School Deep Value Investing Style Inspire You!
Of all the “Superinvestors” of Graham-and-Doddsville, Walter Schloss may be the most relevant to today’s small value investor.
Buffett is the top dog, but the strategies he currently employs are likely out of your reach. When a financial crisis hits, you’re probably not getting calls from General Electric and Goldman Sachs to buy preferred stock at favorable rates!
Walter Schloss kept things simple — when he set up shop in the mid-’50s, he had only one file cabinet; when he closed up shop, this had only grown to four. Operating from a room adjacent to his apartment in the last years of his fund, Schloss’s investment operation more resembled a DIY investor than a professional money manager.
Schloss never strayed far from his obscure corner of the market. He never “leveled up” to the role of business mogul. Even in the last years of his life, after closing his fund and managing his personal capital, he continued with his “old school” manual screening method: scouring Value Line for new deep value investment ideas.
Value investing may be tougher in a world where money never sleeps, but don’t let that discourage you! Schloss’s old-school style of investing still holds relevance in today’s markets:
- Your key criteria should be discount to Net Current Asset Value (NCAV) or tangible book value.
- Screen for low levels of debt to equity. A highly leveraged company on its way to Chapter 11 may erroneously appear “cheap” on a stock screener.
- Insider ownership is another important criteria. If management is not confident in future performance, why should you be?
- Build a widely diversified portfolio. For long-term performance, it is valuation, not your understanding of a company’s intricacies, that will make you money in the markets.
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