Value Investing: From Graham to Buffett and Beyond’s Profile of Walter and Edwin Schloss Part 2

A few weeks ago, we talked Bruce Greenwald’s fantastic “Value Investing: From Graham to Buffett and Beyond” and the chapter and Walter and Edwin Schloss. We continue the second and final part of the series with this post.

“Edwin Schloss pays attention to asset values, but he is more willing to look at a company’s earnings power. He does want some asset protection. If he finds a cheap stock based on normalized earnings power, he generally will not consider it if he has to pay more than three times book value. “

• We have noted in previous posts that when analyzing Schloss’ old holdings, there were some companies in the list that had never traded below 2.0x book. This finding, that Edwin Schloss, paid up a bit, jives with the data.
• In my opinion, the key phrases in this quote: “Normalized Earnings” – Remember both Walter and Edwin Schloss like to go back at least 20 years in terms of financials. More often than not during that 20 year period there will be a couple of booms and busts (in terms of cycles). With that information in hand, you can look at where margins will fall in the steady state. I.E. You are not going to look at a homebuilder and use 2004 and 2005 volume and margin numbers to get a sense of normalized earnings power.

“When they begin to take a hard look at a new company, the Schlosses make sure to read the annual report thoroughly. The financial statements are important, no doubt, but so are the footnotes. They want to be certain there are no significant off-balance sheet liabilities. They look at the history of capital spending to see what conditions the fixed assets are in. A company that has a fully depreciated plant may be reporting higher earnings that a rival that has just completed a new factory, but if the rival has spent its money carefully, it is likely to have a more modern and efficient operation. Ten years of advertising expenses don’t show up on the balance sheet, but they do create some value for a brand, provided that the company knows how to exploit it. The Schlosses are looking for recovery potential. The stocks they buy have become cheap for a reason, and their success lies in their ability to form a sufficient accurate estimate of whether or not the market has overreacted.”

• In my opinion, this is why the Schlosses can’t be called robots. They are not just picking statistically cheap stocks – they are looking for things the market may have missed or overreacted on. For instance, if a company has spent a significant amount of capital in the last few years their margins will be lower than an older company (depreciation schedules are different). This can cause companies to miss EPS numbers – something I am sure the Schlosses do not care about – when the market overreacts and the stock price falls over the “Schloss cliff” they are ready to pick it up on the cheap
• Very good point about off balance sheet liabilities. For instance, a number of retailers carry very little corporate debt but a massive amount of operating leases which (in my opinion) need to be capitalized to get a better sense for the true leverage of a company
• Remember – these stocks are cheap for a reason – your job as a value investor is to determine where the market is wrong.

“Because the Schlosses hold their positions on average for four or five years, they have time to become more familiar with the company. They continue to look at each quarterly report, but they do not obsess about day to day price swings or two-cents-per share earnings disappointments or positive surprises…Since everything about their approach orients them towards companies that are not in rapidly changing industries in which technological innovation may undermine value in weeks, if not days, they can afford to sit back and wait.”

• Again, note the four to five year holding period.
• As noted above, they care less about earnings misses.
• Just like Buffett, the Schlosses tend to avoid technology. What I find interesting about this quote is if you look at the stock holdings of the Schlosses over the years there are a smattering of these sorts of companies (including bio tech). I’ll try to reconcile this in future posts.

“Still, when asked to name the mistake he makes most frequently, Edwin Schloss confesses to buying too much of the stock on the initial purchase and not leaving himself enough room to buy more when the price goes down. If it doesn’t drop after his first purchase, then he has made the right decision. But the chances are against him. He often does get the opportunity to average down – that is, to buy additional shares at a lower price. The Schlosses have been in the business too long to think that the stock will now oblige them and only rise in price. Investing is a humbling profession, but when decades of positive results confirm the wisdom of the strategy, humility is tempered by confidence”

• In the book, the paragraph about the one noted above read: ”The disappointments or reduced expectations that have made it cheap are not going away any time soon…” This is so important: Too often investors will see a “Schloss Cliff” in a stock and start buying – it takes time for the market to digest certain information – why do you think the Schlosses hold for 4-5 year. In my opinion, current investors are far too impatient to try to mimic the successes of Walter and Edwin Schloss
• I remember once reading that Walter will buy a small position to understand what it feels like to own a stock and then maybe own a 1/2 position after a certain time period – That gives me a lot of room to double up to make up as it were

“The decision to sell a stock that has not recovered requires more judgement that does selling a winner. At some point, everyone throws in the towel. For value investors like the Schlosses, the trigger will generally be a deterioration in the assets or earning power beyond what they had initially anticipated. The stock may still be cheap, but the prospects of recovery have now started to fade.”

• This paragraph above is basically the deadly value trap that so many value investors struggle with. These value traps are almost always still cheap on any statistical basis – but either the business is deteriorating in some way not first anticipated or the margin of safety has eroded
• Seth Klarman once wrote that when his thesis for an investment turns out to be wrong, he sells and re-evaluates. I hear similar sentiments from the paragraph above.

“The Schlosses run a diversified portfolio, but they do it without prescribed limits on the size of a position they will take. Though they may own 100 names, it is typical for the largest 20 positions to account for around 60 percent of the portfolio. They have occasionally had up to 20 percent of their fund in a single security, but that degree of concentration is a rarity. They are buying cheap stocks, we must remember, not great companies with golden futures…Diversification is a safeguard against uncertainty and an essential feature of the Schlosses’ successful strategy…Although they are not going to end up with a portfolio invested in one or two industries, they will overweight their holdings when they find cheap stocks clustered together in out-of-favor sectors. At times like these, they can pick the better companies within these discarded securities. If the price of a commodity such as copper has plummeted, then copper related stocks will be on sale…Companies with low costs that are not overburdened by debts are safe bets at these times, primarily because nobody wants to own them.”

• Some great portfolio manager advice here: I’ve also noticed in running a portfolio that I will find cheap companies in one sector (for example, medical tech and defense are very cheap sectors right now). With that, my allocations will start clumping up – but because the investments I make (from an equity standpoint) run with very little leverage, I have confidence they will make it through to brighter prospects.
• I might have mentioned this once on my other sites (or this one for that matter), but I once saw Carl Icahn speak about his strategy – he buys companies (via the debt) in beaten down industries – reduces leverage dramatically and wait for the cycle to turn – very similar to what Schloss is doing.
• This diversification strategy is so Graham like – some investment will be terrible, but a few will be doubles and triples which more than make up for the losses.
• So often the sell side looks 1 – 2 years in advance – If copper was dirt cheap, in some point in the future, it will become more valuable – as long as a company is not burdened by debt and can not burn cash flow (i.e. low cost), things will turn out alright.

Before closing up, my favorite quote from the chapter:

“It may also explain why the Schlosses do not disclose to their partners the names of the companies whose shares they own. In the main, they invest in unpresentable securities, stocks no one wants to brag about at cocktail parties or anywhere else.”

That is value investing to a tee – Unheard, unloved, hated names (with little debt remember).

For further reading on value investing with Walter and Edwin Schloss, please purchase the book. Or of course, check back for future value investing posts.