This article is an excerpt from the ebook How To Invest In Stocks Quantitatively: A Quant Toolbox User Guide which is available for FREE download on the Quant Toolbox Page.
People who are new to investing often think that it takes wits, guts, and tremendous amounts of study to become genuinely successful in investing. Well, it is not surprising when the most well-known faces in investing are Charlie and Warren. Charlie Munger, the intellectual who articulated the notion of mental models and latticework, and Warren Buffett, who spends hours every day, reading, and not only on investing. No wonder that some folks keep away from researching their own investments, not because they lack the passion or the time, but because they think that they are just not smart enough.
That false perception changes when one discovers Walter Schloss. Schloss (1916-2012), albeit being one of the greatest investors ever lived, is not well-known outside of the professional investors’ milieu. Ask the beginner investor who Schloss is, and you’ll get a puzzled response.
But that’s a big miss. We can learn so much more from Schloss than we can from Buffett or Munger. Schloss’ approach to value investing is a simple one. He learned the principles of what works in wall street from his teacher and employer Benjamin Graham, and he applies those principles methodically and consistently. In contrast to Buffett and Munger, Schloss does not develop a deep and thorough insight on the intricate facets of the companies and management team he invests in, but rather, he is interested in the quantitative aspects of the stocks he buys. While Buffett and Munger remain a far ideal of super-intelligent and well-educated investing gurus, Schloss is a middle-of-the-road man that every investor can successfully copy.
Walter Schloss managed an investment partnership from 1955 until 2001. His son, Edwin, joined him in managing the partnership in 1973. The Schlosses have returned about 20% a year (15% after fees) vs. 7% a year for the S&P 500 during that period. Here is how Schloss himself describe how he started, in a lecture he gave to Ivey School of Business:
“Well, what happened was – I went to work in 19. My father lost his job and there was really no money in the family. And so I got a job as a runner at Carl M. Loeb & Co., which became Loeb, Rhoades later on. It’s a big brokerage firm, but it was small when I went there. And then, they put me into the cashiers department. A year later I thought I wanna get a little bit more money. I was making $15 a week and I thought I could get a little more. So, I asked about it, if I can get into the security analysis department, which is, they called it statistical department in those days. I spoke to the partner who had gotten me the job as a runner, and I said, could I become a security analyst instead of [indiscriminable], and he said NO. I think, maybe, I had no money and I couldn’t bring in brokerage fees. In those days, all commissions were fixed. So that, the wealthy people would send their family in and they would get fixed commissions. Now, of course, it have become a competitive field. So, anyway, he said, no, you can’t do that. But he said, [read] the book called Security Analysis by Benjamin Graham, and if you read that book, you won’t need anything else. So I got hold of the Security Analysis…that was a very good book. I found that Benjamin Graham who had written the book was a customer of Loeb’s and I could see the stocks they owned. It seems that Loeb would send me to what’s called the New York Stock Exchange Institute. They were trying to teach the employees, on a small basis, how the stock exchange worked. And also, Benjamin Graham taught a course in statistical analysis. I took two of his courses, Security Analysis and Advanced Security Analysis. I thought Graham was wonderful. He’s sort of, like, Warren Buffet. I mean, you see Graham, you understand the way he thinks, and it works.”
Benjamin Graham, Schloss’ and Buffett’s teacher and employer, advocated a quantitative approach to investing. In Graham & Dodd’s Security Analysis, they write (5th edition, p. 82):
“Broadly speaking, the quantitative factors lend themselves far better to thoroughgoing analysis than do the qualitative factors. The former are fewer in number, more easily obtainable, and much better suited to the forming of definite and dependable conclusions. Furthermore the financial results will themselves epitomize many of the qualitative elements, so that a detailed study of the latter may not add much of importance to the picture. The typical analysis of a security—as made, say, in a brokerage house circular or in a report issued by a statistical service—will treat the qualitative factors in a superficial or summary fashion and devote most of its space to the figures.”
The last sentence should be read twice and be pondered upon:
“The typical analysis of a security…will treat the qualitative factors in a superficial or summary fashion and devote most of its space to the figures.”
While both Walter Schloss and Warren Buffett had the same teacher and employer, their ways drifted apart. Buffett went on to develop qualitative security analysis to mastery, reading hundreds of pages every single day while developing a well-informed understanding of how various businesses and industries operate. Walter Schloss, on the other hand, lacking the intellect and education that Buffett had, adopted a simple approach, yet nonetheless an effective one.
In an interview, Schloss mentions that he didn’t have to work very long hours or travel long distances to achieve his superior returns. He mentions that he would spend his days in a small office working nine to four and spent most of his time browsing through the Value Line publication, in search for compelling stock investments.
Summarizing Schloss’ approach:
Browse among cheap stocks, find mispriced opportunities, build your position gradually as the stock price declines, and hold for several years as part of a diversified portfolio.
The key to Schloss’ approach was finding cheap stocks. He searched for stocks selling at an absolute low P/B multiple by simply browsing through the Value Line publication. P/B was his starting point:
“Use book value as a starting point to try and establish the value of the enterprise. Be sure that debt does not equal 100% of the equity (Capital and surplus for the common stock).” (Factor #3, 16 factors needed to make money in the stock market, 1994).
Adjusting to these days, when we are aided by computers, that metric could be P/Sales, P/FCF, EV/EBIT or anything else. Then, Schloss would check the relative valuation of the stock, comparing the multiple to the stock’s history:
“When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as 125 and then decline to 60 and you think it attractive. 3 years before the stock sold at 20 which shows that there is some vulnerability in it. “ (OID interview)
In a 2008 article, titled Experience, Forbes gives an instructive example of how he thinks about cheap:
“One company he’s keen on now shows the Schloss method. That’s the wheelmaker. Superior Industries International gets three-quarters of sales from ailing General Motors and Ford. Earnings have been falling for five years. Schloss picks up a Value Line booklet from his living room table and runs his index finger across a line of numbers, spitting out the ones he likes: stock trading at 80% of book value, a 3% dividend yield, no debt.“ Most people say, ‘What is it going to earn next year?’ I focus on assets. If you don’t have a lot of debt, it’s worth something.”
While Schloss favored companies selling below book value, he acknowledges that for some companies there is intangible value not listed in the books. In the OID interview, he gave Schenley and Kraft as examples for companies that have built a brand name through large investments in advertising. This brand name allows them to achieve above-average profitability, yet it is not reflected in the balance sheet. The definition of cheap is thus flexible and depends on the market conditions.
Edwin Schloss: We used to look for companies selling at half of book. And if they weren’t available, we looked for companies selling at two thirds of book. Now we’re looking at companies selling at book value. But we hardly ever pay over asset value unless it’s a special situation or franchise.
OID: You’ve consistently excelled in down markets. Yet it sounds like you will adjust your standards to find the best available bargains if there aren’t bargains meeting your normal standards.
Walter Schloss: That’s about it. We lower our standards to fit the situation – so-called relative value.
After determining that a stock is cheap, on an absolute and relative basis, Schloss would check its quality metrics. He wasn’t interested so much in the very recent metrics and could buy stocks with falling earnings or even negative earning. He was more interested in the history of the company. He wanted to see capacity and potential for improvement. And to put it in context, the quality was always secondary to value.
OID: Why don’t you look at business quality more closely?
Walter Schloss: I don’t think I’m capable of it.
OID: I find that hard to believe.
Walter Schloss: Warren understands businesses – I don’t. Warren understands insurance businesses – I don’t. And he understands banking and publishing companies. We’re buying in a way that we don’t have to be too smart about the business….
OID: Because of the asset protection?
Walter Schloss: That’s right. If you buy a great business, how much do you pay for it?
Schloss admits that he is not an expert in analyzing industries or the idiosyncratic state of specific stocks within an industry. That realization is key, as he is not even attempting to outsmart the professional analysts. He uses simple rationalization to find cheap stocks with decent potential and diversifies broadly. And the key here…is that it works. It had worked for Schloss remarkably well for four decades, and it can still work now. My approach to Stock Analysis is a quantitative one. I am a follower of Graham and Schloss, much more than we are those of Warren Buffett.