I just read an old Forbes piece on Walter Schloss: Making money out of junk. As many regular readers know, Schloss is one of my all time favorite investors. Read more about Schloss on my resource page and also check the Walter Schloss category. He made 21% per year for 47 years, investing in a simple, methodical, low stress manner working 9-4:30 with no other employees or assistants other than his son Edwin.

Here are some key takeaways from the interesting Forbes piece:

  • Focus on cheap stocks. This means not worrying about earnings at the moment, only asset protection.
  • You have three things in your favor here:
    • Earnings turn around and the stock appreciates significantly
    • Someone buys control of the company (buyout)
    • The company begins buying its own stock

One thing I’ve really learned with Schloss is that it’s difficult to buy stocks that have problems. I think that’s a reason why many value investors underperform. They end up buying good businesses, but at prices that will only yield mediocre future returns because it’s hard to buy stocks with problems, or stocks with seemingly no way out. That’s the very reason why the latter type of stocks get mispriced. It’s hard for everyone (including value investors) to own them. This is an important thing to remember. Think differently. Sir John Templeton said you have to do things differently from the crowd if you want a better than average result.

Make a List of Investors Who Have Actually Achieved Significant Results

I have a relatively short list of investors that I’ve extensively studied that have produced exceptional long term results. I highly recommend doing this as it will provide insight into what actually creates significant outperformance. (It’s not always what you might think). There are lots of well known investors, but when you look at their track records, many of them have produced just average results (maybe 100 or 200 basis points better than the S&P). I’m not interested in modest outperformance. I’m certainly not interested in average performance (although in the investment business, the S&P 500-which I consider “the average”-is actually quite good). Nonetheless, I want to do much better.

So make a list of guys who have made 30% a year, or 50% a year in Greenblatt’s case. Study Schloss who made 21% per year for 47 years. Study Graham and Buffett. Study Pabrai. You might notice the same key things I noticed…

How Did The Best Investors Achieve Their Results?

Two things that I’ve noticed over and over again when studying the investors who have outperformed (Pabrai, Buffett, Schloss, Graham, Greenblatt, etc…):

  • They were very concentrated (they did extensive research and bought big positions), or
  • They were diversified, but they bought stocks that no one else wanted (they were far less concerned about understanding the intricacies of the business, and more concerned with valuation and numbers)

Easier said than done (even for most value investors). Concentration is tough, and buying junk is tough. That’s why it’s easier (and less profitable) to own a diversified basket of good companies. It’s easier on you emotionally, and it’s easier to pitch to clients. Over time, you’ll do just fine, but your results won’t be much different than what the overall S&P 500 does.

Read the entire Forbes article for more info on Schloss’ ideas from 1973. 

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8 Responses to Walter Schloss 1973 Forbes Article & Two Ways to Outperform the Market

  1. Darryl M says:

    I had that article in my collection on Schloss and was trying to send it to you awhile back but could not find your email address anywhere on this site… Were could I find your email address John?

    I came to alot of the same conclusions you are now realizing…

    Buy lots of junk or a few of the franchise business..

    Either way it is tough indeed…

    The problem is I did not have the stomach to buy junk and because anything can happen in a business, found it hard to concentrate to.

    So what can a guy do???

    I had to come up with something a bit different…

    You may not think this is possible but what I figured out one could do is to buy a basket of average to above average business making good money, and concentrate more heavily in the sure things or franchises.

    Just one example…

    18 months back one could buy walmart at a very attractive price. This was a classic buffettology world class franchise type buy.

    So one could put 10% of your money in each one of these sure things..

    I can find maybe 3 to 5 of these high quality franchises each year…

    Then the rest of my portfolio I put in average type business at about 2% to 3% each..

    I not 100% sure on these but I know they are undervalued by the #’s and they look like half decent business compared to buying junk.. I read the annual report and try my best to understand it, make sure it still has buffetttology like fundamentals and that these are not fading at the time I buy..

    Let’s use something you know John…

    Lets look at EZCORP… ok?

    Balance sheet looks strong and has very little long term debt…

    It’s #’s look good both in the present and the past, earnings are projected at $2.52 this year and $2.89 next year…

    If you were to buy the entire business at $15 per share your earnings yield would be 16.8% a year and it’s pre tax earnings yield would be 25.2% a year…

    As a business man myself this looks like a pretty good business and sure beats 0% in the bank…

    Yes there are some unknowns, but that is why it is so undervalued, and why you need to own a basket but it is a far cry from the junk that Schloss used to buy.

    Plus if you could buy at $15 is under book value even…

    If you put 2% of your money in this one and buy dozens along with a few concentrated sure things you have to outperform the market big time.

    I not saying you have to buy EZCORP or that I love it, I just using it as an example that we both know.

    But from my experience in the markets I have been able to find several dozens of this type of business like EZCORP each year with no problem…

    And buying a basket of these undervalued business is a pretty sure way to make good returns.

    Using another example from your idea’s is the gold stocks that I also like as you already know…

    Now you can also buy the gold stocks as well at very low valuations and put maybe 2% in each one as a little bit more unsure with these… I for one am waiting for them to get even cheaper but once you can start buying at .5 book values and pe’s of 4 to 6 this is pretty good value that in the long hall you have to make money in.

    I mean they have to revert back to the means, and when they do your gonna make good money with little risk since you are so well diversified.

    Take a look at this Business now John..

    http://www.gurufocus.com/financials/BVN

    The numbers should hit you over the head, like being hit by a baseball bat…

    Look at the growth, the return on equity, the earnings, the balance sheet and the valuation… You have to make money if you by a basket of good undervalued business like this.

    I can find dozens like these each year that are undervalued…

    So concentrate in the franchise business when you can and when they are clearly undervalued, then buy a basket on non junk but average business that have nothing wrong with them but for some reason or either undervalued due to a scare of unknown which may or may not ever happen anyways….

    I for one also like buying a basket of perfectly good average or above average companies on small market or industry pull backs at low valuations… I find these are my bread and butter and almost sure things…

    As you know it is very competitive out there and you must keep learning and working hard if you want to outperform the market.

    So what I am saying is you don’t have to buy junk or concentrate in only a few…

    I have found there is a happy medium….

    I find those that buy the franchise at to high a valuations make no money, and those that buy junk that is cheap lose alot of money since they get even cheaper.

    What I am trying to say is that over the years I have discovered is that there is a happy middle ground were you can still make big but with less risk and you can still sleep at night to then:-)

    I will try to explain more in the future with some examples that I have bought in the past or currently looking at now.

    • John Huber says:

      Lots of good points Darryl. I have spent countless hours thinking about portfolio management and the sliding scale between cheapness and quality, and the interplay between the two. Couple thoughts: I agree that the Graham bargains in large part are much less investable than they were in his day (although Greenbackd did an outstanding white paper on how the net nets continue to dramatically outperform (to the tune of 20% plus) for the past 75 years. But it’s not a very good scalable strategy as they are small, illiquid and not always prevalent. But, buying those bargains still works.

      Also, I’ve studied Schloss’ list of stocks that he owned, and I found a lot of the cheap stocks that you’d expect. However, Edwin Schloss (his son) had a profound impact on his father, and you’ll notice a few franchise compounders in the list of 1000 stocks that Schloss and Associates owned over the 5 decades that they ran money for… including McDonalds, and even Starbucks!! I had to do a double take when I saw SBUX on his list. The only time that got remotely cheap was during the 08-09 bear market. Now that could have been a meaningless small position, but still interesting.

      So the vast majority of Schloss stocks were the industrial cheap stocks trading at book value or around book.

      But the interesting thing is that Schloss started his fund right around the time that Graham folded shop because he couldn’t find bargains. Schloss folded in 2001, but many other small funds have popped up and new excellent track records have been born out of the 2002 bear market and the 2009 bear market.

      So guys retire, get bored, etc… I think Graham retired because the market was getting moderately pricey and he had many other interests. As he was getting older, he may have just decided he’d like to pursue some of those other interests. Some say that they can’t find bargains anymore, and that might be true at that particular time. But the market always has opportunities coming around the corner. Even in this market there are plenty of interesting stocks that are cheap, and cheap and good.

      As for your thoughts on WMT and other high quality businesses. I agree there as well that those franchise firms offer margins of safety via their high and predictable cash flows. The cheap stocks are backed by tangible assets, the Cokes, Walmarts, PG’s, JNJ’s, etc… are cash cows. They are great businesses that can make investors a lot of money over time via compounding and reinvestment.

      My own portfolio is very dynamic. I like to cherry pick ideas and I’m flexible. I’m happy to buy Starbucks at $8 in 2009, because I thought the franchise would survive. I sold way too early, but I tend to do that to reinvest into other cheap ideas. But I like big positions in high conviction ideas. But overall, most of my ideas come from the philosophy of Greenblatt and Graham that buying a basket of stocks that are cheap, preferably with high quality (high return on capital combined with high earnings yield in Greenblatt’s case) will work out over time.

      You can pepper the portfolio with a concentrated position when you find one, but in the meantime, you’re adequately diversified basket will be working for you.

      I also use some special situation ideas occasionally, but only when I think the risk reward is favorable.

      But overall, it’s just trying to buy stocks for less than they are worth, staying adequately diversified, and letting compounding work its magic.

  2. Darryl M says:

    opps when I pasted this from my word document the paragraphs vanished..

    Sorry…

  3. Darryl M says:

    Studying all the old greats over time I realized this…

    Graham through most of his investing days and Schloss for the first 25 years of his bought junk which is true… But the junk back then were much safer and cheaper as well as more plentiful than today.

    Do to the fear of the 1929 crash people hated stocks, and people for the most part stayed out of the stock market for the next 25 years, making many stocks really cheap and it caused stocks that were junk or losing money very very cheap.. So cheap in fact they could be bought for cash on the books only, or as a net net or for the working capital on the balance sheet against all liabilities and pay only maybe 60% of that yet.

    What Graham found that if you could buy a basket of 100 of these you could make 15% to 20% per year. When these dried up when the markets went higher Graham was forced to retire in 1957 or so… Schloss kept on and took over, but found it harder and harder to find cheap stocks and was forced to invest in stocks that were no longer net nets and just cheap stocks that were losing money for the most part but had low book values. But even junk stocks with low book values dried up by 2001 and father and son were forced to retire…Schloss system of buying low price to book stocks with low debt even if they were junk would still work if you could own 100 of them like he used to have at any one time.. Just that owning 100 junk stocks would be a hard sell to clients and not really my thing.

    Also the biggest mistakes investors make is by reading Grahams early works then trying to invest that way even though those types of stocks and the saftey that went with them no longer exist… So they just buy falling stocks or some really really low pe stocks in cyclic industries or other things and it has been very painful for many.

    Buffett after he was done with the net net thing and by the mid 1960′s and with Mungers influence would buy a basket of average business that he could make good earnings yield on and looked like pretty good business and bought them during a correction of an industry or general stock market correction then sell them once they became higher valued.. And when a business with really good prospects came along every few years hold buy and hold them for years in higher concentrated positions due to their better long term prospects they had than just merely average businesses as they kept growing and growing. Think WPO

    What I like about this system is that it still works to this day, unlike the net nets which are now pretty much extinct if you want to buy hundreds.

    So I pretty much copied alot of the 60′s Buffett, were he bought a basket of the cheaper average companies with higher earnings yield that had reasonable future prospects a few years out and then concentrated a little higher in the sure bets… Of course I could never go 50% in one stock as I not as good as understanding business like the oracle :-) But 10% concentration in in a Walmart or Well Fargo is no problem for me…

    Buying a basket of pretty good businesses when they are undervalued to simple valuation metrics your gonna make money even if a few turn out to be lack lusters, as a whole and bought in a basket you will outperform.

    Simple effective but very powerful…

  4. bjk says:

    Pabrai? Didn’t he sustain 65% losses in 2008? I don’t care what happened in the market, suffering a 65% is disqualifying.

    • John Huber says:

      Hi BJK. Thanks for reading. Yes, the 60% drawdown is a tough pill to swallow. But keep in mind, he’s averaged 26% per year since 1995 and that includes the 2008-09 down period. In the last four years he’s averaged 32% per year, which is far better than most funds-in fact, I don’t know of any other 9 figure or higher fund with 32% returns the last four years.

      Like Charlie Munger said: “If you can’t watch your holdings go down 50%, you probably shouldn’t own stocks.” Munger and Buffett have seen BRK go down 50% on three different occasions.

      Also, Munger went down 60% in his partnership in the 1970′s, but still averaged in the mid 20′s.

      Anyhow, the point I’m trying to make is that these guys don’t get worried about temporary loss of capital. They worry about permanent loss. They also know that to achieve returns of 25-30% annually over a multidecade period, they have to be concentrated. Pabrai has 40% of his fund in his top two positions (BAC and GM). He takes 10% or larger positions on average. That combined with his edge creates high returns. He’s right over 90% of the time.

      So it’s just a different philosophy. Graham and Schloss wouldn’t have preferred this, and Graham’s own experience with a similar 70% drawdown in the early 30′s caused him to reevaluate his strategy. His famous philosophy was born out of that experience.

      So it’s just a different temperament. I agree with you that it’s not ideal to go down 60%. But it doesn’t mean you should “disqualify” him, because he, Buffett, and Munger (all who have gone down 50% or more at points in their career) have a lot of ideas to learn from.

      I personally have the temperament that makes me lean toward Graham and Schloss, but I’m always trying to learn from guys with the greatest track records because most people don’t think like them.

      Also, the reason most people don’t outperform is because of the fear of losing money. Mutual funds are destined for poor results because they own 100 stocks of average companies at average valuations. This doesn’t work. In my post I pointed out the two ways to outperform: Buy really great companies at really great prices (naturally you’ll be concentrated because those opportunities are rare), or… buy really cheap companies (more of them around thus you’ll be more diversified). Both are difficult, and both lead down the road less traveled. But executed properly, both give you the chance at large returns…

  5. lei says:

    i think one can not be necessary to buy 100 stocks of schloss’s style. it is good to buy some for example 15-20 to assure that they can come back. so be contrarian is a painful way to invest but it is rewarding. for example when solar industry is taking a market beating, then you buy first solar around 11 and now it is traded at 54.89.

    • John Huber says:

      Yeah I think 100 stocks increases the maintenance headache that you would have to track your portfolio. Diversification is a nice tool, but after a certain level, it begins to have a diminishing effect. Concentrating the investments is a great way to achieve huge returns, but you have to understand your edge. For me, it’s more comfortable to have a basket of stocks that are undervalued, and that as a group should yield satisfactory long term results. Then, occasionally there will be opportunities to take big positions in your high conviction ideas. The more convicted you are, the more concentrated you can be.

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