4 Lessons from Walter Schloss’ OID Interview via Value Edge
This interview was conducted in 1989 by Outstanding Invest Digest for Walter and Edwin Schloss, the managers of Walter J. Associates. It was a generally interesting read, and I would like to share a few excerpts which I found particularly insightful. You can find the full transcript here. Please note that the following excerpts below might not be in the same sequence as the original.
OID: In terms of the way you look at a stock, relative to the way Graham looked at a stock or Buffett looks at a stock, how do you look at it differently?
Walter Schloss: Basically, we like to buy assets.
OID: Why assets? Why not earnings?
Walter Schloss: Assets seem to change less than earnings. You could argue that assets are not always worth what they’re carried for. Graham made an argument at one point that inventory was a plus, not a minus. In an inflationary period, having a big inventory might be very helpful. While in a deflationary period, a big inventory would not necessarily be good. But if you are going to have to liquidate inventory in the next week, that would not be good for you. If you have a nice inventory and business is alright, you benefit from having that inventory. So I don’t know. It may be a wash depending on other factors. How do people value inventory? Fifty percent of what it’s carried at? It may be worth more than that. Generally, it’s not as good as cash or receivables – we know that. But it may not be as bad as some people say. If you have two companies – one with a plant that’s 40 years old, another with a new plant – both are shown on the books but the new plant may be much more profitable than the old one. But the company with the old one doesn’t have to depreciate it. So he may be overstating his earnings a little bit by having low depreciation.
OID: Lies, damn lies and financial statements?
Walter Schloss: That’s often the case. Ben made the point in one of his articles that if U.S. Steel wrote down their plants to a dollar, they would show very large earnings because they would not have to depreciate them anymore. Would that be proper? Of course, he didn’t think it would be. But that means a company could really increase its reported earnings. And that’s only one of the reasons why Edwin and I aren’t wild about earnings. They can be manipulated – legally. If people are just looking at earnings, they may get a distorted view.
Edwin Schloss: I think a lot of people have been hurt by buying something solely on the basis of a low P/E. We could go for a low P/E or for a high P/E. Basically, earnings are hard to predict.
Walter Schloss: If a guy estimates earnings of $2.25 and it turns out to be $2.50 – that shouldn’t really change the value of the stock that much. But the stock price often changes radically when that happens. On the other hand, with book value at $25 a share you’d be rather surprised if the next year it fell to $15.
OID: I hate to beg in public, but could you give us an example or two to help us understand your thinking process?
Walter Schloss: Cleveland Cliffs may give you a good example of our thinking process. Their primary business was selling iron ore to steel mills. We bought their stock not because we were looking for a cheap investment in the steel industry. We looked at the stock because we thought it was a good value. Cleveland Cliffs was the best company in its field. As I recall, Warren bought a lot of it at around $18 a share and later sold it around his cost. Butthen, when the steel industry was in decline and so many of these companies defaulted on their debt, and the biggest shareholder sold his share because he no longer liked the industry, the stock went down to $6 a share. We bought a lot of it.
OID: Going where others feared to tread.
Walter Schloss: That’s right. We bought it although there was talk of bankruptcy. If we’d lived in Cleveland, we probably wouldn’t have bought it because we would have been too close to all the bad things. Anyway, after we bought it, the company started to do better. They’ve sold off some assets and bought back some stock. We didn’t buy it knowing what would happen. But we did like the idea that it was the low-cost iron ore producer and they have 50% of the reserves in America.
OID: Amen. I understand you guys don’t even like to talk with managements of the companies you own. Is that true?
Edwin Schloss: You can waste a whole lot of energy running all over the country checking on managements of the companies you own. We only go to annual meetings if they’re within a 20-block radius of the office.
Walter Schloss: I think I agree with Ben Graham. He didn’t like to speak with management because he thought he would be influenced by what they said. On the other hand, if you’re smart enough…. Warren could go to an annual meeting and because he’s very analytical and not emotional about it, he could analyze what goes on without being swayed by the fact that the guy talks well, acts well or whatever. He could probably do it. He’s very good at it. I don’t think I would be. Besides, while it’s nice to go to meetings, they’re time consuming. I agree with the expression, “You never know all about a stock, until you own it.”
OID: Besides balance sheets, what else do you look at?
Walter Schloss: You’ve got to get a feel of a company – their history, background, ownership, what it’s done, the business they’re in, dividend payments, where earnings are headed. You’ve just got to get a general feel of a company.
But as I’ve said, you never know all about a stock until you own it.
If you didn’t already know, Walter Schloss quantitative, asset-based style of investing is highly similar to Graham’s. This is in contrast to Buffett who is able to discern the quality and hence, future earnings of the companies he invests in. Ironically, he is Graham’s most famous student despite their significant differences. However, Schloss does still look at the qualitative aspect of companies as well. Why? I believe that the qualitative factors of a company determine your quantitative adjustments. For example, the liquidating value of a luxury watch retailer’s inventory would be proportionally higher than say, some food manufacturer. I think some people believe that, because Graham’s style is so quantitative, that the qualitative factors do not matter at all. We can see that this is not true; they still matter to a significant extent – the extent to which they affect your quantitative adjustments. A distinction has to be made between paying for the quality of a company and simply knowing its implications on asset valuation.
OID: Looking for shareholder-oriented managements.
Walter Schloss: That’s right. Obviously, you can’t protect yourselves from mistakes. But we try to get in with people we feel are honest. That doesn’t mean they’re necessarily smart – they may be dumb. But 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.
This is something I have never considered before, and it can be a reminder for those who have already realised this. The lesson here is that there are complexities to a ‘good’ management – a capable management is not necessarily a good management for investors (contrary to what I thought hitherto). In that regard, financial performance alone does not imply a good management. Similarly, you can have a shareholder-friendly yet incapable management. However, neither of which is ideal for investors.
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.
OID: Speaking of cheap stocks, what’s cheap today?
Walter Schloss: We don’t see much that’s cheap now. It’s much more difficult to find bargains today than it was 10 years ago.
OID: Actually, that’s debatable. Most people would probably do well to own what makes them uncomfortable – if only they wouldn’t then sell at the worst possible moment. But it’s fortunate for you and your partners that you’re most comfortable in stocks. Has your investment philosophy changed over time?
Walter Schloss: Yes. I think it has – largely because of the situation in the market. Graham-Newman used to buy working capital stocks – which I thought was a great idea. But by 1960, there were practically no working capital stocks. With the exception of 1974, at the very bottom of that market, there have been practically no working capital stocks. A good way of seeing it is to look at Value Line’s list of working capital stocks. If you go back 15 years, you’ll see they have some on the list. Today, there are very few. And the ones that are on the list are really pretty bad – often with a lot of debt – especially in relationship to the equity. With working capital stocks gone, we look next at book value.
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. Many so-called fundamentalists don’t even pay attention to book value anymore. They will after they lose half of their money. It’s getting very tricky.
Walter Schloss: It seems now that everybody else is doing what we’re doing – or at least a lot of people are. And many people have huge amounts of money to invest. So we try to get in between the rain drops.
Initially, it would seem that Walter Schloss relied on relative valuation to find ‘cheap’ stocks as time progresses and the quintessential cheap stock became significantly less common. There are indeed modern-day strategies based purely on relative valuation (buying first decile stocks in terms of certain ratios etc). However, by noting that it was more difficult to find bargains today (1989), it is evident that he has a clear, absolute concept of what is cheap and what isn’t, in spite of using relative valuation. What I gather is that relative valuation and absolute valuation should complement each other. In today’s efficient market, it is significantly more difficult to find cheap stocks. Standards may have to be relaxed but we should always be mindful of the subtlety between cheap and cheaper. Both Schloss and Buffett have always been able to identify times where there is nothing good in the market. Relatively valuation alone will never yield such a conclusion.
OID: Better rich than right, I believe the saying goes. As I mentioned to you in a prior conversation, Templeton’s worst ten years investment-wise were his first ten years. And you told me that the same was true for you.
Walter Schloss: Yes, that’s right. I think the first ten years you get kind of acquainted with what you’re doing.
There is a learning curve to investing, nothing surprising about this. But I think the main insight comes when you view it with the previous point. Buffett and Schloss have lived through many bulls and bears. They are able to tell when stocks, in general, are too expensive because of their years of experience. For novices like me (who is nowhere near the 10 year mark), relative valuation becomes more unreliable and less emphasis should be placed on it.