Just How Efficient is Efficient?
Adherents of Benjamin Graham have often comprised an ideological minority within the broader investing community, especially since the advent of Efficient Market Theory. Reasons for Value Investing languishing in obscurity are unsurprising, as the pursuit of obscure, illiquid, cheap and oft-derided securities is far from glamorous and requires considerable labor, independent thinking, and a mind oriented towards pessimistic outcomes. Despite the lack of superficial attractiveness of a value oriented perspective, the rewards and protection afforded by the approach can be considerable and have been proven time and time again.
Within the past several decades there has been a protracted debate between Value Investors and proponents of the Efficient Market Theory about the merits of each school of thought. These two viewpoints on investing are diametrically opposed - with proponents of the Value approach asserting that one is able to achieve returns surpassing market averages through diligent research of individual companies and situations. Those who support the Efficient Market Theory, in contrast, believe that superior returns are solely determined by luck, and that returns in excess of market averages are the product of a random walk...Or something like that. You can probably tell where I stand in the debate.
The Superinvestors of Graham-and-Doddsville
In a 1984 speech later adapted into an article, Warren Buffett discussed his personal experience and those of his colleagues in applying the fundamentals of the Graham-Dodd approach to investing, achieving returns that significantly outperformed the market over the long run. The content of The Superinvestors can be found here, courtesy of Columbia University. Though the speech is a wonderful explication of value investing, for the sake of brevity I will not discuss it in depth (aside from garnering reader interest by mentioning coin-flipping orangutans), instead I will focus on the exceptional qualities of one individual mentioned as a "Superinvestor."
Walter Schloss began his career on Wall Street at the age of 18, as a runner. His family struggled with financial difficulties during the Great Depression and did not attend college. Despite not attending college, Schloss sought to further his knowledge independently and was drawn to Ben Graham's investing seminar at Columbia University. Walter, who passed away in 2012 at the age of 95, was a gifted, meticulous and risk averse investor. Though he left behind limited writings and only a few interviews in comparison with some of his more famous colleagues, I believe that they are of incredible quality, accessible and furnish a very unique perspective.
In The Superinvestors, Warren Buffett had this to say about Schloss "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."
An employee at the Graham-Newman partnership along with Warren Buffett, Walter Schloss left Graham's firm to start his own partnership - which he successfully managed for over four decades and achieved an annual return that in aggregate outperformed the S&P 500. Like Graham, Walter Schloss was a champion of quantitative analysis. He also was a firm believer in a diversified portfolio, in marked contrast to the limited diversification and qualitative focus of his colleague Warren Buffett.
Tricks of the Trade
Interviews with Mr. Schloss can be found online interspersed through a series called "The Best of Value Investing" - an excellent series that is split into five parts on Youtube which is very informative for those interested. I will list a few quotes by Walter Schloss and then comment on both the lessons that I have extracted and the stocks I have invested in with his approach.
1. "I like to buy companies that don't have a lot of debt, because then they don't have to worry about paying it off."
This one is so brilliantly simple that I had to put it first. A company will go bankrupt if it is unable to pay any loans, and consequently will often wipe out the common stock. If a company is purchased at a good price, retains the most meager levels of profitability but has no (or very little) debt and pays a dividend, then I would be content to hold my shares until the discrepancy is corrected.
Two companies that I invested in about a year ago were Consolidated Water (CWCO) and Strattec (STRT), both companies paid dividends and had little if any debt. They were also trading at a discount to book value plus cash per share and operating in businesses that were both easy to understand. These companies were small, with market capitalizations under $150 million when I acquired my shares in both. I purchased my shares in Consolidated Water almost a year ago when the company was at $7.32 a share and offering a dividend yield a little over 4% - with nearly $11 worth of assets plus cash per share. I purchased my shares of Strattec in July at $21.50 when the company had no debt, a 2% dividend and $30 dollars of assets plus cash.
2. "I have no problem buying a good company, but I want it at a discount"
Classic Graham, purchasing companies that could be liquidated or acquired at a significant premium to the current price their shares were offered furnishes a very healthy margin of safety. The intrinsic nature of the business is also important to take into account.
3. "I don't like to lose money, and therefore I like to buy stocks that are somewhat protected on the downside and the upside sort of takes care of itself."
Purchasing shares at depressed prices often tests the conviction of many investors. It is important to slow the game down and separate the price of a stock from the value of its total underlying assets. My recent article about GrafTech (GTI), which was testing 52 week lows and has since rebounded significantly (in addition to experiencing insider buying) demonstrates the utility of bottom fishing. If you can be comfortable with a low price of a company and are confident in its future prospects - there is a possibility of a gain in addition to increased protection against permanent capital loss - especially if the company has hit multi year lows.
4. "It really was better for me to look at the numbers rather than try to look at people themselves"
Charismatic CEO's can be obfuscating terrible losses with a smile on their face. Stock brokers and research departments at large banks can have hidden agendas when they are selling shares or recommending their clients make purchases. In many scenarios, the most reliable sources of information are found in corporate reports and statements in addition to personal focus and independent decision making, or from managers whose interests are aligned with their shareholders. When I read a report from a large institution touting a stock - I am by default skeptical and tell myself that "they are always lying." If you do a little bit of digging, you can find research reports from huge, well known, institutions saying Apple was going to hit $800 and that Herbalife deserved to be over $60.
A way to insulate yourself is to go for the stocks which are unpopular or uncovered - they are likely to be free from the influence of large entities both on your thinking and on the share price.
5. "I try to not be involved emotionally"
Often times when emotion enters into the equation, an investor has already lost money -- Even before he or she has purchased or sold shares. When I purchase shares in a company, I calculate the upside and when my stock reaches that level - I'll put a stop in to protect my realized profits. Once I see the inherent discount resolved in a situation, I often have no real opinion about the prospects of a company and consequently am not bothered to part with my shares. If it continues to go up, I'll happily revise my stop order - but never take it off.
6. "If I like a company and think it's a good little company, I'll buy more on the way down"
Adding to a position that you have conviction in is an important lesson. Being able to average your cost basis down in a company that has a margin of safety and a sustainable business model can prime you for outsized gains - especially in a bear market. Despite the fact that it is often a harrowing experience for many investors that do not have a contrarian temperament, if the appropriate company and situation presents itself - there are significant rewards to be had.
7. "You can get it at the library"
Research, Research, Research. The only way to form a somewhat accurate assessment of a company is to read its reports in depth, sifting through hundreds of pages for footnotes and appendices that contain hidden gems or in many cases - reveal hidden pitfalls. Look at the company's history - not just for one or two years, but a decade or more.
When an Investor Known for Longs Goes Short
Reviewing a collection of the stocks owned by the Walter and his son, Edwin's partnership during the 1990's - something becomes apparent: the fact that they rarely went short. This is unsurprising, as going short requires an enormous amount of conviction and contains many more risks than simply going long. For a risk averse individual that does not like to lose money, going short is often too much trouble. For an investor known for being extremely conservative and risk averse, anything that is short sold is notable. Of the three stocks the partnership was short on in the 1990's, two were tech companies that are still around today - albeit at very different valuations: Yahoo (YHOO) and Amazon (AMZN).
Yahoo!: Wrong Price in the 1999 - Right Price in 2013?
Yahoo is a particularly interesting example to me given the context of this article. The company currently offers many of the things that Walter Schloss found attractive in a security and in the past made it on his very limited list of stocks that he was willing to sell short. After the meteoric rise of the companies share price during the technology bubble and its correspondingly spectacular collapse, the share performance has been inconsistent for nearly a decade. In a similar vein to Priceline.com and Amazon however, Yahoo has the potential to recover and remain a significant player in the technology sector.
Why Schloss Might Like Yahoo! Now
I believe that this situation is a perfect example of the adage that there are "no wrong stocks, just wrong prices." Despite the fact that Warren Buffett and Charlie Munger confine themselves to areas which they have a considerable understanding - I believe that Schloss-style investors would have been and still may be very interested in Yahoo! shares from a strictly quantitative perspective.
The company has very little debt, a large cash position and book value plus cash that is close - though currently not very close - to the companies asking price. So far, these criteria would make it a stock that Walter would have been paying close attention to, and possibly even purchased several months ago, when the shares were offered at much lower prices relative to total assets. Walter Schloss, like so many value investors, preferred to purchase shares in companies that were hitting new lows and consequently often came with problems - something that is no stranger to long term shareholders of Yahoo!. The main task is to distinguish if these problems are superficial or permanent in nature.
Currently, With a P/E of 7.17, the company is valued much lower earnings multiple when compared with its peers. This is unsurprising to me, as Yahoo! has been oft derided when compared to many of the new darlings of tech including Facebook (FB) and Linkedin (LNKD) as well as Amazon. Having a book value of $13.06 and cash per share of $3.80 against a current price of $23.59 and debt at less than 1% of total cash reserves, Yahoo!'s balance sheet is in a very attractive position. Despite the fact that I believe Yahoo is attractive at these price levels, I believe that the company's current run up of over 60% since hitting it's 52 week low of $14.59 in October poses a challenge to investors who follow the Walter Schloss way, as the man had difficulty buying stocks on the way up and preferred to purchase companies when they hit new lows. Purchasing shares currently, especially after the considerable rally, merits careful evaluation. Though the company has enjoyed a considerable run-up in price, there are reasons a value-oriented investor would be interested in the security...
Value in Yahoo: More to Come?
Yahoo! has interests in two companies that have the potential to considerably increase the asset value and cash position of the company. Yahoo!'s stakes in both Alibaba and Yahoo! Japan - offer the company a significant windfall upon liquidation of the companies interests. As the Chinese e-commerce giant Alibaba approaches its IPO, Yahoo! has the potential to either liquidate its stake into (what I expect will be) a fervor of demand after the company's initial offering or partake in the long term growth of the company - which continues to be a growing and dominant player in the region.
Quality of Management
I also think that Yahoo might retain a promising future as it begins to realize value from its holdings, recent acquisitions and what I believe is the exceptional and prudent leadership of Marissa Mayer. Though Mayer has recently received mixed reviews for deciding to severely curtail the Yahoo! work-from-home program, I believe that this move was wise and will help to foster both collaboration and innovation as employees once again begin to interact with each other on a face to face basis. How Mayer got to the decision is also very important for investors to consider - it was through data. Mayer has repeatedly championed the use of raw data when it comes to decision making.
Even though by expressing an opinion about the management of Yahoo! I am deviating slightly into the qualitative - I believe that it is warranted in this situation as Yahoo! has suffered through a crisis of leadership in recent years and in my opinion requires both equal measures of management stability and rationality to thrive. While tech companies are often extremely difficult for value investors to buy, due to pervasive nebulous valuations and the ever-changing nature of Internet related businesses, Yahoo!'s current fundamentals appear to be strong and have the potential to grow even stronger through value added events.