Worried About the Future?
Walter & Edwin Schloss – Our Mentors’ Hall of Fame
Only the market will price junk at a 75% premium to quality!
Kendall J. Anderson, CFA July 17, 2011
Worried About the Future?
So much of our daily lives are centered on world events and the impact those events have on our individual lives. When we see the unemployment figures our first thoughts are not the government figures that are flashed on the news wires, it is thoughts of a relative who lost his or her job or of a child or grandchild who just graduated from college struggling to find work. It may even be thoughts of your own situation, working a job you really dislike to keep the bills paid.
When we see that our government is failing day after day to agree on a way to pay our country’s bills we envision our own way of solving the problem, such as increasing someone else’s tax bill or cutting someone else’s income. Of course our personal ideas are usually beneficial to our own lives and or the lives of our family. If our income is high, then obviously the best solution is to cut spending. If our only source of income is a social security payment or an unemployment check, then obviously the best approach is to increase taxes on the rich.
We tend to take any view on the economy in a very personal way so it is easy to understand why those of us who have accumulated savings make investment decisions based on a deep personal belief in what drives returns. My own experience leads me to believe that most investors, including professionals, believe that the economy drives investment returns. Because of that belief the research people undertake is driven by economic forecasters.
In my experience, the economic forecasts are compiled and delivered to investment company gurus who produce a recommended asset allocation policy. It is the job of the chief strategist and their marketing assistants to spread the word throughout the world to their clients, salespeople and anyone else that may be interested. These strategists can become quite famous – Jeremy Grantham of GMO, Mohammed El-Erian of PIMCO, Liz Ann Saunders of Charles Schwab and Bob Doll of BlackRock to name just a few.
What I find interesting is that the allocations suggested by market strategists have very little input into the construction and maintenance of a portfolio constructed by a professional manager. Portfolio managers do consider economic forecast in their decision process, however, the majority of their decisions are driven by individual stock and fixed income analysts and not the market strategists. Could it be that portfolio managers are more concerned with the health of the businesses they own in their portfolios? Could it be they are more concerned with the ability of a business, or a government, to repay a loan with interest?
If you are worried about the current economic state of affairs you may be relieved by what research analysts are telling portfolio managers. First, they seem to be in agreement that businesses are doing fine, especially those that have a global market for their products and services. Second, they seem to agree that interest rates will be higher at some point in the future, and that the majority of government debt is safe as far as the ability to pay interest on their borrowing. And most importantly, they are saying that the earnings you should expect from your investments will be driven over time by the ability of companies to pay you some income with a little left over to reinvest.
Walter & Edwin Schloss – Our Mentors’ Hall of Fame
There has always been and will always be, I believe, a struggle between market strategists and financial analysts for the minds and dollars of investors. Jonathan Cheng, in his article “Stocks Fall. Optimism Stands Tall,” from the June 27th “Abreast of the Market” column in the Wall Street Journal described this struggle pretty well. He writes:
The disconnect between analysts on the one hand and strategists and economists on the other comes largely because analysts are largely focused on their individual companies and industries. That gives them a deeper but narrower view than those who look broadly at macroeconomic factors.
You will have no difficulty finding advice and commentary from market strategists and economic forecasters. Just open your latest brokerage statement and read the commentary. Buy any paper or business magazine, visit any investment website or just turn-on the television or radio and within minutes you can easily have as much access as you want. To get into the minds of a portfolio manager you will have to dig a little deeper — search for those rare interviews or written commentaries hidden in a book at the library, or reproduced and stored on a hard drive somewhere out in the cloud. When we took back our business in 2008, we made the decision that you would never have to search in the library or some hidden database to understand our thoughts. It is why we write to you each month. Besides our monthly letters to you, we hope that you will make an effort to visit our web site where we post additional commentary.
I have been privileged to have many mentors throughout my career. These were not the typical mentor as I have, in fact, met only a stark few of them personally. I consider Walter Schloss to be one of these mentors I have not met, but have been privileged to benefit from the shared knowledge of his writings and presentations. He was introduced to me early in my investment career through Warren Buffett’s presentation at Columbia University in 1984. His talk, The Superinvestors of Graham-and-Doddsville, was transcribed and reproduced in the fourth edition of Benjamin Graham’s classic The Intelligent Investor.
My introduction to Walter Schloss by Warren Buffett:
…Walter never went to college, but took a course from Ben Graham at night at the New York Institute of Finance. Walter left Graham-Newman in 1955 and achieved the record shown here over 28 years….Walter has diversified enormously, owning well over 100 stocks currently. 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 doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. 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’s one of his strengths; no one has much influence on him.
Of course like anyone I paid very little attention to this introduction, I was mostly concerned with his “performance”. When Warren gave this speech in 1984 Walter Schloss (with his son Edwin beginning in 1973) had produced a compounded rate of return of 16.1% for his clients over the past 28 ¼ years while the S&P 500 compounded at 8.4%. To put a little more meaning into that, his original 19 investors contributed approximately $5,000 each and he placed $5,000 into his partnership for a grand total of $100,000. This original $5,000 compounded at 16 1% was valued at $333,940. The same $5,000 placed in the S&P 500 (there were no index funds at the time) would have been valued at $44,360. Because of Walters Partnership structure, where he charged a percentage of the gains as his fee, his take from his $5,000 was $1,155,235. He had to earn a gross return of 21.3% compounded to earn his clients 16.1% over those years.
By the way, this record was updated through the year 2000. The results are just as spectacular. For the 45 years he had been managing money, Walter produced for his clients a compounded rate of return of 15.3%. In early 2000, Edwin told Walter he could not find anything cheap enough to buy, so for the next two years they shut down the partnership. Warren Buffett once again honored the great Walter Schloss, this time in his annual letter to Berkshire Hathaway shareholders. He dedicated an entire page to Walter, but it is this paragraph that I want to share with you:
Walter did not go to business school, or for that matter, college. His office contained one file cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary, clerk or bookkeeper, his only associate being his son, Edwin, a graduate of the North Carolina School of the Arts. Walter and Edwin never came within a mile of inside information. Indeed, they used “outside” information only sparingly, generally selecting securities by certain simple statistical methods Walter learned while working for Ben Graham. When Walter and Edwin were asked in 1989 by Outstanding Investors Digest, “How would you summarize your approach?” Edwin replied, “We try to buy stocks cheap.” So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.
Warren’s tribute to the Schlosses made them famous, but the majority of individuals who have read Mr. Buffett’s tribute were blinded by his performance, as was I in my original introduction to this father and son team decades ago. Over these years, I have tried to keep up with both Walter & Edwin through the few articles and interviews they gave. It was in February of 2008 that Walter was a guest speaker at The Ben Graham Centre for Value Investing. The Centre was established with the support of Fairfax Financial Holdings Limited at the Richard Ivey School of Business at the University of Western Ontario. I watched via a video that is still archived on the Schools website. This archived presentation, which I would encourage you to watch, may just have been what the Doctor ordered for yours truly.
I don’t have to remind you of the great financial meltdown in 2008. Justin had just become an active partner in our firm, we’d made a major purchase of all non-family held shares of the company at a rather unreasonable price, and since I eat my own cooking, I was watching my personal portfolio implode along with our clients. We were struggling to find some comfort from anyone and anywhere we could. One source that helped was the video presentation of Walter. I felt a kinship— Walter is a CFA, as am I. Edwin attended the North Carolina School of the Arts, as did my oldest daughter, and Edwin as is Justin, is the only individual who carries the power to influence his father’s investment policies.
More importantly, their approach “we try to buy stocks cheap” came through loud and clear. This message, “buy cheap”, delivered at just the right moment by someone who lived through 17 recessions. Someone who created returns for his partners that could never be explained by Modern Portfolio Theory or the economists, academics or market strategists that rely on mathematical proofs for verification of results. This message gave me and Justin the courage we needed to look directly in the eye of the storm and decide that stocks were cheap. It carried us through the next few months as stocks continued their descent. It gave us the courage to sit down and encourage you to hold on! For that reason alone I have placed Walter and Edwin Schloss in my Mentor’s Hall of Fame.
Only the market will price junk at a 75% premium to quality
Our Hall of Fame Member developed his own concept of quality that mirrors a modern definition advanced by the American Society for Quality; The characteristics of a product or service that bear on its ability to satisfy stated or implied needs. Walter Schloss’s idea of a quality business was a company with a good history, with minimal amounts of debt, and a simple capital structure with management having a meaningful ownership in the business. Even with these quality characteristics, Mr. Schloss would only purchase shares when he felt they were cheap.
I find his definition of quality appealing and we all should know that buying cheap is the greatest protection against loss of capital that an investor has. Yet, in today’s world, most investors do not own common stocks directly. Instead the majority purchase common stock by buying a beneficial share in a pooled investment account. This could be a mutual fund, an ETF, an annuity, or a pooled defined contribution plan of an employer. Because of this Mr. Schloss’s definition of quality has a very limited application for most of us.
If investors are unable to determine quality based on fundamentals, then knowing whether or not quality is important to them, how they judge quality if it is, and if they are willing to pay a premium for that quality, may improve our investment decisions. I have obtained some help for us from a recent study titled “The Discriminating Consumer: Product Proliferation and Willingness to Pay for Quality” by Marco Bertini, Luc Wathieu and Sheena S. Iyengar, who introduced the paper this way:
We propose that a crowded product space motivates consumers to better discriminate between choice options of different quality. Specifically, this paper reports evidence from three controlled experiments and one natural experiment that people are prepared to pay for high-quality products and less for low-quality products when they are considered in the context of a dense, as opposed to a sparse, set of alternatives. To explain this effect, we argue that consumers uncertain about the importance of quality learn from observing market outcomes. Product proliferation reveals that other consumers care to discriminate among similar alternatives, and this inference in turn raises the importance of quality in decision-making.
You may want to read the study to get the full meaning of their findings, but let me simplify their outcomes. When there are a whole bunch of similar products available for us to choose from, we are willing to pay more for what we think is higher quality and are not willing to pay as much for what we think is junk. If we do not know the difference between quality and junk, we will learn from others who we think do know the difference.
In one of our professors’ studies, two groups of people were shown a table of different dark chocolates. One group’s table had 5 chocolates, the other 21. They were all told that the chocolates were ordered from left to right according to their “premium rating”. They were asked how much would they pay for one of the chocolates and to rate how much they agreed with this statement; “Buying good quality is always important, but it is particularly important when it comes to chocolate.” The results - Those with the choice of 21 chocolates were willing to pay 40% more for the highest quality chocolate than those who only had 5 to choose from, while both groups overwhelmingly agreed with the statement.
The study group either knew the quality difference in chocolate or just assumed the quality by the order and number of choices, to set their price. Because most investors do not know how to determine quality in the Schloss way, they are making decisions by looking at the market and what others are doing just as our chocolate lovers. It is well known that almost every new dollar invested into a mutual fund will carry the Morningstar Rating of 4 or 5 Stars. An S&P Rating is mandatory for bond investors. For investors, this rating is used as a substitute for knowing quality. In the insurance industry, an AM Best Rating is our substitute for knowledge. And of course we know that people will substitute market appreciation for quality. They will find it easier to buy what has already gone up, thinking that past price appreciation is the best measure of quality.
Bertini, Wathieu & Iyengar’s study indicates that people are willing to pay for quality, however, it seems this doesn’t apply to individual common stocks, at least for today. The S&P 100 is comprised of 100 major, blue chip companies across multiple industry groups. Most of us would consider these 100 companies as high quality. The S&P 600 measures the small cap segment of the market that is typically renowned for poor trading liquidity and financial instability. Most of us would consider these 600 companies as low quality when compared to the blue chip companies that are members of the S&P 100. Yet when we consider that the S&P 100’s blue chip common stocks have an average price just 16x trailing earnings per share, while the 600 companies with poor trading liquidity and financial instability have an average price of 28x trailing earnings per share, investors are paying a 75% premium for junk. Only in the market can junk carry a premium to quality.
Take a lesson from our newest Hall of Fame Member. Buy quality when it’s cheap!
Until next time,
Kendall J. Anderson, CFA
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.