Benjamin Graham was the godfather of value investing and even today his common sense approach to investing provides a road map for long-term success, which can easily be replicated by any investor.

Following a piece last week on Walter Schloss’ criteria for company liquidations, which drew on Benjamin Graham’s advice for investing in special situations, this article looks at Benjamin Graham’s advice for investing in special situations. This advice was published in the Q4 1946 issue of the Analyst’s Journal. The advice was originally presented in the book, Security Analysis 1951 edition (Pages 729 – 734).

Benjamin Graham: What is a “special situation”?

“First, just what is meant by a “special situation”? Convention has not jelled sufficiently to permit a clear-cut and final definition. In the broader sense, a special situation is one in which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance. In the narrow sense, you do not have a real “special situation” unless the particular development is already under way.”

“This distinction is readily apparent by reference to the wide fields of bankrupt corporations and preferred stocks with large back dividends…Many practitioners will say that a company…does not constitute a special situation until a reorganization plan has actually been submitted; similarly, there must be a definite plan on foot for taking care of dividend accumulations.”

“The essence of a special situation is an expected corporate (not market) development, within a time period estimable in the light of past experience. Thus here, as almost everywhere else in finance, wide experience is a major factor in lasting success; it must be supplemented by careful study of each situation and the possession of sound though somewhat specialized judgment.”

Calculating a return

There is a logical and important reason for favoring this narrower definition of a special situation. By doing so we are able to conceive of these commitments in terms of an expected annual return on the investment. As will be seen, such a calculation involves quite a number of estimates in each case, and thus the final figure bears little resemblance to the bond yields taken out of a basis book. Nevertheless, this technique is valuable as a guide to the operator in special situations, and it gives him an entirely different attitude toward his holdings than that of the trader, speculator or ordinary investor.

In one respect, however, the calculation goes beyond the lore of the yield book. If we are willing to make the necessary assumptions, the attractiveness of any given special situation can be expressed as an indicated annual return in per cent with allowance for the risk factor. Here is a general formula:

Let G be the expected gain in points in the event of success;

L be the expected loss in points in the event of failure;

C be the expected chance of success, expressed as a percentage;

Y be the expected time of holding, in years;

P be the current price of the security.

 

Then

 

Indicated annual return = GC – L(100% – C)/YP

An example

We may take as a current example the Metropolitan West Side Elevated 5s selling at 23. It is proposed to sell the property to the City of Chicago on terms expected to yield in cash about 35 for the bonds. For illustrative purposes only (and without responsibility) let us assume (a) that if the plan fails the bonds will be worth 16; (b) that the chances of success are two out of three—i.e., 67% (c) that the holding period will average one year. Then by the formula:

Indicated annual return = 12 x 67% – 7 x 33%/1 x 23 = 24.7%

Note that the formula allows for the chance and the amount of possible loss. If only possible gain were considered, the indicated annual return would be 34.5%. (Sequel: The purchase was affected, and the bondholders have since received $33.5 in cash, retaining also “stubs” currently worth about $5.)

The various types of special situations

• Class A. Standard Arbitrages, Based on a Reorganization, Recapitalization or Merger Plan…
• Class B. Cash Payout, in Recapitalization or Mergers…
• Class C. Cash Payments on Sale or Liquidation…
• Class D Litigated Matters…
• Class E. Public Utility Breakups…
• Class F. Miscellaneous Special Situations…

Source document: Special-Situation-Investing-by-Ben-Graham

The post From The Archives: Benjamin Graham’s Advice For Investing In Special Situations appeared first on ValueWalk.

Bruce Greenwald Class (Jan. 22, 2004) No. 1 On Value Investing: An Overview via CSInvesting

This lecture provides an overview of the value investing process from search strategy to valuation to investment.

Read on his Web-site his buying criteria. You want to learn this process. A part of what Buffett has done is offer a tax dodge. A private company owner can sell to Berkshire in a stock for stock exchange without paying taxes and have a diversified company in exchange.

READINGS:

The Intelligent Investor by Benjamin Graham and Bruce Greenwald’s Book: Value Investing from Graham to Buffett and Beyond.

Class Case Studies

This is a class in a specific kind of investing. There are two basic approaches. There are short-term investors (preferably not investing taxable money). Many technical investors who do not care about the underlying quality of the companies invest solely on price information. Although some value investors build a time element into their investments. There are investors who look at short-term earnings. Analysts spend their time on earnings’ forecasting. If you think IBM is going to do $1.44 vs. the analyst estimates of $1.40, then you buy IBM, because analysts are behind the real growth in earnings. Your estimate is correct.

Another group, who has given up altogether, they believe the markets are efficient; they index. Unless the distribution is very skewed, then only 50% of the investors can outperform the market.

This is a market for long-term investors with a particular orientation. You look at a security and it will represent a claim on earnings and assets. What is that claim worth?
If you think that a company is worth $22 to $24 per share, then you look to buy with a margin of safety. When the margin of safety is sufficiently large, you will buy. You will look for bargains.

Value Investors constitute only 7% of the investor universe. There is substantial statistical evidence that value investing works: higher returns with lower risks than the market.
Value Investing (“VI”) rests on three key characteristics of financial markets:

1. Prices are subject to significant and capricious movements that can temporarily cause price to diverge from intrinsic value. Mr. Market is to offer you various prices, not to guide you. Emotionalism and short-term thinking rule market prices in the short-run.

2. Financial assets do have underlying or fundamental economic values that are relatively stable and can be measured by a diligent and disciplined investor. Price and value often diverge.

3. A strategy of buying when prices are 33% to 50% below the calculated intrinsic value will produce superior returns in the long-run. The size of the gap between price and value is the “margin of safety.”

1st Evidence: Markets are not efficient. There is overwhelming evidence for periods going back to 1860, the markets are not efficient. Substantial evidence. 70% of professional investors under perform. It is so strong that it is almost disappointing.

The statistical approaches using value criteria automatically beat the market by 3%-5%. You must do better by reducing risk or concentrating.

Tweedy Brown: Stock Price as a Pct. of Book Value, 1967 – 1984 (from What Has Worked In Investing)

Over 8% difference in performance between lowest to highest price to BV!

Buy statistically cheap stocks and sell statistically expensive stocks.

If that does so well, why do they need you (professional money managers)? The big value firms have outperformed the market with lower variances.

2nd Evidence: Lazard and Oppenheimer beat the market with lower variances (less risk).

A disproportionately number of investors who have outperformed the market is similar to Warren Buffett. Note the investors from Graham and Doddesville.

From the Superinvestors from Graham and Doddesville:

A group of investors who year in and year out have beaten the record of the S&P 500.

225 million American coin-flip, each time the losers drop out. After 20 straights heads being flipped, there will be 215 Americans each having won $1 million. $225 million won and $225 million lost. Monkeys could do the same thing, but what if the monkey all came from a particular zoo in Omaha, Neb.?

The intellectual origin: A disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddesville. Their only focus is on two variables: price and value.

The investors were: Walter Schloss, Tom Knapp, Bill Ruane, Charlie Munger and Rick Guerin.

It is instant recognition–buying a dollar for 40 cents. What is the business worth?

This group assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business not buying the stock.

Risk vs. reward is negatively correlated.

The secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, I have seen no trend toward value investing in the 35 years that I’ve practiced it. –Warren Buffet.

See full PDF below.

The post [Archives] Bruce Greenwald Class No. 1 On Value Investing: An Overview appeared first on ValueWalk.

**I should make clear that this is not a series that’ll tell you how to invest, or what to look for. It is only designed to help improve your investing process by observing the processes of some of the world's greatest money managers.

Calculating a business's intrinsic value is a key principle of value investing. But the process of calculating intrinsic value is highly subjective, and many of the world’s greatest value investors all use different methods.

Warren Buffett provides one definition of intrinsic value in Berkshire’s Owner's Manual. He writes:

“Let's start with intrinsic value, an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

The brilliant Aswath Damodaran takes this definition of intrinsic value a step further, stating that:

“It is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk...At its core, if you stay true to principles, a discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant's estimate of what fixed and current assets are worth is the true value of a business.”

S&P 500 Intrinsic Value

Defining Intrinsic Value - Changing with the times

There’s no denying that the concept of intrinsic value has changed over the years. The founding fathers of the deep value school of thought, Benjamin Graham and David Dodd were more concerned about a discount to asset value than complex, long-term DCF models. Graham alumni including Warren Buffett in the 60s, Walter Schloss, Max Heine, Peter Cundill and the Superinvestors of Graham-and-Doddsville group placed little emphasis on cash flow forecasts.

Still, the underlying concept of buying the business rather than the share price remains the same. Moreover, Berkshire’s Owner's Manual gives a great rundown of why the concept of valuing a business like Berkshire has changed from a book value to DCF approach over the years.

“...in 1964 we could state with certitude that Berkshire's per-share book value was $19.46. However, that figure considerably overstated the company's intrinsic value, since all of the company's resources were tied up in a sub-profitable textile business...Today, however, Berkshire's situation is reversed: Now, our book value far understates Berkshire's intrinsic value, a point true because many of the businesses we control are worth much more than their carrying value.”

Graham did publish his own, rather simplified intrinsic value formula.

Benjamin Graham on defining intrinsic value

Benjamin Graham presented the following formula for calculating a stock's intrinsic value:

IV = EPS x (8.5 + 2g)

• IV = Intrinsic value
• EPS = Diluted earnings per share
• 8.5 = Fair price to earnings ratio for no growth company
• G = Conservatively estimated growth in EPS for the next 7 to 10 years

The formula was adjusted to factor in opportunity costs relative to the risk-free rate:

IV = EPS x (8.5 +2g) x 4.4
Y

• 4.4 = The average yield for high-grade corporate bonds in 1962 when the model was introduced
• Y = The yield on AAA rated corporate bonds

And after arriving at an intrinsic value, Graham then computed his relative intrinsic value formula:

RIV = IV ÷ Current Share Price

If the answer to this relative intrinsic value calculation was greater than one, Graham considered the stock to be undervalued. The stock in question was deemed to be overvalued if RIV = <1.

Defining Intrinsic Value - The perfect blend

Overall, it seems one of the best approaches for calculating intrinsic value is to use a blend of values. A mix of DCF figures, book/asset values and long-term growth potential.

This is approach is favored by Seth Klarman who uses a mix of valuation metrics to arrive at, what I’m going to call, an “intrinsic range”. From Greg Speicher’s blog:

“Klarman has said that he frequently sells too early. I suspect that this due not only to his aversion to speculating, but also because of his understanding of intrinsic value. Klarman, like Graham before him, sees intrinsic value not as a specific precise number, but as a range of values. Therefore, it makes sense to sell as the stock price move up into the lower end of this range of values. Otherwise, the higher the price goes, the more you become dependent on the “greater fool” to bail you out.”

And finally, Wally Weitz’s investment process. The following excerpt is from the second half of an exclusive ValueWalk interview conducted with Wally earlier this month.

“...We need to find out everything we need to be comfortable in making a five or ten-year rough projection of cash flows. Because that’s what our valuation is based on; what an owner would be able to collect over the next five or ten years if they owned the whole company...We build a model of how the income statement works. All too often this is based on estimates, which, hopefully, we are appropriately skeptical about...Then we do a discounted cash flow model using a 12% discount rate...Then we’ll make a high case for, if a few things go right, how good could it be. Then a low case based on if something goes wrong...We want to buy at a deep discount to business value…”

In reality, calculating intrinsic value should be a simple process; a DCF calculation with an appropriate discount rate applied. But there’s much more to it than this.

In part two of this series, I’m going to take a look at the methods of intrinsic value calculation favored by renowned value investors. Stay tuned for more on defining intrinsic value!

The post Defining Intrinsic Value: Observing The World’s Greatest Money Managers Pt. 1 appeared first on ValueWalk.

Are your portfolio returns down to skill or luck? Have you outperformed due to stock picking skill or just good luck, aided by the wider market rally? Conversely, has your portfolio underperformed due to a run of bad luck or poor decisions? It's hard to tell.

Those that outperform are more likely to say that it was their skill that yielded results. While those investors that have lagged the market are most likely to blame a run of bad luck.

Michael Mauboussin, the head of Global Financial Strategies at Credit Suisse, looked at the key distinctions between skill and luck in his book The Success Equation: Untangling Skill and Luck in Business, Sports and Investing.

Skill vs. luck

Even though The Success Equation was published several years ago, it remains highly relevant to this day.

Mauboussin writes that the best way to describe the difference between skill and luck is:

“There's a quick and easy way to test whether an activity involves skill; ask whether you can lose on purpose. In games of skill, it's clear that you can lose intentionally but when playing roulette or the lottery you can't lose on purpose.”

In an interview with Forbes at the end of 2013, Michael Mauboussin notes that the best way to describe skill is with its dictionary definition:

“I’m going to define skill right out of the dictionary: The ability to apply one’s knowledge readily in execution or performance. You know how to do something, and when you’re asked to do it, you can do it effectively.”

While luck is much harder to define:

“I’m going to say that luck exists when three conditions are in place. Number one, it operates on an individual or an organizational basis, such as you or your team or company. Second, it could be good or bad. By that, I don’t mean to suggest that it is symmetrical, as in it could be equally good or bad. But rather there is a plus sign or a minus sign. The third thing is that it is reasonable to expect that a different outcome could have occurred. If those three things apply, then you’re in a situation where luck exists.”

But how does this relate to investment performance? Well, Michael Mauboussin notes that in the short-term, a lot of investment results are based on luck. However, in this case, luck and skill overlap.

Blurred Line

As Michael Mauboussin noted in another interview, this time with his employer Credit Suisse:

“There is a lot of skill in markets and investors themselves are all very similarly skillful – this is reflected in prices. As a consequence, that leaves more to luck and is the reason why short-term outcomes can mostly be put down to luck.”

Nevertheless, Mauboussin also notes that over the long-term, any serious study of investment performance will show that skill plays a huge part in manager performance.

But here’s the thing, investors and fund managers have, on average always underperformed. The average investor has only achieved an annual return of around 2.5% for the past two decades, underperforming almost every other asset class over the same period, barring Japanese equities. Source.

Mauboussin notes that, for the most part, investors' dramatic underperformance is due to the 'dumb money effect':

“...people tend to invest when things are good and they tend to pull their money out when things are bad. Because they invest when things are good, they then have subsequent underperformance. They then pull their money out when things are bad so they miss the subsequent rebound. So, the dumb money effect basically says that people do what they should not do all the time. Bad timing is at the heart of this.”

The dumb money effect blurs the line between luck and skill further.

Mauboussin - So you want to be skillful at investing?

There is a certain degree of luck in all investing processes. The big question is, how do you reduce the element of luck in your investing process and improve your skill? Mauboussin:

“The key for investors is to understand the kinds of mistakes they are likely to make. There is some interesting literature on heuristics and biases: this is the notion that we use rules of thumb that tend to give us the right answer most of the time, but they also lead to biases. So, you have to learn about those things. Secondly, it is important for investors to always distinguish between fundamentals and expectations. Asset prices, for example stocks, reflect a set of expectations for the future. The key is to think about what fundamentals have to be in place for that to happen or to make sense. To sum up, it is really a combination of learning about the literature and then applying it successfully.” -- Source

Michael Mauboussin elaborated on this view in an interview with Forbes. This time Mauboussin described the processes involved in investing and how they are essential to improving investing skill:

“...you really have to focus on process.

How do I know if my process is any good? Number one, has it worked in the past and is it economically sound? Number two, I think of good processes as having three essential elements. Element one is analytical: having an ability to find situations in which you believe something the world doesn’t believe and in which you have a good foundation for such a belief.

The second is behavioral: we are all subject to behavioral mistakes and cognitive biases. Are you aware of those things and are you taking steps to manage or mitigate them? The third, which is less true for individuals and truer for organizations, is what I call institutional. This element relates to the constraints in your personal or professional life that don’t allow you to do the best thing possible in terms of your process...If you’ve done that and you get a bad outcome in the short term, you pick yourself up, dust yourself off and you go back at it the next day because over time the process will lead to success.”

Here, Michael Mauboussin refers to the use of checklist to improve investment performance --a topic I’ve covered before:

• Why A Checklist Is An Investor’s Best Friend [Part One]
• Why A Checklist Is An Investors Best Friend [Part Two]

Some of the world’s best value investors, Benjamin Graham, Walter Schloss, Charlie Munger and Mohnish Pabrai to name a few, are well known for their use of checklists in investing.

Mauboussin - Conclusion

The vital conclusion to draw from Michael Mauboussin’s work is as follows. Unless you have an investing process, a checklist, or set way of going about choosing investments, you are relying on luck to drive your investment performance.

Improving your investing process, will improve your investing skill and should drive outperformance. It’s no coincidence that those investors with a set way of doing things (Benjamin Graham, Walter Schloss, Charlie Munger and Mohnish Pabrai) were/are still able to produce some of the best performances around.

• The Role Of Luck And Skill In Investing - Forbes
• Investing: Distinguishing skill from luck | The Economist
• Skill Versus Luck in Investing - Global Trends - Credit Suisse

The post Michael Mauboussin: How To Determine If Your Investment Performance Is Driven By Skill Or Luck appeared first on ValueWalk.

Notes From A Discussion Given By Jean-Marie Eveillard At NYSSA On Global Value Investing by Redfield, Blonsky & Co.

[munger]

April 14, 2005

1. Jean-Marie Eveillard was asked if he is fairly certain that intrinsic value will be achieved by the companies he invests in.  His reply was, " More like hoping or praying that intrinsic value will be achieved.  At the same time I am hoping and praying that the analysis in determining the intrinsic value is correct."
2. Value investors were uncommon in the USA 20 years ago.  It is like that today in the international investment climate.  Hence the potential to find an out of USA value investment is greater, because arena is less proliferated.
3. Corporate governance outside the USA is greater today than it was 20 years ago.
4. Claims there is a big difference between GAAP and IASB (International Accounting Standards Board) .
   a. GAAP looks at specific rules, whereas IASB looks at the "spirit" of the transaction.
   b. Large companies take advantage of GAAP to smooth earnings.  Examples of this are paying corporate officers with Stock Options as opposed to cash compensation.
   c. Walter Schloss said that he has never bought a foreign stock.  His argument was trust of USA accounting.  Now that there are scandals, that thought process is no longer valid.  Biggest scandals are those with major US companies which are engaged in "intellectual dishonesty".
5. You must distinguish between international investing and emerging market investing.  As you invest internationally, look at similar valuation methods as you would in the states.  These are based on your investment philosophy.  Continue to use Ben Graham, Warren Buffett and other traditional methods.  Look for inefficiencies in companies presentation.  What I suppose he means is to understand the accounting method, quality of earnings, cash flows, etc.  Know when to use "Sum of Parts" versus "earnings methods".

6. Value investors must be patient.  This can take 3 to 5 years or longer.  Sell Side research is very short term minded.  Sell Side research determines if there is a catalyst for current growth.  If Sell Sides see no growth in year or two, they will discard that investment.  Value investors will look at a temporary no growth investment.  Value investors should not rely on a catalyst.  A low growth field will have no or minimal competition.
7. Look at China and India , and see if you can invest in an indirect route.  For example, what will those countries be consuming.
8. 6 - 7% of his portfolio has been and probably will continue to be in Precious Metals.
9. Jean-Marie Eveillard does not use Discounted Cash Flow methods.  He certainly applies valuation metrics on expected cash flow.  He didn't say this, but I suspect that he has a road map on investing, whereas the parameters are always changing and updated.  He discussed how he uses a range of intrinsic values for one company.  Hence his valuation thoughts can have a =/- 30 % or so.  He likes to see a stability of cash flow.  He didn't mention this, but I assume he looks for companies with earnings or cash flow predictability.
   a. He claims that PEG ratios are "garbage".  ( I can see his point, but do disagree, as you can use the PEG in the same method as mentioned in part 9. above.)
   b. What would  a somewhat knowledgeable investor pay today for a business.  Again, he commented on using either Graham or Buffett approach.
   c. When he is in a good mood, he says this about Wall Street, " Wall Street is a vast promotion machine."
   d. When he is in a bad mood, he says this about Wall Street, " Wall Street is a den of thieves."
10. Buying Criteria.
    a. He does not use screens.
    b. Jean-Marie Eveillard will often buy at an enterprise value of 10X EBIT
    c. He will sometimes buy at enterprise value of 15X EBIT.  He did mention "15X EBIT is not exactly cheap."
    d. Always restates financials when valuing.  He didn't mention the following, but I would imagine that he looks for earnings quality, smoothing scenarios, moderate to aggressive accounting applications, conservative applications, historical cost versus fair value accounting.  When using "Sum of Parts" method, conservatively value the assets and the debt.  Realize that your valuation can be materially incorrect.
11. You do not need to visit management.  This is especially true when using Ben Graham type of analysis.  In theory, when you meet with management, they are either going to be silent.  They aren't going to be able to tell you anything that will materially change your investment thesis.  He stressed that even an intellectually honest person (mentioned Warren Buffett), will not tell you the weaknesses of their own business.
12. low interest rates are almost over.
13. Jean-Marie Eveillard will often buy a company at $30, then again at $25, again at $20, and so on.  These are times to accumulate, if your investment thesis is correct.
14. He mentioned that Seth Klarman is good reading.  I will have to look into that.
15. Jean-Marie Eveillard mentioned Marty Whitman's distinction between a "temporary unrealized capital loss" (this is described in 13. above) versus a permanent impairment of capital.  A  "temporary unrealized capital loss"  is absolutely nothing to worry about.  The following is my extrapolation of permanent loss of capital....   A permanent impairment of capital is acknowledgement that you %^&$ed up your investment.  When this happens (and it will happen), you need to acknowledge your mistake, recognize that you are human, and move on.  The day that you realize that your analysis is wrong, is the when you need to change your investment position and move on.
16. Update your intrinsic value analysis when new information becomes available.  Continue to look for severe over or undervaluation.
17. This was very important for me.  He mentioned that Warren Buffett became the 2nd richest man while he lived in Omaha Nebraska.  (I won't comment on the use of the word, "rich" versus "wealthy".)  Warren Buffett is certainly wealthy, and of course, I find him to be incredibly "rich".  A rich man is someone who is happy even if they have no material wealth.  Well, I guess I did get into the use of the word, "rich".
    Rely on your research.  Don't worry what the herd says.  Just make sure your research is correct.  I often do this by constantly revisiting your research and trying to poke holes in it.  As mentioned often on our site, "Doubt is central to understanding."
18. "It is warmer inside the herd"
19. "Use a sensible investment approach"

The post [Archives] Notes From Jean-Marie Eveillard On Global Value Investing appeared first on ValueWalk.

How I Blew A 102% Gain In Net Net Wonder Stock Sangoma Technologies by Evan Bleker, Old School Value

(This is a guest post and may not reflect the thoughts and opinions of Old School Value)

[klarman]

Back in late 2013 I found what was nearly the perfect net net stock.

It was conservatively financed.

It was buying back stock.

It was loaded with cash.

…but somehow I managed to muck it all up.

Investors who have signed up to get free net net stock picks already know just how highly I thought of Canadian telecom firm Sangoma Technologies. When I scooped up the company in November of 2013, the company was trading at just $0.20 per share, and a massive 44% discount to NCAV.

Even better, the company was well into a successful turnaround. The business had been hit hard as the telecom industry shifted from old school copper wire to digital technology, leaving Sangoma’s main product dated and increasingly irrelevant.

To address the problem, management doubled down on research and development, planning a series of new product offerings. 19, to be exact. When I found the company, many of these projects had already been released and were making up a good chunk of revenue.

Things were looking positive for the firm and it didn’t take long for investors to recognize that fact. Within 3 weeks of my purchase, the stock was already up 40%, and 100% only 4 months later which made for an annualized 140% return.

So how did it end so badly?

Buying Net Net Stocks

Buying net nets is really quite simple.

You look for firms trading well below NCAV, ensure that NCAV is stable or growing, and then make sure the company hasn’t taken on too much debt. Everything else is really a bonus.

To aid with research, I created my own checklist, my Core7 Scorecard, crafted from a mountain of net net stock studies, as well as the writing of Warren Buffett, Ben Graham, and Peter Lynch. All of this knowledge ensure that I’m picking the best possible net net stocks, but you can just as easily use Jae’s.

The point is to be selective and weed out the bad apples, such as resource exploration firms, pharmaceutical businesses, or companies with significant operations in China, to group together a diversified basket of high probability bets.

You don’t have to be a wiz with research, either. Warren Buffett makes knowing the intricate details of a company and industry his business, but net nets work on a different investment principle. Using a net net strategy really comes down to leveraging the population returns of net nets in general.

What attracted me to Sangoma was that it had many of the bonus items on my Core7 Scorecard, which put it in an elite group of companies.

Selling Net Net Stocks

A lot of the pros say that selling is the hardest part of investing. For net net stock investors, though, it’s really quite easy.

Net current assets provide a firm valuation. Since we’re buying based on a discount to net current assets, it also makes sense to sell a holding once NCAV is reached.

In the end, net net stock investing is really quite simple: buy solid net nets at deeply discounted prices, and sell them once they reach net current asset value. So how did I muck up my investment in Sangoma Technologies so badly?

The Earnings Fallacy

Walter Schloss says that earnings of secondary companies can be erratic, and an investor can only really project the earnings of large growth companies with any accuracy at all.

While it wasn’t profitable, Sangoma had earned a decent amount of money in the past. With how good the company’s outlook seemed, specifically the promise of a profitable and growing product portfolio, it seemed inevitable that the company could regain much of its former earnings power. When this happened, my delusional thinking went, the stock price would follow.

By summer the company had postponed the roll out of its remaining products to focus on working out the bugs in a recently released product. Earnings growth stumbled, and so did the stock, now down to $0.30 from a 52 week high of $0.42.

Then came a bit of bad news. 14 months after I bought the stock, the firm announced that it had acquired two businesses that it hoped would add meaningfully to earnings.

As a net net stock investor, I want to see a stable NCAV. Long term assets don’t factor in to my valuation, and earnings only ever play a supporting role in my investment decision. With these two acquisitions, I knew that the company would be either growing its share count, taking on debt, or handing over a large chunk of cash.

I suspected that all of these were bound to ravage the company’s NCAV but hoped that I was wrong so decided to wait for the final numbers to come in.

Stick to Your Strategy

The biggest problem retail investors have is that they don’t adopt a simple, yet highly profitable, investment strategy and then stick to it.

Ironically, a lot of small investors think that they’re Warren Buffett. They look at Buffett’s returns, and say to themselves, “I’ll just do what Buffett does.” But without Buffett’s skill and experience, this amounts to falling into the Warren Buffett trap and can prove fatal to investment returns.

Choose something simple, something doable, then stick to it.

When you stick to a strategy, you develop expertise in that strategy, and are able to make much better investment decisions as a result. Sure, flexibility is useful as an investor, but if you’re flexible without developing significant competence in any one investment strategy then you’ll just end up earning far lower returns than you otherwise could.

I chose Graham’s net net strategy because of its simplicity, but also because it has proven by far to be the most profitable value investing strategy available. Not many other strategies come close to matching the 15% excess return over the market, or 25%+ average annual returns, that Graham’s net net strategy has consistently shown.

You don’t have to be a net net stock investor (it’s not for everyone) but you should stick with a great value strategy once you adopt it.

…and that was my major mistake.

Ultimately, by waiting to see the company’s profits rebound and hoping for bigger gains, I was playing a different game than the one I had become skilled at. I was stepping outside of my circle of competence and hoping for more. I got greedy.

The Bloody Aftermath

Sangoma’s numbers came out in May and, as expected, net current assets had eroded. The company’s share count was way up, and so was its debt, while its cash balance had shrunk dramatically.

It’s net current asset value had shrunk from $0.324 per share to $0.171 per share, a drop of over 47%, so I decided to get out.

It is still possible that Sangoma Technologies could regain its former earnings power, but that’s far outside my expertise.

If I had stuck to my chosen investment strategy, and had gotten out after the price spiked, I would be sitting at a far higher annualized return than the 30% I ended up with.

About the Author

Evan Bleker is a net net investor and founder of Net Net Hunter. To receive free net net stock ideas and value investing articles, sign up now at Net Net Hunter.

The post How I Blew A 102% Gain In Net Net Wonder Stock Sangoma Technologies appeared first on ValueWalk.

One of the best ways of learning something is to teach it to others. When Benjamin Graham, the father of value investing, started teaching at Columbia University in 1928 he was already an accomplished investor but I’m sure that the process of articulating his investment strategy helped himself as well as his students. These classes also resulted in the investment classic Security Analysis written together with Graham’s Columbia protégé professor David Dodd. It is number 2 on our list of the best investment books ever.

H/T Valueinvestingworld.com

Up until 1978 the value investing course was subsequently taught by Roger Murray who also edited several editions of Security Analysis. The list of investors who over the years have taken the course reads like a who’s who of successful money managers including Warren Buffett, Mario Gabelli, Charles Royce, Walter Schloss, Glen Greenberg and countless others. If there is one institution in the teaching of value investing, this is it. Columbia, one of the six Ivy League business schools and situated on Manhattan, is still retaining this proud heritage and the person carrying the torch for the last several decades is Bruce Greenwald who teaches the present course in value investing. Other high profile investing names currently associated with Columbia are Jean-Marie Eveillard and Joel Greenblatt.

[klarman]

With an academic background in electrical engineering and a Ph.D. in economics Bruce Greenwald might not strike you as the obvious candidate as Graham’s successor but he’s grown into being one of the world’s premier authorities on value investing. The New York Times has – no doubt to his liking - dubbed him “a guru to Wall Street’s gurus”. Bruce Greenwald has also co-authored numerous books on investments and strategy including Competition Demystified and Value Investing, number 5 and 18 on our top list of investment literature. All those who have taught the value investing course over the years have developed their own personal touch with regards to what they present. So what is it that Bruce Greenwald teaches, what is the Bruce Greenwald Method? Given his background he has carved out a very interesting niche in-between the areas of microeconomics, corporate strategy, franchise value investing and deep value investing.

This is “the story of investing according to Bruce” as I to my best ability can interpret it.* After an introduction the text will cover Bruce Greenwald’s process that consists of a search strategy, a valuation method, a research method and a risk management practice. In the end we wrap up.

The Bruce Greenwald Method

There are a number of approaches to investing. If you are going to succeed as an investor you should really pick just one or potentially two – in the latter case they should be kept mentally separate.

The first distinction to make is if you are a believer in efficient markets or not. If you are, you should simply index your securities holdings and focus on asset allocation and cost minimizing. If you are not (and you would have the evidence on your side), you have to choose a strategy that fits your personality and specifically whether you need instant gratification or not. If you do, you should use a short-term strategy – either a technical momentum style or a short-term fundamental strategy. Momentum trumps value in the short term - even though you will have the trading costs working against you. There are successful managers in the technical quant type of camp with Renaissance Technologies as a shining example. The problem is that the short duration of the strategies they are using makes them have to reinvent themselves every 12 or 24 months. Very few firms have this capacity. Most investors, and almost the entire sell side, are short term fundamentalists who try to forecast short term changes in corporate financials – typically estimates of EPS – and map this against consensus numbers. The issue here is that this is a strategy that depends on an information advantage and since everybody crowds into this space, that advantage of having information that no one else has is really, really hard to sustain.

This leaves us the longer term investing approaches such as so called growth investing or value investing where you aspire to buy securities that are priced lower by the market than you think they are fundamentally worth. The notion here is that price and value are not the same; “price is what you pay, value is what you get.” Value investors have dubbed the discrepancy between a security’s price and its intrinsic value “margin of safety” and often demand a 30 to 50 percent discount to be interested in a stock. Value investing is simply looking for bargains in the financial markets. This is a strategy that in fact almost everybody claim they use. Certainly few claim to be buying securities for a higher price than they think they are worth. Further, the evidence is quite clear that – while value investing works - investors overpay for stocks with the highest expected growth rates with underperformance as the result. So in this longer-term area, value investing is the more rational choice.

See full PDF below.

[buffett]

The post The Bruce Greenwald Method: The Story Of Investing appeared first on ValueWalk.

Your Essential Guide To Walter Schloss Investing by Evan Bleker - Net Net Hunter

“Basically we like to buy stocks which we feel are under-valued, and then we have to have the guts to buy more when they go down. And that’s really the history of Ben graham. That’s it.”

[schloss]

Who do you look up to when it comes to investing?

A lot of investors put their faith in Warren Buffett — and for good reason. Buffett has one of the best investment records in the industry, and has been wracking up great returns for investors since the early 60s.

Lesser known, but no less impressive, however, is a man that Buffett warmly refers to as “Big Walt.” When it comes to investing, Walter Schloss is a legend.

Warren and Walter met at a Marshell Wells shareholder meeting, while the company traded below net current asset value, and ended up sharing an office at Benjamin Graham’s investment firm in the 1950s. As those who have already requested free net net stock picks know, Graham's original net net strategy has produced fantastic returns since at least the 1930s. At the time, Graham charged both with finding net net stocks and both ended up adopting that same strategy in their own private practices years later.

While Buffett eventually moved on to buying large well-protected firms in the 1970s, Walter Schloss was able to earn one of the most enviable records on Wall Street by sticking to Graham’s original framework. As Buffett put it in Superinvestors of Graham-and-Dodsville,

“…He knows how to identify securities that sell at considerably less than their value to a private owner… 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.”

Walter Schloss’ record hasn’t exactly disappointed. Over the 47 years since the closure of Graham-Newman, the high school only graduate managed to earn a solid compound annual return of 16% for his investors after management fees. While that’s an incredible 60% higher than the S&P 500, his actual portfolio returns were much better.

Just how good? When Warren Buffett dubbed Walter Schloss a super investor back in 1984, Walter had already been managing money for 28 years. According to records obtained by Buffett, Walter Schloss’ returns before management fees stood at a compound annual return of 21.3%. Not bad for a guy who never attended college!

Many investors think that making money on stocks requires using advanced investment strategies, or having a 6th sense about the market, but Walter’s investment strategy was surprisingly simple. In fact, it’s so simple and so profitable that small retail investors should really pay attention.

Walter Schloss on What Not to Do

Many investors love to forecast the direction of the markets but, while it’s possible to guess correctly from time to time, investors have proven unable to make accurate market predictions to the extent that they just can’t be relied on to yield great returns over the long run. Walter Schloss understood this well, so stayed clear of this trap. In an article titled Setting the Right Pace, he clarified that his stance wasn’t just philosophical but stemmed from his inability to know which way the market will go,

“I am not good at market timing, so when people ask me what I think the market is doing, their guess is as good as mine.”

It wasn’t just market timing — Walter Schloss also distrusted the promises of management and earnings projections. When talking about his investment in the Milwaukee Rail Road, a firm that Schloss was told would be acquired, Walter Schloss recounted,

“I paid $50 a share for it because I was going to get $80. Well, that was in 1969, the market went down and the deal didn’t go through. You have to be very careful when people say they are going to do something.”

On the earnings front, Discounted Cash Flow calculations applied to equities were strictly out due to the trouble estimating profits to get a solid valuation. As Walter explains,

“I really have nothing against earnings, except that in the first place earnings have a way of changing. Second, your earnings projections may be right, but people’s idea of the multiple has changed. So I find it more comfortable and satisfying to look at book value.”

In fact, as time passes, earnings become even more tricky to estimate. In a letter reprinted in the Harvard Business Review in 1965, Schloss wrote,

“…earnings are much more likely to fluctuate than are book values, and therefore, estimating longer term earnings than, say, the next year or so can be subject to serious error.”

But it wasn’t the case for Walter Schloss that all earnings based valuations were out. In Sixty-five Years On Wall Street, he highlights which companies investors can produce plausible profit projections for and which firms they can’t,

“…one of the things about these undervalued stocks… is that you really can’t project their earnings. There are stocks where there’s growth and you project what’s going to happen next year or five years. Freddie Mac or one of these big growth companies, you can project what they’re going to do. But when you get into a secondary company, they don’t seem to have that ability.”

Interestingly, while most professional money managers focus on earnings, Walter Schloss based his investment strategy on something that proved far more valuable in practice.

Walter Schloss’ Ideal Investments

During his early career, Walter Schloss leveraged Benjamin Graham’s famous net net stocks strategy. From Setting the Right Pace,

“I used the same investment approach I used at Graham-Newman — finding net-net stocks. It was all about capital preservation because I had to serve in the best interests of my investors.”

Graham developed his net net stock strategy after suffering devastating losses in the 1930s. His focus was on finding a strategy that would help protect an investor’s downside while providing significant upside potential.

The strategy proved exceptional. While Graham found that he could produce average annual returns in excess of 20% per year by buying a hundred or so decent quality net nets, he also found net nets to provide good downside protection. Graham may have underestimated the strategy’s potential, however. Later studies pegged the strategy’s average annual pretax returns at between 20 and 40%.

“Back in the 1930s and 1940s there were lots of stocks, like Easy Washing Machine, and Diamond T Motor, that used to sell below working capital value. You used to be able to tell when the market was too high by the fact that the working capital stocks disappeared. But for the last 15 years of so, there haven’t been any working capital companies.”

While Walter Schloss and his son, Edwin, hunted for net net stocks throughout their career, as the markets moved higher, there were far fewer net nets on offer. To compensate for this dry spell, Schloss shifted to buying distressed firms that were trading at low prices relative to book value. From 65 Years on Wall Street,

“[Our strategy has] changed because the market has changed. I can’t buy any working capital stocks anymore so instead of saying well I can’t buy ‘em, I’m not going to play the game, you have to decide what you want to do.”

Net net stocks almost completely dry up during overheated markets, which can spell trouble for investors who insist on sticking to domestic securities. But, there’s always a depressed market somewhere, which gives investors willing to venture out into friendly international markets a huge advantage. Currently, Net Net Hunter members are finding the most promising opportunities in Japan.

Walter Schloss Investing 2.0

Perhaps mistakenly, Walter Schloss stubbornly stuck to North American markets, forcing him to shift his strategy. Like Buffett in the late 1960s, he just couldn’t wrack up the same returns without significantly more work. But, rather than focus on growing businesses, Walter stayed true to his deep value roots with a natural extension of Graham’s net net stock strategy. While not nearly as profitable, it still produced good returns. From a 1985 Barrons article, The Right Stuff: Why Walter Schloss Is Such A Great Investor,

“[W]e look at book value, which is a little lowering of our standards…”

Walter Schloss knew that second editions of a product were not always better. Despite the lack of net nets, Schloss put Graham’s principles to work by buying firms for less than the value of their realizable asset values. In The Right Stuff, he explained,

“You don’t have to just look at book value. You can look at what you think companies are worth, if sold. Even if it isn’t going to be sold. Are you getting a fair shake

The post Your Essential Guide To Walter Schloss Investing appeared first on ValueWalk.

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Was Warren Buffett A True Value Investor When He Bought Precision Castparts? by Chuck Carnevale, F.A.S.T. Graphs

[buffett]

Introduction

When I first got interested in investing in common stocks some 50 years ago, I thought it would be wise to research and then study the investing behaviors and philosophies of the recognized investor greats.  My efforts first led me to Ben Graham, and from there to many other famous value investors such as Philip Fisher, Walter Schloss, William J.  Ruane, Irving Kahn, Peter Lynch, and of course the venerable and perhaps most famous of all, Warren Buffett.

Although each of these investing greats had their own unique style and approach, they were all investors that focused on value.  Consequently, I patterned my own investment philosophies and beliefs on sound valuation.  Admittedly, assessing sound valuation is not a perfect science.  However, there are certain fundamental principles that do apply and have passed the test of time.  One of those principles is to be only willing to invest when fundamentals, primarily earnings, can be purchased at a price that makes economic sense.

Does Warren’s Purchase of Precision Castparts Make Economic Sense?

Yesterday, Seeking Alpha reported on Warren Buffett’s purchase of Precision Castparts Corp (PCP) under the following headline: “Buffett pays high price for Precision Castparts.”

There were several links in the report, but this one suggested that Warren was paying a P/E ratio of 18×1 year’s forward earnings:

“It's the biggest deal of Warren Buffett's career: BRK is paying $235/share for PCP, a 21.2% premium over Friday's closing price and 18x projected profit over a 12-month period.”

Since I’ve been a long-term follower of Warren Buffett, I thought it would be interesting to evaluate Warren’s purchase through the lens of the F.A.S.T. Graphs™ fundamentals analyzer software tool.  My first graph produces a look at the company’s earnings and dividends only (yes, PCP does pay a miniscule dividend).  What we discover is a reasonably consistent record of operating earnings growth averaging 15.6% since 2003.  Although there is minor cyclicality along the way, Precision Castparts has been a very profitable enterprise.  Note that although earnings fell in 2009, the company remained highly profitable even during the Great Recession.

With my second graph I bring in monthly closing stock prices (the black line) and a calculation of the historical normal P/E ratio (the dark blue line).  It’s interesting to note that since 2003 Precision Castparts’ stock price has been awarded a normal P/E ratio of 18.2, which is the multiple of the dark blue line across the entire graph.

What I found interesting is that coming off of excessive valuation in 2013, Precision Castparts’ stock price fell precipitously throughout all of 2014 and prior to Warren’s purchase throughout 2015.  At the beginning of 2015 the stock price went right on through the historical normal P/E ratio of 18, and just prior to being purchased by Warren Buffett was trading at a theoretical fair value blended P/E ratio of 15.4.

However, what I found most interesting is that the price that Warren Buffett is paying brings the stock price into alignment with its historical normal P/E ratio.  Personally, I do consider that a moderately steep price to pay.  On the other hand, perhaps it’s not too high considering he’s buying the entire company.

When I examined the associated performance report with the above graph, it provided additional perspective on why Warren Buffett might have been interested.  This high-quality aerospace and defense company has dramatically outperformed the average company as measured by the S&P 500 since 2003.  However, Warren Buffett’s purchase did provide a nice boost to the historical returns of long-term shareholders.

At its closing price on August 7, 2010 Precision Castparts was trading at a blended fair value P/E ratio of 15.4.  Once again, this is below the historical normal P/E ratio of 20.3 since fiscal year 2011.

Consequently, an argument could be made that Warren Buffett is paying a slight discount to the company’s historical normal P/E ratio over the past 5 or 6 years.  I’m not suggesting that he’s buying the company cheap, I’m simply pointing out that relative to historical norms, it doesn’t appear that he is overpaying either.

Next I thought it would be interesting to do a quick examination of Precision Castparts’ historical gross (gpm) and net profit margins (npm).  I chose the period 1999 to present in order to offer a perspective on whether margins were improving or declining.  Interestingly, Precision Castparts’ gross and net profit margins have been on the upswing over the past 6 or 7 years.

Warren Buffett often talks about the book value of Berkshire Hathaway in his reports.  Therefore, I thought it might be interesting to look at Precision Castparts’ book value (common equity per share-ceps).  As of the end of fiscal year March 2015, Precision Castparts’ book value was $76.64.  Consequently, Warren Buffett is paying approximately 3 times book, which I don’t consider a steep price for such a strong profit growth company.

Precision Castparts has also seen strong growth in assets per share (atps) since fiscal year March 2009.  As of the end of fiscal year March 2015, Precision Castparts had assets of $136.24 per share.

Finally, I took a look at Precision Castparts’ revenues since fiscal year-end March 2009.  Once again, I discovered strong double-digit average growth of revenues.

Summary and Conclusions

Warren Buffett has indicated that he will utilize about $23 billion of Berkshire Hathaway’s cash and borrow $10 billion to fund the approximately 97% of Precision Castparts that he did not already own.  Although I do not feel that he necessarily stole the company, considering that he is purchasing the entire enterprise the deal seems to make sense, and is just what I would expect from Warren Buffett.  Therefore, to answer the question posed in the article title, it appears that Warren Buffett has been true to his value investing principles.  Regardless of how the reader may feel, I hope this presentation provided some additional insights into the mind and investing strategy of the venerable Warren Buffett.

Disclosure:  No position at the time of writing.

Disclaimer: The opinions in this document are for informational and

The post Was Warren Buffett A True Value Investor When He Bought Precision Castparts? appeared first on ValueWalk.

Walter Schloss: The Hippocratic Method In Security Analysis

[schloss]

That excellent compendium of reflective thinking known as The Practical Cogitator from which our own pseudonym may have been filched - contains an interesting account by L.J.Henderson of the method of Hippocrates, "the most famous of physicians." This procedure is described as follows:

"The first element of that method is hard, persistent, intelligent, responsible, unremitting labor in the sick-room, not in the library; the complete adaptation of the doctor to his task, an adaptation that is far from being merely intellectual. The second element of that method is accurate observation of things and events; selection, guided by judgment born of familiarity and experience, of the salient and the recurrent phenomena, and their classification and methodical exploitation, The third element of that method is the judicious construction of a theory ~ not a philosophical theory, nor a grand effort of the imagination, nor a quasi-religious dogma, but a modest pedestrian affair, or perhaps I had better say, a useful walking~stick to help on thereof."

Henderson goes on to suggest that this procedure, so successful in the study of sickness, may well be employed in studying " the other experiences of everyday life." That phrase would scarcely suggest our special line of endeavor; yet the temptation to draw parallels between security analysis and medicine is almost irresistible. Both medicine and security analysis partake of the mixed nature of an art and a science; in both the outcome is strongly influenced by unknown and unpredictable factors; in both we may find - in Henderson‘s phrase - "the concealment of ignorance, probably more or less unconsciously, with a show of knowledge."

If we give our imagination a little rein we can develop systematic analogs between the work of the physician and that of the analyst. We can set off the client, with his cash resources and his security holdings, good and bad, against the patient with his constitution and his physical vigor or ailments. This suggests that the typical doctor who ministers only to the sick is fulfilling but a part of his function, as would a security analyst who was consulted only when investments went wrong. The full duty of the physician as of the analyst, should be to assist the patient-client to make the most effective use of all his resources - in one case physical, in the other financial.

Another analogy, more forced yet perhaps more useful, may be drawn between the individual patient and the individual security. Suppose doctors were asked by insurance companies to tell at what rate they should insure given applicants‘ against sickness and death. This would involve an appraisal of each applicant's health factors in quantitative terms, perhaps.gs a per cent of "par." Is not this at bottom.what the security analyst does, or should do, with respect to the stock or bond issues he examines? He must judge whether they are good risks at going prices; or conversely, name the price at which they would be good risks. Both the physician and the analyst must consider a host of factors in arriving at these judgments; they must expect unforeseeable events to play hob with some of them; they must rely on sound methods, experience and the law of averages to vindicate their work.

We have pursued our analogies farther than is prudent, in order to gain a better hearing from security analysts for the Hippocratic method. The first element listed at the outset - "unremitting labor in the sick-room" - we shall concede is followed by our responsible analysts. We do work hard and persistently; we do gain our knowledge of securities at first hand - in the board room, if not in the sick room.

See full PDF below.

[schloss]

The post Walter Schloss: The Hippocratic Method In Security Analysis appeared first on ValueWalk.

What You'll Learn

1. Walter Schloss' performance record vs Buffet

2. Walter Schloss on his investment philosophy

3. Walter Schloss on buying stocks

4. Walter Schloss on selling stocks

I've shown you how small investors can beat the professionals on Wall Street by not playing with the same rules.

Walter Schloss was such a man.

OK… well he was a professional, but not in the normal sense.

He didn't play by Wall Street rules. He took the unorthodox route of ignoring news, ignoring tips, sticking to cigar butts and holding thousands of stocks over his lifetime.

The result?

Here's a table view. Unfortunately, data is only available up to Q1 of 1984.

Walter Schloss

Schloss Partnership Annual Returns 1956 to 1984 Q1 | Click to enlarge

Over this period of 28 and a quarter years, the Schloss partnership returned a staggering 21% CAGR.

Just to show you how good he was, here's a side by side of Walter Schloss' performance against Buffett and the S&P over their overlapping periods.

What's impressive about both Schloss and Buffett is their ability to have a good year even when the market was down.

(You can also see why Buffett is a legend. His performance speaks for itself. Sure there are lots of ups and downs, but even in his “down” years are still positive.)

[buffett]

Look at the chart and it proves that you can do well independent of the market.

Now what's most impressive about Walter Schloss' record is that he didn't have a college degree.

So how did he do it?

Well let's get into his brain and find out based on the many quotes I've scoured from the internet.

The Schloss Investing Approach – Quick Summary

Philosophy and Style

Investors are best served using a Benjamin Graham value approach, looking for stocks that are hitting new lows and those trading at a price lower than their book value per share.

Universe of Stocks

Stocks are selected from among well-known “Campbell Soup” companies. Exclude foreign stocks and those in industries with which the investor is unfamiliar.

Criteria for Initial Consideration

• Ten-year track record
• No long-term debt
• A low price-to-book-value ratio
• A stock at or near its 52-week low price
• High insider ownership

Portfolio Construction

• Limit holding of one stock to no more than 20% of entire portfolio
• Well-diversified portfolio of up to 100 stocks
• Holdings weighted based on their perceived values, putting less money in positions the investor is less sure about
• Use limit orders to purchase stocks

Stock Monitoring and When to Sell

In general, try for a 50% profit from any holding before selling. If a stock's price is falling and the company's fundamentals are sound, buy more.

Walter Schloss on His Investment Philosophy

Keep things clear and simple. There's no need to chase complicated stocks or situations if you don't understand it.

When it comes to investing, my suggestion is to first understand your strengths and weaknesses, and then devise a simple strategy so that you can sleep at night.

I don't like stress and prefer to avoid it, I never focus too much on market news and economic data. They always worry investors.

You have to invest the way that's comfortable for you.

Try not to let your emotions affect your judgment. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.

I think investing is an art, and we tried to be as logical and unemotional as possible. Because we understood that investors are usually affected by the market, we could take advantage of the market by being rational. As [Benjamin] Graham said, ‘The market is there to serve you, not to guide you!'

I like Ben's analogy that one should buy stocks the way you buy groceries not the way you buy perfume

The ability to think clearly in the investment field without the emotions that are attached to it is not an easy undertaking. Fear and greed tend to affect one's judgment.

He goes on further about the way he approaches building a portfolio and protecting his capital.

Don't buy on tips or for a quick move. Let the professionals do that, if they can.

Remember that a share of stock represents a part of a business and is not just a piece of paper.

Prefer stocks over bonds. Bonds will limit your gains and inflation will reduce your purchasing power.

Listen to suggestion from people you respect. This doesn't mean you have to accept them. Remember it's your money and generally it is harder to keep money than to make it. Once you lose a lot of money it is hard to make it back.

Most look at earnings and earnings potential, well I can't get into that game.

I used the same investment approach I used at Graham-Newman finding net-net stocks. It was all about capital preservation because I had to serve in the best interests of my investors. Many of them were not wealthy, and they needed me to generate returns that would allow them to cover their living expenses.

I try to protect myself from permanent loss of capital by investing in stocks that are depressed.

When you buy a depressed company it's not going to go up right after you buy it, believe me.

I like to buy companies with very little debt so it has a margin of safety.

I like to buy basic businesses not high flyers that sell at huge multiples.

I'm not very good at judging people. So I found that it was much better to look at the figures rather than people.

We don't own stocks that we'd never sell. I guess we are a kind of store that buys goods for inventory (stocks) and we'd like to sell them at a profit within 4 years if possible.

Remember the word compounding. For example, if you can make 12% a year and reinvest the money back, you will double your money in 6 years, taxes excluded. Remember the rule of 72. Your rate of return into 72 will tell you the number of years to double your money.

You never really know a stock until you own it.

Walter Schloss on Buying Stocks

Walter Schloss ran with the idea of buying cheap stocks and taking a more quantitative approach. Instead of following every stock he owned, he heavily focused on valuation and buying at a discount to his intrinsic value.

You don't have to perform complex valuations either.

At old

The post The Profoundly Simple Wisdom of Walter Schloss on Producing Towering Returns appeared first on ValueWalk.

Walter Schloss - Ben Graham And Security Analysis: A Reminiscence by RedField, Blonsky, Starinsky & Co.

[schloss]

From 1976

Ben Graham was an original thinker as well as a clear thinker. He had high ethical standards and was modest and unassuming. He was one of a kind. I worked for him for nearly 10 years as a security analyst.

In re-reading the preface to the first edition of Security Analysis, I am impressed all over again with Ben’s views. I quote . . . “[W]e are concerned chiefly with concepts, methods, standards, principles, and above all with logical reasoning. We have stressed theory not for itself alone but for its value in practice. We have tried to avoid prescribing standards which are too stringent to follow or technical methods which are more trouble than they are worth.”

Security Analysis says it all. It is up to analysts and investors to put Ben’s ideas into practice.

Back in 1935 while working at Loeb Rhodes (then called Carl M. Loeb 8t Co.), one of the partners, Armand Erpf, gave a good piece of advice when I asked him how I could get into the “statistical department.” In those days and perhaps today to some extent, the best way to advance was by bringing in business. If you had a wealthy family or friends, you brought in commissions. Security analysis was in its infancy and who you knew was much more important than what you knew. If you didn’t have connections, it was difficult to get ahead. In any case Mr. Erpf told me that there was a new book called Security Analysis that had just been written by a man called Ben Graham.

“Read the book and when you know everything in it, you won’t have to read anything else.”

I took Ben’s course in Advanced Security Analysis at the New York Stock Exchange Institute (New York Institute of Finance).

Ben Graham was a good speaker, enthusiastic and logical. Ben did something that I haven’t seen done often. He would take an undervalued situation at that time, such as the bankrupt bonds of Baldwin Locomotive, and show how much the new securities would be worth based on their projected earning power and assets and relate this to the price of the bonds. Many bright Wall Streeters such as Gus Levy of Goldman Sachs, who later became the top arbitrageur in the country, used to take his course. I often wondered how much money people made on Ben’s ideas by transforming them into investments.

Ben was very generous with his thoughts and his time, particularly with young people. By offering me a job as his security analyst as I was about to leave the Army at the end of 1945, he changed my life. I know he helped others in our field too.

At Ben’s memorial service, Dave Dodd, Ben’s co-author, told how he had got involved in the book.

It seems that Ben Graham was asked to teach a course at Columbia University on investments and he agreed to do it with the stipulation that he would only do so if someone would take notes. Dave Dodd, a young instructor, volunteered and took copious notes at each of Ben’s lectures. Ben, using the notes, then went ahead and wrote Security Analysis. As Dave said, Ben did the work but he insisted that Dave get credit by being co-author.

Professor Dodd went on to become a very successful investor and a director of Graham-Newman Corporation, an investment trust that Ben had founded in 1936 with his partner, lerome Newman.

The ability to think clearly in the investment field without the emotions that are attached to it, is not an easy undertaking. Fear and greed tend to affect one’s judgment. Because Ben was not really very aggressive about making money, he was less affected by these emotions than were many others.

Ben had been hurt by the Depression, so he wanted to invest in things that would protect him on the downside. The best way to do this was to lay out rules which, if followed, would reduce his chance of loss.

A good example of this was the day I happened to be in his office at Graham-Newman when he received a telephone call that they had Bought 50 percent of Government Employees Insurance Co. (now (GEICO). He turned to me and said, “Walter, if this purchase doesn’t work out, we can always liquidate it and get our money back.”

The fact that GEICO worked out better than his wildest dreams wasn’t what he was looking for. As the saying goes, a stock well bought is half sold. I think Ben was an expert in that area.

Graham-Newman followed the precepts set down by Ben and the fund prospered. Compared to today’s investment company, it was tiny. Its total net assets on January 31, 1946, were $3,300,000.

Ben’s emphasis was on protecting his expectation of profit with minimum risk. If one wants to get hold of Moody’s Investment Manuals for the 1947-4956 period, it is interesting to see Graham-Newman’s holdings. Many of them were small, practically unknown companies but they were cheap on the numbers. It is instructive to read their annual report for the year ended January 1946. It states that their general investment policies were twofold.

1. To purchase securities at prices less than their intrinsic value as determined by careful analysis with particular emphasis on the purchase of securities at less than their liquidating value.
2. To engage in arbitrage and hedging operations.

I helped Ben Graham with the third edition of Security Analysis, published in 1951. In the appendix is an article on special situations that first appeared in The Analysts Journal in 1946. In the article, he had worked out an algebraic formula for risk-reward results that could be applied today, 37 years later.

In 1949, The Intelligent Investor was published. This was a book for the layman but it focused on security analysis and gave prestige to the field. Its fourth revised edition is still in print.

One day, I came across a very cheap stock based on its price at the time, Lukens Steel. We bought some but expected to buy more.

At this point, Ben went out to lunch with a man who kept telling Ben about one blue chip after another. At the end of the meal he asked Ben if he liked anything and Ben said we were buying some Lukens Steel.

Security Analysis: The Classic 1934 Edition by Ben Graham

See full PDF below.

The post [Archives] Walter Schloss – Ben Graham And Security Analysis: A Reminiscence appeared first on ValueWalk.

Five Super Reads To Help You Calmly Navigate Choppy Markets by Jae Jun, Old School Value

It’s been a while.

About 3 years since we’ve had any sort of market correction.

And because it’s been so long, you’ve probably forgotten how it feels to see your portfolio drop 10%.

I have.

So whenever markets get choppy with uncertainty or I feel like I’m falling into a worrying or fearful state of mind, I pull out my set of “emergency” articles that helps put things back into perspective and gets me back into the right frame of mind.

These articles, letters or memos act as my investing compass.

[schloss]

• The Super Investors of Graham and Doddsville
• Walter Schloss 16 Factors Needed to Make Money in the Stock Market
• Seth Klarman on the Painful Decision to Hold Cash
• Seth Klarman on the Value of Not Being Sure
• Ditto by Howard Marks

[klarman]

Shut out the noise, grab a soothing beverage, and read these papers.

Here are my favorite parts from each of the papers.

The Super Investors of Graham and Doddsville

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc.

Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.

I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.

16 Factors Needed to Make Money in the Stock Market

Following on from the article on Walter Schloss’ profoundly simple wisdom, Schloss wrote down 16 golden rules to make money in the stock market.

The Painful Decision to Hold Cash

It’s painful until it isn’t.

The alternative is to remain liquid, defy the steady drumbeat of performance pressures, and wait for the prices of at least some securities to drop. (One doesn’t need the entire market to

The post Five Super Reads To Help You Calmly Navigate Choppy Markets appeared first on ValueWalk.

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Don't Sweat The Coming Market Crash by Evan Bleker -- Net Net Hunter

[munger]

Investors are understandably worried about a coming market drop. The last recession we had, in the dark days of 2009, almost left the US on the dustheap of history. With markets now well into their 7th year of this abnormally long bull market, many of the structural problems that triggered the 2009 crisis unsolved, and the Chinese market scare only a month behind us, it's no wonder that investors are jittery.

But a market drop is one thing, and investing quite another. A market drop does not necessarily spell disaster for an intelligent investor. If investors maintain a long term perspective, they should be even less worried.

But can you go one step further and avoid large market drops altogether? If you could, your returns would definitely improve since you would be taking advantage of all of the positive years and sidestepping the down years completely.

So, is it possible to time the market to avoid market drops?

Caution From the Greats

If so, I’d definitely adopt that strategy. The problem is, all of the advice that I’ve come across from great investors has advocated against trying to time the markets. Here are some of the best I’ve read…

Peter Lynch

"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves."

"I can't recall ever once having seen the name of a market timer on Forbes' annual list of the richest people in the world. If it were truly possible to predict corrections, you'd think somebody would have made billions by doing it."

Walter Schloss

“I am not good at market timing, so when people ask me what I think the market is doing, their guess is as good as mine.” Link

Seth Klarman

“In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.”

Warren Buffett

“You know, people talk about this being an uncertain time. You know, all time is uncertain. I mean, it was uncertain back in - in 2007, we just didn't know it was uncertain. It was - uncertain on September 10th, 2001. It was uncertain on October 18th, 1987, you just didn't know it.”

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”

Charlie Munger

“I'll take someone any day who just says "I don't know" what an individual stock or the market as a whole is likely to do (near-term and even much longer) over those who are willing to make prognostications. Better to just expect difficult market conditions from time to time and realize that those difficulties may look nothing like those of the past; maintain reasonable but conservative expectations then end up pleasantly surprised if things go a bit better.”

Benjamin Graham

“The last time I made any market predictions was in the year 1914, when my firm judged me qualified to write their daily market letter based on the fact that I had one month’s experience.  Since then I have given up making predictions.” Link

With names like that making such critical comments on market timing, it’s no wonder I’m skeptical. But it’s not just the investment legends that steer me off of trying to time the markets, the research seems dead-set against it, as well.

Studies Show…

It's one thing to advise the little guy not to try to time the market, like your parents trying to advise you not to drive too fast when you first get your license, but can the pros themselves time the market successfully?

Apparently not. In "Mutual Funds: Risk and Performance Analysis For Decision Making," John Haslem summarizes the research done on mutual fund managers to get a sense of how well the pros can time the markets to boost their overall returns. What he finds isn't confidence inspiring, to say the least.

Of the 13 studies cited, none found that mutual fund managers could time the market -- that is, get out of the market before a big drop and into stocks before a rebound -- to any extent at all. What managers did do this successfully couldn't do it consistently and most market timing managers were subject to significantly more risk.

How much more risk? Failing to time the market correctly could decimate your returns. According to Haslem, the maximum downside risk is twice as large as the maximum upside potential. Not only that, but managers would need a minimum 69% accuracy to beat a buy and hold strategy! They would have to be right 7 of 10 times! Being right 100% of the time to avoid a market drop, but only timing market re-entry right 50% of the time, would have still underperformed a regular buy and hold strategy...

As one of the study authors quipped, "Despite the overwhelming evidence against timing, it -- like alchemy before it an astrology to this day -- still boasts devoted followers."

When it comes to net net stocks, you really have to be in the game when those good years happen or you'll inevitably underperform. The same goes with the S&P 500. One of the studies cited by Haslem found that of the 64 years covered, large market surges were concentrated in only 55 months -- 7.1% of the months studied were responsible for most of the S&P 500's return!

Another dark finding is that market timers have a bad tendency of getting out of the market after it has fallen, and into the market after it's already surged. This causes a market timer to not only suffer the large drop, but miss the inevitable bounce back up in price!

Can You Use Market Valuation, Such As The Shiller PE, To Dodge Market Drops?

Tobias Carlisle is best known by his popular blog Greenbackd. In fact, he’s one of the few people who were influential in helping me jump into net net stocks with both feet.

On the blog, Tobias publishes research that he’s conducted on different value investing, including a great pair of articles which examined the impact of trying to use the Shiller PE market valuation method to try to time the market. From “Worried About a Crash?”:

“Can an investor concerned about a big crash use a systematic timing tool to exit the market before the crash without giving up too much return? One possible method for doing so is to use the Shiller PE as a valuation tool, and to move the portfolio into cash at some given level of overvaluation. The backtests below show the returns and drawdowns for exiting at four different levels of the Shiller

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Walter Schloss was a direct student of Benjamin Graham, and is one of the “Super Investors” mentioned by Warren Buffett in his famous essay, The Super Investors of Graham-And-Doddsville.  

Walter Schloss followed Benjamin Graham’s cigar-butt style of investing throughout his five-decade long career on Wall Street. From 1955 to 2002 — when he stopped managing money — by Schloss’ estimate, his investments returned 16% per annum on average after fees, compared with 10% for the S&P 500 over the period.

Even today, Walter Schloss’ deep value philosophy remains relevant. His common sense approach to investing provides a road map for long term success that can easily be replicated.

Walter Schloss: Rare letter

Unfortunately, Walter Schloss didn’t give many interviews over his career, but there’s still a great deal of information out there that details his style of investing, as well as his thoughts on the market.

Below is an excerpt, followed by a copy of a letter Walter Schloss wrote to the Commercial and Financial Chronicle in December 28 1953, while he was still working at the Graham – Newman corporation.

The letter, titled In Defense of Stock Dividends, comments on advantages to stockholders of stock (scrip) dividends over their cash alternatives.

“…no one, I believe, has said that paying cash dividends is worse than paying stock dividends, although sometimes payment of large cash dividends may jeopardize a corporation’s expansion program. The payment of stock dividend is used when a corporation decides that earnings have to be retained for expansion purposes, but that the stockholder should get some tangible evidence that the directors are cognizant of his needs…a stock dividend will also help those investors in companies which have been paying small cash dividends and re-investing the balance of earnings without giving the stockholder a fair return on his investment (capital and surplus).”

The post From The Archives: Walter Schloss In Defense Of Stock Dividends appeared first on ValueWalk.

Walter Schloss was undoubtedly one of Benjamin Graham’s best students. Schloss practiced deep value investing right up unit his death in 2012, achieving an average return of around 16% per annum using Benjamin Graham’s cigar-butt strategy.

And this performance has made Walter Schloss a figurehead of the deep value landscape. He was a lifelong friend of Warren Buffett and Schloss featured in Buffett’s essay ‘The Superinvestors of Graham-and-Doddsville’.

Walter Schloss – Remains relevant

Even today, Walter Schloss’ deep value philosophy remains relevant. His common sense approach to investing provides a road map for long-term success, which can easily be replicated by any investor.

As part of his common sense approach to investing, to help minimize the risk of making mistakes and streamline the investment process, Walter Schloss used checklists to ensure that potential investments met his deep value criteria.

Below is one such checklist used for investing in liquidation situations.

The list is titled ‘Criteria For Liquidations Where Money Is Held By Company’ and copy of the original document can be found below. This note was first written by Schloss during May 1952.

Criteria For Liquidations Where Money Is Held By Company

1. Percent of profit should be minimum 15-20% per annum based on estimate of time and payments to be made.
2. Should be a few points spread between market and estimated work-out despite percentage gain.
3. If in litigation — issue should be earning some money during the period or at least not losing (much) money
4. Prospect of loss on investment should appear remote. Use Graham’s formula on special situations.
5. Issue should be first in line for payment — not junior security

COMMENT:   Preferable to buy liquidations before initial payout as most of the money received back and low remaining cost then increases percent return.

WARNING:     Liquidations not as profitable as formerly due primarily to competition of specialists in the field.

With the above criteria in mind I reviewed our present holdings and it appeared based on our figures and reports that Wealdon Corporation still seems attractive.

We presently own $28,500 or 1500 shares in Graham-Newman and $68,000 or 3596 shares in Newman & Graham

Our Average Cost	Present Market	Estimated Work-out	Time	Annual % Profit
19	18 7/8	23	1 yr.	21%

[Note on page: Graham formula. 80% chance of success at 23 within 1yr]

It would appear likely that a larger payment estimated $15-$20 a share will be paid within a year. To satisfy ourselves that the management is thinking along these lines, I would suggest that Lawrence Kessel go to Baltimore and talk with J.B. Warton.Jr. the Treasurer, who is the active officer. If this appears inadvisable, then a telephone call to him is suggested.

If the additional information we secure is satisfactory, I believe we should increase our holdings in Graham-Newman Corporation to $50,000 and Newman & Graham to $100,000.

Walter J. Schloss

The post From The Archives: Walter Schloss’ Criteria For Company Liquidations appeared first on ValueWalk.

This is part one of a ten-part series on the life and career of Benjamin Graham, the Godfather of value investing and Dean of Wall Street.

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Benjamin Graham — Part one: Introduction

Most investors will have heard of Benjamin Graham. Often called the ‘Godfather of value investing,’ Benjamin Graham revolutionized Wall Street during the first half of the last century.

Indeed, Graham wasn’t just a value investor. When Graham first came to Wall Street, the market was mostly populated by high net worth speculators. Graham introduced to the market the notion that shareholders should view their shareholding as an ownership interest, rather than a betting slip for the world’s largest casino.

And nearly fifty years after his death, Graham’s teachings are still relevant. His out-of-date books, Security Analysis, and the Intelligent Investor are still in print and teaching today’s investors how to think about the market.

The tremendous success of Benjamin Graham’s students is also a testament to his legacy. Investing greats such as Warren Buffett, Walter Schloss, Bill Ruane and Irving Kahn all learned their trade from Benjamin Graham.

Benjamin Graham: Not just a value investor

You could be forgiven for thinking that Benjamin Graham was a value investor through and through, but this couldn’t be further from the truth. Many of investment strategies being used on Wall Street today, were at some point used by Graham.

For example, in many ways the Graham-Newman investment partnership was the world’s first hedge fund, shorting securities and collecting performance fees years before A.W. Jones founded what was considered by many to be the first hedge fund in 1949.

But the most far-reaching impact Benjamin Graham made the finance industry, was that of shareholder activism. Jeff Gramm’s upcoming book: Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism details Graham’s relatively unknown activist career.

Benjamin Graham: Intrinsic value

Graham essentially invented the notion of “intrinsic value.” Prior to his arrival on Wall Street, many analysts didn’t even bother to read financial reports, as Graham wrote in his memoirs, “…financial information was largely going to waste in the area of common stock analysis…I found Wall Street virgin territory for examination by a genuine, penetrating analysis of security values.”

These findings became the cornerstone of Graham’s teachings. Financial information not price fluctuations was the most important factor of security analysis. To illustrate this point, Graham invested his now famous “Mr. Market” analogy:

“…Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. ”

“If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”

“The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

“Summary

The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.” — The Intelligent Investor by Benjamin Graham 4th Revised Edition, 1973, Chapter 8, the Investor and Market Fluctuations, pgs 204 — 205.

Jason Zweig, who currently writes for The Wall Street Journal and who likely read more about investing than most people alive today, updated the Mr. Market analogy in one of the more recent versions of The The Intelligent Investor:

“Stocks are crashing, so you turn on the television to catch the latest market news. But instead of CNBC or CNN, imagine that you can tune in to the Benjamin Graham Financial Network…”

“…the image that fills your TV screen is the facade of the New York Stock Exchange, festooned with a huge banner reading: “SALE! 50% OFF!”…Then the anchorman announces brightly, “Stocks became more attractive yet again today, as the Dow dropped another 2.5% on heavy volume-the fourth day in a row that stocks have gotten cheaper. Tech investors fared even better, as leading companies like Microsoft lost nearly 5% on the day, making them even more affordable. That comes on top of the good news of the past year, in which stocks have already lost 50%, putting them at bargain levels not seen in years. And some prominent analysts are optimistic that prices may drop still further in the weeks and months to come”. — The Intelligent Investor by Benjamin Graham 4th Revised Edition, 1973, Commentary to Chapter 8, the Investor and Market Fluctuations, pg 222.

Benjamin Graham the activist

As

The post Benjamin Graham — Part One: An Introduction To The Godfather Of Activism appeared first on ValueWalk.

This is part two of a ten-part series on the life and career of Benjamin Graham, the Godfather of value investing and the Dean of Wall Street. You can find the first part of the series at the link below.

Benjamin Graham — Part One: An Introduction To The Godfather Of Activism

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Benjamin Graham — Part two: The Graham–Newman Partnership

The Graham–Newman Partnership is considered by some to have been the world’s first hedge fund. However, information on the partnership is limited, so if readers have any feedback or sources for the information below it would be greatly appreciated. This is just a brief overview of Graham–Newman’s endeavours between 1926 and 1958, I’m going to take a more detailed look at their investment strategy in part three of this series. 

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Benjamin Graham first went to Wall Street in 1914, two months before World War 1 broke out, as a chalker on Wall Street with Newburger, Henderson and Loeb. As a special favor, he was paid $12 a week instead of $10 to begin. Then when the war broke out, the stock exchange closed, and Graham’s salary was reduced back to $10. Still, Graham continued to work for the firm and his hard work paid off when he was promoted to partner during 1920.

According to several sources around 12 years later, during 1926, Graham formed his investment partnership with Jerome Newman and started perfecting his deep-value investment strategy.

Graham--Newman: Wiped out

From 1914 to 1929 Graham experience 15 years of continuous success but the crash of 1929 floored Graham. It is claimed that he was personally wiped out as, like many investors at the time, he had an enormous pile of margin debt.

“...I knew was that prices were too high. I stayed away from the speculative favorites. I felt I had good investments. But lowed money, which was a mistake, and I had to sweat through the period 1929-1932. I didn't repeat that error after that.” -- Source: An Hour With Ben Graham

The crash of 1929 helped Graham develop his deep value strategy. Losing everything pushed Graham only to take positions in securities where the risk of permanent capital loss was low. And by concentrating on deep value situations, the Graham--Newman Partnership had recovered its losses from 1929 by 1937, just in time to ride out yet another period of market turbulence.

“HB: The 1937-1938 decline, were you better prepared for that?

Graham: Well, that led us to make some changes in our procedures that one of our directors had suggested to us, which was sound, and we followed his advice. We gave up certain things we had been trying to do and concentrated more on others that had been more consistently successful. We went along fine.” --  Source: An Hour With Ben Graham

This is where things begin to get complex. As far as I can determine, the Graham--Newman Partnership closed in 1936 to be replaced by the Graham-Newman Corporation. The letters for the Graham--Newman Corporation are available online, so from here on out returns are a lot easier to calculate, However, up to 1936 I have been unable to find (online at least) and concrete evidence of the Graham--Newman Partnership's performance.

The Graham--Newman Corporation was run as a sort of mutual fund. Shares were issued at $99, and the company reported earnings per share for the year, alongside a net asset value and dividends. Most of the company’s profits were returned to shareholders via dividends.

Graham--Newman: Impressive returns

For the ten year period from 1936 to 1946, the Graham--Newman company earned $245 per share, before contingent compensation. Of this sum, $204 accrued to shareholders, $161 was paid out in dividends, and $41 per share was paid in compensation to managers, just under 17% of total earnings during the period. The average percentage gain to stockholders over this first decade of operation was 17.6% per annum.

And while Graham is best known for his analysis of common stocks, during this early part of his career his portfolio was built around bonds and preferred stocks. On January 31, 1946, the Graham--Newman Corporation’s portfolio totalled $4.17 million, of which $2.2 million was invested in bonds ($1.4 million in railroad bonds alone), and $863,000 was invested in preferred stock. Only $1.1 million or 26.4% was devoted to common stocks (of this $122,192 was in railroad shares, and $320,075 was invested in investment company common stock).

According to one source, by 1958, the year of liquidation, a total distribution of $840.62 per share had been made to investors as Graham--Newman’s enterprise wound down -- that’s a total return of 750% over 30 years, excluding distributions made. Including distributions the Partnership boasted an average annual return of 17%. 

Over the same period, the Dow Jones Industrial Average returned 4.7% per annum, excluding dividends but including the 1929 market crash.

However, based on figures taken from the Graham--Newman Corporation letters, the returns for investors were much lower. The figures in the letters show that investors received total distributions of $484.42 per share including the initial purchase cost of $99.

Graham--Newman: Compensation

The Graham--Newman Partnership also had an unusual (for the time) performance linked pay structure. Each director received a base salary of $15,000, just under $200,000 today based on CPI figures. In addition to this base salary, the directors were entitled to:

12. a) 12.5% to each, of the excess of the dividends paid during the year over an amount equal to $0.018 per share per day,

1. b) 10% to each of the excess of the overall net profit, adjusted to reflect unrealized appreciation or depreciation in the market value of the securities.

So, it’s fair to say that Benjamin Graham and Jerome Newman were well compensated for running the company.

The post Benjamin Graham — Part Two: The Graham–Newman Partnership appeared first on ValueWalk.

This is part two of a ten-part series on the life and career of Benjamin Graham, the Godfather of value investing and the Dean of Wall Street. You can find the first part of the series at the link below.

1. Benjamin Graham — Part One: An Introduction To The Godfather Of Activism
2. Benjamin Graham — Part Two: The Graham–Newman Partnership

To ensure you do not miss the rest of the series sign up for our free newsletter.

Benjamin Graham — Part three: Looking for bargains

Unlike most hedge fund letters today, Ben Graham’s letters to the shareholders of the Graham-Newman corporation were brief. In most cases, the letters only included a one page a summary of the corporation’s earnings for the year, dividend distributions and net asset value per share. An auditor’s report was also attached.  

These short letters make it difficult to study the trades Graham was making and the rationale behind them. Luckily, the late Walter Schloss, who was a student, employee and disciple of Graham has spoken frequently about how Graham went about managing investments at the Graham–Newman Corporation.

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Benjamin Graham: Deep value

After nearly being wiped out in the crash of 1929, Benjamin Graham set about developing his deep value strategy, which he believed would ensure that he would never have to deal with the losses of 1929 again. As Walter Schloss described at the 1999 Grant’s Interest Rate Observer Fall Investment Conference:

“He [Benjamin Graham] was very upset about losing money. A lot of us are. So he worked on a number of ways of doing this and one of them was buying companies below working capital and in the ‘30s there were a lot of companies developed that way.”

Graham described the strategy himself in an interview in March 6 1976:

“...when we talk about buying stocks, as I do, I am talking very practically in terms of dollars and cents, profits and losses, mainly profits. I would say that if a stock with $50 working capital sells at $32, that would be an interesting stock. If you buy 30 companies of that sort, you're bound to make money. You can't lose when you do that…”

“...what everybody else is trying to do pretty much is pick out the "Xerox" companies, the "3M's", because of their long-term futures or to decide that next year the semiconductor industry would be a good industry. These don't seem to be dependable ways to do it.”

“...they [the efficient market supporters] would claim that if they are correct in their basic contentions about the efficient market, the thing for people to do is to try to study the behavior of stock prices and try to profit from these interpretations. To me, that is not a very encouraging conclusion because if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what's going to happen to the stock market.”

Going back to Walter Schloss:

“So, when I came to work for Ben, he had 37 common stocks in his common stock portfolio...They had $4,100,000 million of which $1.1 million was in common stocks...He had very small amounts of these stocks and you figure $1,100,000 with 37 stocks, it wasn’t very much.”

“Basically the rest of his portfolio was made up of bankrupt bonds, against which he sold ‘when-issued’ securities, some convertible preferred stocks where he shorted the common stocks against them.”

All in all, when it came to portfolio management there were no limits on the types of securities Graham could buy. For this reason, many consider the Graham---Newman Corporation to be the world’s first hedge fund. As well as buying common and preferred stock, Graham shorted certain issues, occasionally took an activist stance (as covered in part one) and got involved in special situations.

Irving Kahn another Graham disciple, wrote the following in a tribute to Graham after his death in 1974:

“Graham-Newman concentrated on finding value in securities wherever they might be. This resulted in a heavy selection of over the counter issues, including companies with limited floats.”

“What makes this result even more impressive was the high quality of the things they brought. While the names of the securities were often less than household names, their intrinsic high value made them far safer investments than most big listed companies.”

“Other examples of how Ben’s principles and methods influenced the securities industry are his ethical standards. These included demanding full disclosure of pertinent facts both in the balance sheet and the income account, He was just as forthright in criticizing the obsolete dividend policies of AT&T as with some family-controlled company that accumulated massive cash to the detriment of their public shareholders.”

Strict process

Graham had a very strict set of rules for selecting securities to buy for his portfolio, which I’ll cover later in the series. But for now, here’s Walter Schloss again on Graham’s strict investment process:

“…he [Ben Graham] had very strict rules. He wasn’t going to deviate. I had a fellow came to me from Adams & Peck…an old line railroad brokerage company…This fellow came to me, a nice guy, and he said “The Battelle Institute has done a study for the Haloid Company”…a small company that made photographic paper for, I think Eastman Kodak. Haloid had the rights to a new process and he wanted us to buy the stock. Haloid sold at between $13 and $17 a share during the depression and it was selling at $21 [1947-48]…I thought it was kind of interesting. You’re paying $4 for this possibility of a copying machine which could do this. Battelle though it was OK. I went into Graham and said, “you know, you were only paying a $4 premium for a company that has a possibility of a good gain,” and he said, “no Walter. It’s not our kind of stock.” -- Source: Grant’s Interest Rate Observer Fall Investment Conference.

What’s really interesting to note is that after World War Two, Benjamin Graham actually struggled to make any money at all from net-nets situations and his strategy had to change as a result. Walter Schloss explains:

“When Ben was operating in the 1930s and 1940s, there were a lot of companies selling below their net working capital (NET NET). Ben liked these stocks because they were obviously selling for less than they were worth but in most cases, one couldn’t get control of them and so, since they weren’t very profitable, no one wanted the,. Most of these companies were controlled by the founder or their relative and since the 30s was a poor period

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This is part four of a ten-part series on the life and career of Benjamin Graham, the Godfather of value investing and the Dean of Wall Street. You can find the first part of the series at the link below.

1. Graham–Newman — Part One: An Introduction To The Godfather Of Activism
2. Benjamin Graham — Part Two: The Graham–Newman Partnership
3. Graham–Newman — Part Three: Looking For Bargains

To ensure you do not miss the rest of the series sign up for our free newsletter.

Benjamin Graham — Part four: GEICO and the end of Graham–Newman

In 1948, Benjamin Graham made one of the most significant investments of his career: GEICO.

GEICO, or to give the company its full name, the Government Employees Insurance Company officially started operating in 1936, the same year the Graham–Newman Corporation was set up. Then in 1948, Graham paid $712,000 for a 50% stake in the company and secured the position of Chairman of the Board.

This was somewhat of a gamble for Graham. GEICO was never considered to be a value play; it was a high-flying, expensive growth stock, which was exactly the type of company Graham had spent his whole career trying to avoid.

It’s ironic then that GEICO turned out to be Graham’s greatest investment.

Graham–Newman – Benjamin Graham: Buying GEICO

Graham’s decision to acquire 50% of GEICO (around 25% of his capital) also attracted the attention of a young man named Warren Buffett. After learning that Graham had acquired a position on GEICO’s board, a 21-year-old Buffett took the train to Washington on a Saturday to find out more about GEICO. Buffett found the office closed, but a janitor directed him to Lorimer Davidson, an executive at GEICO who spent 4 hours with this “highly unusual young man”. After the meeting, Buffett purchased $13,000 of GEICO stock, which was around 65% of his savings at the time. A few years later he wrote about GEICO in The Commercial and Financial Chronicle — Warren Buffett: The Security I Like Best.

I would like to be able to say that Graham’s decision to buy such a huge slug of GEICO was based on thorough analysis, an attractive valuation and a great deal of skill, but it seems most agree that Graham got lucky with GEICO. As Jason Zweig, Intelligent Investor columnist for The Wall Street Journal has put it:

“In short, they [Graham and Newman] broke their rules to buy the stock, and they broke their rules to keep it.”

Graham, is his own words, admits to the theory of luck as the cause of GEICO’s success:

“Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions. Are there morals to this story of value to the intelligent investor? [One] is that one lucky break, or one supremely shrewd decision — can we tell them apart? — may count for more than a lifetime of journeyman efforts.” (The Intelligent Investor, 4th revised edition, Postscript, pg. 289)

25 years after Graham purchased his stake in GEICO for $712,000 the 50% shareholder was worth more than $400 million. If anything, the GEICO chapter in Graham’s life is a lesson to be alert and always prepared for an opportunity to hit the home run ball.

“In 1948, we made our GEICO investment and from then on, we seemed to be very brilliant people.” — Benjamin Graham March 6 1976

Graham and his partner, Jerome Newman made the decision to distribute the corporation’s holding in GEICO to shareholders during 1948, the same year the holding was acquired. GEICO shares were trading at $54 in the market on 31 January 1949, around the time of distribution, compared to a purchase price of $21.21. The screenshot below shows the total returned to investors.

And this chart shows the GEICO distribution compared to the returns of the Graham–Newman Corporation over its 20-year life.

If you’re interested in reading more about Graham and GEICO I’ve included some links at the bottom of this article.

Graham–Newman – Distributing GEICO and losing interest

GEICO market a turning point in Graham’s career. After decades of deep value investing, Graham was starting to get bored, opportunities for profit were disappearing as the markets became more efficient:

“That’s why I kind of lost interest. We were no longer very challenged after 1950. About 1956, I decided to quit…the things that presented themselves were typically repetition of old problems which I found no special interest in solving.”  — Benjamin Graham March 6, 1976

Or to put it another way, Graham could no longer find opportunities that would generate outsized returns:

“…we decided to liquidate Graham-Newman Corporation-to end it primarily because the succession of management had not been satisfactorily established. We felt we had nothing special to look forward to that interested us. We could have built up an enormous business had we wanted to, but we limited ourselves to a maximum of $15 million of capital-only a drop in the bucket these days. The question of whether we could earn the maximum percentage per year was what interested us. It was not the question of total sums, but annual rates of return that we were able to accomplish.”  — Benjamin Graham March 6 1976

In part five of this series, I’m going to take a closer look at the winding down of the Graham–Newman Corporation and some case studies. Stay tuned!

Further reading and sources:

• The Luck of a Gecko: The Impact of GEICO on Benjamin Graham’s and Warren Buffett’s Success
• Case Study-The Story of GEICO, Graham, and Buffett
• Was Benjamin Graham Skillful or Lucky?
• Buffett Thoughts on GEICO in 1976
• Warren Buffett The Early Years – Part Three: GEICO

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