Walter Schloss – Part Eight: Graham-Newman

Upon leaving the army in 1946, Benjamin Graham, who was Walter Schloss’ former tutor, approached Walter and asked him to come and work at the Graham-Newman partnership. Schloss quickly decided to take the opportunity and began working for Graham during 1946.

Schloss’ first job at the partnership was to prepare the group’s annual report for its tenth year in business, an important job for a newcomer and one that helped him quickly understand the firm. At the time, the partnership had $4.1 million under management, ($50 million today’s adjusted for inflation), a sizable sum for 1946.

Of this $4.1 million, only $1.1 million was common stock. The rest was made up of bankrupt bonds and convertible preferred stock. There were just over 30 common stock holdings in the Graham-Newman portfolio at the time.

Schloss talked fondly of his time at Graham-Newman and reading through Walter Schloss’ notes and lectures, you really get a good idea of how Graham worked. Continued from part seven:

“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 for business, the stocks remained depressed. What would bring about change?

If the largest Controlling stockholder died, the Estate may want to sell control.

If business got better, then the company would make money.

I remember going to Chicago when I worked for Ben in the late 40s and talked to Mr. Bush the President of Diamon T Motors. A Mr. Tilt owned 50.1% of the stock and wouldn’t sell. The stock sold for $10 and had working capital of $20…when Mr. Tilt finally died at the age of 90…the stock was sold at a premium over $20…

WW2 was a good example of this. The large asset base let many secondary companies earn good money in the war years, the excess profits tax didn’t apply to them and stocks did well. Graham-Newman didn’t do too well after the war in that type of security but their stockholders got rich when G-N distributed GEICO stock to the stockholders in 1949 and GEICO became a growth stock.”

Columbia Business School lecture

Graham had a strict set of value criteria and principles, principles he would stick with no matter how lucrative the opportunity. It seems as if this stubbornness was driven by his desire to avoid losses similar to those he had to deal with during the depression.

Walter Schloss gave a great example of Graham’s stubbornness at Grant’s Interest Rate Observer Fall Investment Conference.

“…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.”

Unfortunately, the company Graham could have acquired for a $4 premium later turned into Xerox. But despite the company’s prospects and low price, Graham refused to get involved, the value wasn’t there.

Side note

As a side note, although this piece is about Walter Schloss and his relationship with Graham, while researching the article, I came across the following statement from Schloss regarding Buffett and his use of Berkshire:

“By setting up Berkshire Hathaway, Warren has done everything very rationally.

By having insurance companies, he is able to use stocks as well as bonds as reserves. By having large reserves he doesn’t have to pay dividend[s]. If Berkshire was only a very profitable manufacturing company with no insurance companies it would have to pay out some dividends.
By keeping all the earnings, Berkshire can keep reinvesting their profits and compound their results. By owning a growth stock, he is able to increase the value of the company…Since it is [Berkshire] in effect a closed-end investment company, Warren doesn’t have to worry about investors redeeming their shares…”

Buffett’s use of an investment vehicle like Berkshire is often overlooked and the above statement from Walter Schloss really sums up the key advantages. Without the Berkshire vehicle, it’s highly likely that Buffett’s returns over the years would have been much lower. There would have been pressure to pay dividends, the ability to reinvest profits would have been much reduced and Buffett would have been unable to effectively use compounding to leverage results over time.

Of course, Buffett’s unrivalled success as a stock picker has been the main factor behind his success over the years. But Walter Schloss doesn’t’ believe that this was his only commendable trait. From the Grant’s Interest Rate Observer Fall Investment Conference: