Walter Schloss: Superinvestor

I came across this interview with Walter Schloss and it was packed with interesting quotes and insights.

Walter Schloss started his career on Wall Street in 1934 as a runner at the age of 18. He read Graham and Dodd’s Security Analysis and later went to work for Graham in his partnership. When Graham closed his partnership, Schloss went on to manage money himself. He managed money from 1956 through 2003 and delivered a 15.3% rate of return.

Here is what “Adam Smith” had to say about him in the 1972 book Supermoney:

“He has no connections or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it.”

Buffett had this to say about him:

“He knows how to identify securities that sell at considerably less than their value to a private owner: And that’s all he does… He owns many more stocks than I do and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That is one of his strengths; no one has much influence on him.”

While others deviated from the Grahamian value approach, Schloss stuck to it for the rest of his career. He started off buying net-nets. When net-net opportunities dried up and his capital expanded, he focused his attention on low price-to-book names.

Here are some great quotes from the interview:

  1. Ben Graham: “In the ’20s he had a deal where he took 50 percent of the profits but he took 50 percent of the losses. And that worked great until 1929 when the market went down and obviously, his stocks were affected, too, and he was not only affected by that, but many of these people then pulled out because they needed money for their own purposes or they had lost a lot of money other places. So, he figured out how he could possibly never have this happen to him again. he 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 that developed that way.”
  2. Work at Graham-Newman: “Anyhow, at that time my job was to find stocks which were under valued. And we looked at stocks selling below working capital, which was not very many.”
  3. Increasing positions in beaten up stocks: “Well, a lot of people don’t like it if you buy a stock at $30 for a customer and then they see it at $25. You want to buy more of it at $25. The guy doesn’t like that and you don’t like to remind him of it. So, one of the reasons I think that you have to educate your customers or yourself, really that you have a strong stomach and be willing to take an unrealized loss. Don’t sell it, but be willing to buy more when it goes down, which is contrary, really, to what people do in this business.”
  4. More on undervaluation: “Basically we like to buy stocks which we feel are undervalued and then we have the guts to buy more when they go down.”
  5. Why the “superinvestors” who worked for Graham succeeded: “I think number one none of us smoked. We were all rational. I don’t think that we got emotional when things went against us and of course Warren is the extreme example of that.
  6. On buying foreign stocks: “Well, my problem with foreign companies is I do not trust the politics. I don’t know enough about the background of the companies. I must tell you, I think the SEC does a very good job and I feel more comfortable holding an American company.”
  7. Selling: “Sell is tough. It’s the worst, it’s the most difficult thing of all and you have an idea of what you want to sell it at and then you sometimes are influenced by the changes that take place. We owned Southdown. It’s a cement company. We bought a lot of it at 12 1/2. Oh, this was great. And we doubled our money and we sold it at something like $28, $30 a share and that was pretty good in two years. When next I looked it was $70 a share. So, you get very humbled by some of your mistakes. But we just felt that at that level it was, you know, it was not cheap.”
  8. Shifting from net-nets to low price-to-book: “Yes, it’s changed because the market’s 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. And so we decided that we want to buy stocks if we can that are depressed and have some book value and are not too, selling near their lows instead of their highs and nobody likes them.”
  9. Q: Tweedy Browne is very quantitative, and Buffett’s more qualitative. Where are you in that spectrum? A: “I’m more in the Tweedy Browne side. Warren is brilliant, there’s nobody ever been like him and there never will be anybody like him. But we cannot be like him. You’ve got to satisfy yourself on what you want to do. Now, there are people that are clones of Warren Buffett. They’ll buy whatever Warren Buffett has. Fine. I don’t know, I don’t feel too comfortable doing that and the other thing is this. We happen to run a partnership and each year we buy stocks and they go up, we sell them and then we try to buy something cheaper.”
  10. Why he didn’t pursue Buffet-Munger style concentration: “Psychologically I can’t, and Warren as I say, is brilliant, he’s not only a good analyst, but he’s a very good judge of businesses and he knows, I mean my gosh, he buys a company the guy’s killing himself working for Warren. I would have thought he’d retire. But Warren is a very good judge of people and he’s a very good judge of businesses. And what Warren does is fine. It’s just that it’s not our — we just really can’t do it that way and find five businesses he understands, and most of them are financial businesses, and he’s very good at it. But you’ve got to know your limitations.”
  11. Selling short: “We did it a couple times and we’re always very upset after we do it. So I’d say not anymore.”

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

 

Going Global with Value Investing

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Holding Cash in a Euphoric Market

I have a problem. 26% of my portfolio is in cash. I hate cash. It earns nothing. My preference is to be fully invested at all times. I prefer not to try to time the market.

But . . . I am frightened by the valuations present in the U.S. market right now. I don’t believe in market timing, but with a Shiller CAPE around 30, average equity allocation at 42% (probably higher now), and market cap to GDP at 132% . . . it definitely feels like the market is primed for a fall. Usually, value stocks tumble with everything else (except for the early 2000s).

This conflicts with my belief that investors shouldn’t time the market. If you own cheap stocks, it shouldn’t matter what the general market is doing, they will eventually realize their intrinsic value. The CAPE ratio or any valuation metric for that matter isn’t entirely predictive. Just because stocks are expensive now doesn’t mean that the market is necessarily going to crash. Valuations may even be justified if interest rates stay low. That seems like wishful thinking, but we’ve gone through long stretches before where interest rates stay very low (as they did in the 1930s and 1940s). You just don’t know. No one has a crystal ball.

Whether it is stocks or companies, all that you can do is put the probabilities in your favor.  Expensive stocks and markets can get more expensive. Cheap stocks and markets can go down. As a group, though, this is unlikely. Buying cheap stacks the odds in your favor.

International Net-Net Investing

The prudent course seems to me to expand outside of the United States for diversification. It is also a way to make sure I am not overly correlated with the US market. The most tempting way to do this is to buy net-nets in foreign countries.

Net-net investing involves buying companies at sub-liquidation values. In the most basic form, you take all current assets and subtract all liabilities to arrive at the net current asset value (NCAV). No value is given to long term assets like plant, property, and equipment which might be more difficult to sell. Graham advocated buying a net-net at 2/3 of the NCAV value and then selling when it reaches full value (thus securing a 50% gain). Graham remarked about net-nets: “I consider it a foolproof method of systematic investment . . . not on the basis of individual results but in terms of the expectable group outcome.”

Studies show that net-net investing is the best way to earn the highest returns. Buffett’s best returns were when he was investing in net-nets in the 1950s and 1960s. Joel Greenblatt created his original “magic formula” with a net-net strategy in 1981. He devised a strategy of buying net-nets with low P/E’s and demonstrated that you could earn 40% returns.  The period he studied was after the market crash of 1973-74. Those net-net opportunities were eliminated during the bull market of the 1980s and 1990s, which is why he didn’t stick to that strategy. Net-net investing is also hard for professionals investing a lot of money, as the stocks usually have extremely low market caps. It’s only something individuals like me can pursue who are dealing with relatively small sums of money.

Those net-net opportunities were eliminated during the bull market of the 1980s and 1990s, which is why he didn’t stick to that strategy. Net-net investing is also hard for professionals investing a lot of money (i.e., over $10 million or so), as the stocks usually have extremely low market caps. It’s only something that individuals like me can pursue who are dealing with relatively small sums of money.

The strategy I pursue during frothy bull markets is Graham’s low P/E strategy that he devised in the 1970s. Graham demonstrated that this strategy delivers 15% rates of return over the long run. 15% returns are incredible but not nearly as exciting as what you can make investing in net-nets which amp up returns to the 20% level. I look at other value factors (price to sales, EBIT-Enterprise Value, relative valuation), but I try to stick to Graham’s rules (low debt to equity ratio and an earnings yield that doubles corporate bond yields).

While Graham’s P/E strategy is my base during bull markets, I look at other value factors (price to sales, EBIT-Enterprise Value, relative valuation). I like to see multiple signals that a stock is cheap but I try to stick to Graham’s rules (low debt to equity ratio and an earnings yield that doubles corporate bond yields).

I would much rather invest in net-nets than the low P/E strategy, as the returns are better, it is easier to calculate intrinsic value, and it is easier to determine the appropriate selling point (you sell when the stock hits the net current asset value). Unfortunately, in the United States, there aren’t enough net-nets available to make it viable. Net-net returns are higher than any other strategy, but a net-net is also more likely to go bankrupt than a normal company, so diversification is paramount. When Graham bought net-nets for his partnership, he would buy them in bulk. I read once that he would own nearly 100 net-nets at any given time.

We live in a different world. To put it in perspective, there are about 9 net-nets in the United States right now. Of these 9 choices, they aren’t of the best quality and most of them can only be bought on OTC exchanges.

Net-nets become available in bulk in the United States during market meltdowns like 2008 and 2009. There were also a lot of them in the early 2000s during the tech crash. During both periods, net-nets performed exceptionally well.

There are quality net-nets available internationally, but the problem I have with buying them is that I don’t trust my ability to read foreign financial statements or research companies. I can’t go into Edgar and read an annual report for a Korean net-net, for instance.

I don’t even know where I can run reliable screens to hone in on the right opportunities. Unforeseen tax consequences would also plague me by investing in individual foreign stocks. While I wouldn’t owe US taxes because this is an IRA account, I would still owe taxes in the foreign countries on any gains. For those reasons, I am not keen on buying individual stocks outside of the United States.

Another reason I prefer buying individual companies in the United States is the SEC. I’m happy that the SEC is active in the US market. The SEC misses quite a bit, but it’s still better than what exists internationally.

For all of these reasons, I don’t want to buy international net-nets even though I think the returns are probably substantial and it would allow me to diversify outside of the frothy United States market.

I will shift to net-nets when they are available in bulk quantities (as they were in 2008 and 2009) during the next market meltdown and I can buy at least 10 quality choices. Unfortunately, that’s not an option in the current market.

A Possible International Solution

Thinking about the issue, I thought of something I once heard of listening to a Meb Faber speech from 2014 at Google. He discussed a really interesting idea: applying Robert Shiller’s CAPE ratio internationally.

Meb Faber has done a great research available on his website about this topic. He has empirically demonstrated that countries with a low CAPE tend to deliver higher returns (as a group) compared to those markets with higher valuations. Just like individual companies with low valuation metrics, this occurs as a group and it’s not an iron clad rule of prediction.

The CAPE ratio isn’t the best valuation metric for a market, but it’s good enough and it’s readily available for most markets.

This brings me to a possible solution: buying international indexes via ETFs for countries posting low CAPE ratios. This would allow me to avoid the tax consequences of international investing in individual stocks, remain consistent with a value approach, and provide adequate diversification. I will also be able to lower my correlation with the US market in a manner consistent with a value template.

I found a decent list of countries by CAPE ratio. The cheapest market in the world right now is Russia. The reasons for Russia’s low valuation is obvious. Oil has been crushed in recent years and Russia’s economy is very oil dependent. They are also under international heat and sanctions. For these reasons, Russia has a CAPE ratio of 4.93. Russia is hated by international investors. Of course, that is music to my ears: the best investments are the ones that everyone hates.

If it’s not behaviorally difficult to buy, it’s not really a bargain.

To give some perspective on how low Russia’s CAPE ratio is — there were only a handful of times that the US has a CAPE ratio that low — the early 1920s, the early 1930s, World War II, the early 1950s, the early 1980s. All of these were exceptional times to buy stocks. Even in March of 2009, the CAPE ratio for the US market only went down to 15.

In the early 1920s, early 1930s and the early 1980s – people hated stocks, which made them the best times to buy them.

Business Week ran a cover in 1979 called “the death of equities”. This was right before the greatest bull market in history from 1982-2000, which took the Dow from below 1,000 to over 10,000. The reason people hated stocks in the early 1930s is obvious. In the early 1920s, people in the United States hated stocks because the country suffered a severe but short Depression, which everyone forgets about because it is overshadowed by the Great one in the 1930s.

It’s true for individual companies and it’s true for entire markets: buy them when everyone hates them, sell them when everyone loves them.

Possible Investments

I haven’t decided if I’m willing to pull the trigger on this idea just yet, but I am curious to hear anyone’s thoughts.

I was considering putting 10% of my portfolio into two of the below ETFs:

iShares MSCI Brazil Index (Ticker: EWZ).  Brazil currently has a CAPE ratio of 10.4.

iShares MSCI Russia Capped ETF (Ticker: ERUS).  Russia currently has a CAPE ratio of 4.9.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

UIHC & FNHC

I sold my positions today in UIHC and FNHC today.

Both are Florida based insurance companies. I bought them last year because they were cheap in the wake of Hurricane Matthew. They are both well-run insurance companies and all they had to do to realize their value was for Florida to avoid another hurricane. With a category 5 hurricane on a direct course for Miami, it seemed prudent to sell both positions.

Last year after Hurricane Matthew, FNHC dropped 25% and UIHC dropped 35%. I’m down in both positions, but I decided to cut my losses short as catastrophic insurance losses in Florida seems very likely.

I got out of FNHC at $14.28 this morning. This was a good price because it later plummetted to $12.82 as investors realized the magnitude of the losses it is about to face. I got out of UIHC at $14.43. It closed at $14.77.

This brings my cash position up to $12,800.99, or 26.4% of my IRA. I evaluated my screens this weekend and couldn’t find anything that really excited me. It is a bit frustrating as my preference is to be fully invested. We’ll see if something comes along, otherwise, I’ll wait til I do a major rebalancing in December.

I’m also considering paring back my position in TopBuild, but I decided to stay put for now.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

When and How Will Value Strike Back?

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Has the bull market erased bargains?

I was listening to an investing podcast the other day and heard an interesting conversation. The guest pointed out that during the internet bubble of 1999, there were a significantly higher number of bargains than there is today. The guest further lamented that in the current environment, the bargains aren’t as widely available as they were back then.

This is an important point. As discussed in my previous post, growth has trumped value for some time now, which is a historical aberration. The disconnect will certainly end, but it’s difficult to say when and how it will happen.

The resolution in the early 2000s of the value-growth disconnect was the ideal situation. The broader market entered a tailspin for nearly three years, but value experienced a significant bull market at the same time, seemingly disconnected from the carnage that took place in large cap stocks.

This is obviously how I would like to see the current situation shake out, but I suspect that the value bull market of the early 2000s was due primarily to the number of bargain stocks that were available because everyone was fixated over the likes of Qualcomm, Cisco, Amazon, Redhat, etc.

I decided to take a look at the data for myself. I looked at the number of earnings bargains available in 1999 and compared them to today, as well as a few other points in time in recent market history. The universe of stocks I looked at was the S&P 1500. The data is below.

number of bargains

Bargain Availability Through the Years

Bargains were available in 1999, but certainly not to the extent that existed during the financial crisis. In 1999, there were 102 stocks with an earnings yield over 10%. As a group, they returned 18.10% in 1999. The number rose to 171 in 2000, and the return was 32.47% for that year. This occurred while the S&P 500 experienced a decline of 10%.

By 2005, the number of stocks yielding over 10% shrunk to 50 and the group returned 8.26% that year, slightly below the S&P 500’s return of 11% that year.

Obviously, the greatest moment in history to buy value stocks was early 2009. At the beginning of 2009, there were 474 stocks (nearly 1/3 of the universe) with an earnings yield over 10%. As a group, they returned 62.78% throughout 2009.

The number of bargains shrunk to 158 in 2012. The population shrunk as we emerged from the financial crisis, but bargains were still more plentiful than they were in the 1999-2008 period. As a group, they returned 10.26% in 2012 and 50.96% in 2013.

Today, the number has shrunk to 64. This is lower than 1999, but it hardly seems as if bargain stocks are no longer available. They are still out there, they are still behaviorally difficult to buy, and this suggests to me that the value premium will remain alive and well. However, I think that the low availability makes it unlikely to value’s resurgence will play out like it did in the early 2000s.

That ’70s Stock Market

The key question is how all of this will play out. History suggests that bigger populations of bargain stocks bode well for future returns. It’s not an iron clad rule that you could plug a formula into, but that’s the general trend.

This suggests that value is limited but not eliminated in today’s market. It also seems unlikely that we will experience a resurgence of value as incredible as that of the early 2000s when value experienced a bull market while the broader market declined.

I would like to believe that this will occur again, but I doubt we will be that lucky.

I think a more likely scenario for the next shakeout will be something more like the 1970s. The late ’60s and early ’70s was one of those times (like the late ’90s and today) where growth trumped value and the S&P 500 soared.

In the early ’70s and late ’90s, everyone preached buy and hold while it worked and few practiced it once times became tough. In all of these eras, popular sentiment was that value investing was dead and that everyone who wasn’t buying sexy growth names was a relic of the past who just didn’t understand how magical the new era was, paying 50 times earnings makes sense because . . .  Copy machines/dial-up-internet/smart phones/blockchain, it’s a new era, markets are so efficient and competitive these days, blah blah blah.

When the shakeout went down in the ’70s, value stocks fell with the broader market. They didn’t experience a bull market like they did in the early 2000s.

For a good look at value returns during this period, I took a look at this analysis of the simple Ben Graham strategy over at Alpha Architect. I also thought a good record to examine were the annual returns of Walter Schloss, whose strategy focused on low price-to-book names. Below is a snapshot of the 1970s from the perspective of the S&P, Walter Schloss and the systematic low P/E low debt Ben Graham strategy.

70s

As you can see, in the 1970s, value delivered the highest returns, but the road was bumpy. Unlike the early 2000s, value didn’t go up while the broader market declined. Value stocks went down with everything else.

During the 1973-74 bear market, Walter Schloss held up better than both the broader market and the systematic Ben Graham approach (a variation of which I’m following with my portfolio). I suspect that Walter Schloss’ decent performance in the recession of 1973-74 is due to his zero exposure to the Nifty Fifty and I also suspect that he held a significant amount of cash.

Walter Schloss was a classic Graham investor focused on asset value. If the bargains weren’t available, he didn’t buy them. This allowed him to experience only single digit losses during the 1973-1974 period.

The systematic Ben Graham strategy didn’t hold up as well, but I think that’s likely because it was fully invested while Walter Schloss was not.

The Future

I don’t know what the future holds, but I do know that buying expensive hyped up stocks is dangerous, regardless of how seductive it looks in the throes of a late bull market. Value will outperform growth and the broader market over time, but the road will be rocky and require patience. In investing, I think patience and discipline are more important than any other characteristic, including intelligence.

While I would love to see a repeat of the early 2000s value bull market, I don’t think we will be that lucky. Due to the fewer bargains available today than were available in the 1999-2000 period, I think a repeat of the 1970s is more likely, which was painful at times, but ultimately rewarding to those who had the patience to stick with a value approach and the discipline to avoid the sexy glamour stocks.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

SAFM

I sold my 29 share position in Sanderson Farms this morning at a price of $143.88. After commission, proceeds for the sale were $4,165.47. This results in a gain of 63.61% from when I purchased the stock last year.

I purchased Sanderson Farm last December because I thought chicken prices could increase and the stock already had an attractive earnings yield. The gains in chicken prices exceeded my expectations and fueled SAFM’s earnings higher.

Sanderson Farm doesn’t have much of a competitive advantage or “moat”. It sells a commodity: chicken. As a cigar butt value investor, I don’t look for enduring franchises, just value. Sanderson was a good value at the beginning of the year, but the increase in chicken prices doesn’t look sustainable to me and I decided to take my profits and move on.

In terms of relative valuation, Sanderson Farms now exceeds the valuation of its competitors. When comparing relative values, I like to look at the price to sales ratio. Here is where the metrics currently stand:

Sanderson Farm: 1.0

Tyson: .6

Pilgrim’s Pride: .9

Sanderson 5-year average: .6

It seems like a good time to take my profits off the table now that Sanderson exceeds the valuation of its competitors and is 66% higher than its typical valuation. If this were a taxable investment account, I may have waited until I reached a full year to take advantage of long-term capital gains. As this is a traditional IRA, there is no reason to hold onto the stock any longer than I feel is necessary.

This sale brings my cash position up to $8,333.90, or 17% of my portfolio. I would like to avoid timing the market so I would like to deploy this soon into new equity. I am considering adding to my position in Gamestop or Dillard’s, but I’ll evaluate some other possibilities this weekend over a bottle of vintage 2017 Coke Zero.

Some possibilities I’m considering that I will research more in depth this weekend:

Companies below tangible book:

Atlantic American Corp (AAME)

Appliance Recycling Centers of America (ARCI)

High earnings yields:

Genesco (GCO)

Foot Locker (FL)

Francesca’s Holding Corp (FRAN)

Interdigital (IDCC)

If anyone has any thoughts on any of these companies, I would love to hear them!

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

The Madness of Men

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The Madness of Men

Value investing has been enduring a tough time. This is certainly true for my own portfolio. I’m down 7.72% year to date compared to an 8.34% gain for the S&P 500. It’s times like this that it helps to look to history.

We’re currently in an era where investors are gobbling up growth companies and they don’t care what the price is. I remember the same mood back when I was in high school. People forget, but the bubble wasn’t simply concentrated in dot-com stocks. The bubble was pervasive among even the most stable of blue chip companies: Cisco, Microsoft, Coca Cola.

Going further back in history, the same euphoria characterized the Nifty Fifty era. The Nifty Fifty was a group of 50 stocks in the early 1970s that grew by leaps and bounds in the 1960s. Many of them were exceptional companies (like McDonalds and Xerox), but the euphoria pushed their valuations to extraordinary levels. Predictably, valuations came crashing down and investors were burned.

Taking things back even further, the same mood characterized the South Seas bubble. That bubble was fueled by optimism over the age of exploration and it famously burned Isaac Newton. Newton remarked of the collapse: “I can calculate the movement of the stars, but not the madness of men.”

Every bubble has something in common. There is something new and exciting in the air that promises to change our lives and this fuels speculation. It starts with a truth (i.e., real estate is an excellent investment for the middle class) and then descends into temporary madness. Of course, the market always corrects this madness. Eventually.

During the dot-com bubble, it was the promise of the internet. The internet was going to transform the way we live and everyone could see it . . . so, Cisco Systems was valued more than General Electric and Pets.com was a thing. They were right about the promise of the internet but wrong about the impact on stocks. Adding fuel to the fire was the promise of the “new economy”. Productivity was surging at the time. Productivity is the key ingredient in economic growth, so the belief was that we were entering an era of permanently higher growth. This fueled predictions of the federal budget deficit going to zero in 10-20 years. In truth, productivity was simply reverting to the mean after stagnation in the 1970s and 1980s. Keep this in mind when commentators say that the current productivity slump is permanent and means that the US economy will never grow faster than 2%.

With the Nifty Fifty, it was optimism about the power of the post-World War II American economy. The 1950s were a good time for the American economy and the 1960s were even better. The unemployment rate was only 3.9% by the end of the decade. Americans experienced abundance that was foreign to them in the past. Suburbs popped up everywhere and car ownership became ubiquitous. In the 1970s, the good times took a hit due to inflation, an oil shock, and the confidence-sapping Watergate scandal. Also, disco. Unaware of what was about to happen, investors thought that you could simply buy the fastest growing companies in the world’s fastest growing economy, and price didn’t matter.

With the South Seas bubble, it was the promise of the age of exploration. The New World opened up two continents that were rich in natural resources and abundance. Surely, investing in the company that would dominate trade in the new era was a surefire bet.

Now, the euphoria is fueled by the promise of scaled up e-commerce in the form of Amazon, cryptocurrency (personally, I only trust a currency that is secured by the full faith and credit of people with guns, aircraft carriers, stealth planes and nuclear weapons), the transformation of our lives by smartphones and the promise of whatever Elon Musk thinks is cool (electric cars, cars that drive themselves, hyper loops, USB ports in our brains, etc.)

Euclidean Technologies Q2 2017 Letter

I was reading Euclidean Technologies Q2-2017 letter and came across this historical nugget:

“Among large-cap stocks, the spread between value and growth is now larger than at any point over the past six decades, with one exception—the top of the dot-com bubble.”  Barrons, June 28, 2017

The letter is a great read and is well worth your time. The letter makes two very key points:

  1. Value stocks are going through the longest cycle since World War II of underperformance versus growth. Each period of time that growth outperforms value, value eventually stages a significant resurgence. Their chart showing this history can be accessed here.
  2. They also have a great analysis of the performance of different valuation metrics since 1970. They find that using enterprise values instead of raw market prices in a valuation ratio works best. They find that all of the major valuations work and, as is demonstrated in Deep Value, the acquirer’s multiple (in both the EBIT and EBITDA variations) exhibit the highest performance. The comparison of different valuation metrics can be accessed here.

Conclusion

I don’t know when or how the current cycle will shake out. I am confident in one thing: buying expensive stocks is dangerous and buying cheap stocks is a safe long term bet, no matter how you slice it. The current disconnect will not last forever.

I think indexing makes sense over the long run and I don’t think we’re on the brink of a 1929 or 2008 scenario. With that said, I do think that this current environment is fueled by performance chasing, just as it was in the 1990s. Just like the 1990s, money is pouring into large cap index funds. As index funds concentrate their bets on the biggest components of the index, those companies see their valuations increase. This isn’t due to any change in their actual business performance but is due to their weighting in the index. The money pouring into index funds is not permanent capital and I suspect many will head for the hills once the current cycle turns on them, as usually happens.

Most investment strategies work and make no mistake: indexing is simply a strategy. It’s a smart, tax efficient and cheap strategy. It will only work for investors if they stick to it, which they typically don’t, as demonstrated by this chart.

Value is having a tough time, but it’s times like this that are the reason value investing works over the long run. If value investing delivered double digit returns every year consistently, then everybody would do it.

The strategy I am pursuing is consistent with Ben Graham’s recommended strategy from the 1970s: buying low P/E stocks that have safe balance sheets. I look at other factors (such as the enterprise multiple), but that’s the gist of what I’m doing. When looking at my own performance, I compare it to this backtest of the strategy done over at Alpha Architect. In 1998, the 20-stock variation of the strategy lost 9.01%, compared to a 26% gain in the S&P 500. In 1999, the strategy gained 4.55% against a gain of 19.53% in the S&P.

The worst year for the strategy was 1969, in which it lost 28%. The S&P lost only 8% that year.

Over the long run, however, Ben’s simple (but not easy) strategy delivered a 15% rate of return. That’s the long run return I’m striving for with this IRA over the next few decades.

I don’t know how long the doldrums will last, but I do know they will end. It may take years, but I’m not going to abandon it. The only thing I may change if the market takes a hit is to shift my focus to asset-based investing (i.e., net nets and stocks below tangible book). The only reason I’m not doing that now is that they are not available in sufficient quantities.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“Deep Value” by Tobias Carlisle

deep

Deep Value” by Tobias Carlisle is one of my favorite books. I have a brief review in the books section of this website, but I think it is worthy of a more in depth review. The price of the book is expensive, but it is well worth it!

Mr. Market is Crazy

For years, I’ve believed that value investing works. It makes sense to me intuitively. It’s better to buy something cheap than something that’s expensive. I’ve read The Intelligent InvestorSecurity Analysis and all of Joel Greenblatt’s books and internalized the lessons. It just makes sense to me to buy earnings and assets for as little as possible.

It also makes sense to me that markets are fallible. I spent my high school years (I graduated high school in 2000) fascinated with a seemingly unstoppable market. I was only a teenager, but it seemed crazy to me that companies producing no earnings could command such high valuations. I remember thinking at the time: “It makes no sense, but these people know more than I do about the subject.” It turns out that they didn’t. An army of market prognosticators with extensive experience and impressive academic credentials were no smarter than me, a 17-year-old kid who hadn’t even gone to college yet.

I went through a similar experience during the real estate bubble. When I looked at charts of real estate prices, I once again instinctively thought that it was insane. Homes were increasing by 30% a year when incomes were stagnant and the raw materials to build the homes weren’t going up. It made no sense. Once again, I turned to the experts. Few were raising any alarms or taking the problem seriously. Surely, a financial bubble couldn’t form in an asset as illiquid and solid as real estate. I assumed that the experts must be right and I must be missing something. After all, they were more knowledgeable than I was. Then, along came 2008.

In 2008 during the crash, I kept thinking back to Benjamin Graham’s description of Mr. Market that I read about in The Intelligent Investor. Ben Graham was right. The stuff I learned in college about efficient markets couldn’t be true. Mr. Market is crazy and Ben Graham was right all along.

Why does it work?

While I believed that value investing works and this was confirmed by my observations, I never understood why it worked. It makes sense that buying dollar bills for 50 cents will work out in the long run, but how is this value realized?

Ben Graham was actually asked this question by Congress in the following exchange:

Chairman J. William Fulbright: What causes a cheap stock to find its value?

Benjamin Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else.

This is the key question that “Deep Value” delves into, through an analysis of data and real world examples.

Mean Reversion

The most powerful force through which value is realized is mean reversion. I always thought of mean reversion in the sense of a stock chart, a price will revert to the mean.

What Tobias explains is that mean reversion applies less to stock charts and more to the actual performance of a business. Tobias explains, for instance, that the biggest earnings gainers of the next few years are typically the worst performing businesses. Other similar studies are brought up in the describing this tendency of businesses to change course.

Poorly performing businesses are trying to turn things around. They are not resting on their laurels. Meanwhile, changes are typically occurring in their industries that are improving things for the better.

I think it’s easiest to think of this phenomenon in terms of chemical companies and basic economics. Chemical companies can all produce the same thing. They all have the same resources. If a chemical runs up in price, all of the chemical companies are going to make more of it. At this point, all of the chemical companies are doing great and their stocks are likely to be bid up to high valuations. Eventually, the chemical will be over-produced and it will drop in price. All of the chemical companies will drop to low valuations. This situation sets the stage for the recovery. The chemical companies will inevitably scale back production. Some companies may go out of business, which will further reduce supply. The reduction in supply will eventually spur an increase in the price, which will ultimately lead to a recovery in the chemical business.

Meanwhile, news stories will be written about what a terrible business it is to produce this chemical, causing this wisdom to seep into the minds of investors. There then exists a situation where chemical companies can be purchased at a discount at a nadir in the business that is about to turn around.

The situation is doubly lucrative: a cheap stock at a point in the business cycle where it is about to turn around.

The lesson here is that human beings tend to think that the future will unfold like the past. Trends that are in place today will go on forever. This is rarely the case and it is one that Tobias demonstrates through a careful analysis of the data.

Mean reversion in business is the main force driving the realization of value.

The Illusion of “Quality”

Prior to reading deep value, I always assumed that the best course for the value investor was to combine “cheap” with “quality”. Yes, there are cheap ugly stocks out there, but many of them are dreaded “value traps”. Meanwhile, careful analysis can lead an astute investor to value investing gems: cheap companies that don’t have any real problems, companies that are growing and generating attractive returns on capital.

Tobias reveals that adding elements such as growth or high returns on capital to a value model actually underperforms cheap by itself. The ugliest value stocks are frequently the ones that lead to the highest future outperformance. This makes sense: if something is truly cheap, there must be a reason for it, and the scarier the reason then the better the bargain an investor will get. Moreover, the uglier the stock, the more likely its prospects for mean reversion.

This lesson is reinforced throughout the book with real world examples and massive quantities of data.

The Acquirer’s Multiple

Tobias’s preferred metric of “cheapness” is Operating Income/Enterprise Value (or other variants, such as EBIT/EV or EBITDA/EV). He provides data showing this metric’s historic outperformance. I found the same thing in my own backtesting, and O’Shaughnessy also verifies this in his most recent edition of What Works on Wall Street in which EBITDA/EV is given a prominent chapter.

The multiple works because it identifies stocks that are not only cheap but have healthy balance sheets. The balance sheet health allows them to survive whatever problems that the business (or industry) is enduring.

Another reason it works is that the metric is most often used by acquirers such as private equity firms.

What is Deep Value?

Another goal of this book is explaining how “deep value” is distinct from other types of value investing.

Most associate value investing with the investing style of Warren Buffett. Buffett began his career buying what he derisively called “cigar butts”, or simple cheap stocks. They were cigar butts in the sense that you could pick them up off the street for free because they were so cheap, and enjoy one last puff.

Buffett moved on from this style for a few reasons. The first was the influence of Charlie Munger, who was less influenced by Graham and was more interested in buying quality businesses.

The second was scale. Buffett became too big to nimbly buy a cheap low capitalization cigar butt, take his free puff, and move on. Frequently, Buffett had to buy up such large quantities of cigar butts where he became mired in the operational struggle.

The second was a handful of experiences that pushed Buffett in the direction of greater quality investments. In investments such as Dempster Mill (a struggling manufacturer of farm equipment) and Hochschild Kohn (a retailer forced to compete at razor thin margins in Baltimore), Buffett had to take controlling influence in each company to turn them around. In both situations, controlling a struggling company took its toll and consumed significant time from Buffett.

The experiences with Dempster and Hochschild stood in contrast to a different kind of investment that Buffett made in the 1970s: See’s Candy. See’s was a good business with a great brand. It generated high returns on capital and required little meddling. Once Buffett bought See’s and saw the benefits of high returns on capital, there was no turning back, and this became the basis for his future investment style. From then on, he bought large stakes in companies generating high returns on capital and held onto them for long periods of time to let them compound.

The 1970s and onward style of Buffett’s investing career is what most people think of when they hear “value investing”. Deep value, in contrast, is the style of investing that Warren Buffett used earlier in his career when he was managing smaller sums of capital and generated higher rates of return. Deep value is the style originally advocated by Benjamin Graham and later applied by investors such as Walter Schloss.

Deep value is buying cheap for the sake of being cheap and allowing mean reversion to return the stock to its intrinsic value.

The Buffett style of investing is certainly preferable because it generates higher compounded returns for longer periods of time, but it is extremely difficult to find businesses that generate high returns on capital that will not succumb to the forces of mean reversion. It is also a crowded trade, as all value investors are attempting to marry quality with cheapness.

Practical Application

Tobias maintains an excellent free stock screener keeping track of the best-ranking stocks according to the acquirer’s multiple, which you can use to systematically implement a value investing strategy. The large cap version is free, he also offers a paid version for the all-cap universe.

Recommendation

It’s rare that a book comes along that changes my mind and makes me see things from a different perspective. “Deep Value” was one of those books. I’ve read it three times so far and each time I gain a greater insight into the ideas that it conveys. I can’t give it a higher recommendation.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.