Walter Schloss: Factors Needed to Make Money In the Stock Market

Walter Schloss: A Superinvestor from Graham-and-Doddsville

SI1Back in 1984 Warren Buffett held a speech at Columbia Business School, later published in the article The Superinvestors from Graham-and-Doddsville. Walter Schloss was one of the superinvestors Warren talked about, and said:

“Walter never went to college, but took a course from Ben Graham at night at the New York Institute of Finance. Walter left Graham-Newman in 1955 and achieved the record shown here over 28 years.

Here is what ‘Adam Smith’ – after I told him about Walter – wrote about him in Supermoney (1972):

He has no connections or access to useful information. Practically no on 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.

In introducing me to [Schloss] Warren had also, to my mind, described himself. ‘He never forgets that he is handling other people’s money and this reinforces his normal strong aversion to loss. He has total integrity and a realistic picture of himself. Money is real to him and stocks are real―and from this flows an attraction to the ‘margin of safety’ principle.

Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do – and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.”

Investor Walter Schloss / SMART MONEY

Walter Schloss’ Rules of Investing

Walter Schloss, founder of Walter & Edwin Schloss Associates, L.P., compiled in a document dated March 10, 1994 the factors and rules to keep in mind when investing to increase the probability of making money in the stock market.

Factors Needed to Make Money In the Stock Market

  1. Price is the most important factor to use in relation to value.
  2. Try to establish the value of the company. Remember that a share of stock represents a part of a business and is not just a piece of paper.
  3. Use book value as a starting point to try and establish the value of the enterprise. Be sure that debt does not equal 100% of the equity. (Capital and surplus for the common stock).
  4. Have patience. Stocks don’t go up immediately.
  5. Don’t buy on tips or for a quick move. Let the professionals do that, if they can. Don’t sell on bad news.
  6. Don’t be afraid to be a loner but be sure that you are correct in your judgment. You can’t be 100% certain but try to look for weaknesses in your thinking. Buy on a scale and sell on a scale up.
  7. Have the courage of your convictions once you have made a decision.
  8. Have a philosophy of investment and try to follow it. The above is a way that I’ve found successful.
  9. Don’t be in too much of a hurry to sell. If the stock reaches a price that you think is a fair one, then you can sell but often because a stock goes up say 50%, people say sell it and button up your profit. Before selling try to reevaluate the company again and see where the stock sells in relation to its book value. Be aware of the level of the stock market. Are yields low and P-E ratios high. If the stock market historically high. Are people very optimistic etc?
  10. When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as 125 and then decline to 60 and you think it attractive. 3 years before the stock sold at 20 which shows that there is some vulnerability in it.
  11. Try to buy assets at a discount than to buy earnings. Earnings can change dramatically in a short time. Usually assets change slowly. One has to know how much more about a company if one buys earnings.
  12. Listens to suggestions 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.
  13. 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.
  14. 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 yrs, taxes excluded. Remember the rule of 72. Your rate of return into 72 will tell you the number of years to double your money.
  15. Prefer stocks over bonds. Bonds will limit your gains and inflation will reduce your purchasing power.
  16. Be careful of leverage. It can go against you.

See here for PDF.

W1

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Advertisement

Measuring the Moat: Value Creation Checklist

“The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.” ―Warren Buffett

M1

Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation

Below is an excerpt of “a complete checklist of questions to guide the strategic analysis” published in the paper Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation, written by Michael J. Mauboussin and Dan Callahan.

See here for full PDF.

MTM2


Value Creation Checklist

  • What stage of the competitive life cycle is the company in?
  • Is the company currently earning a return above its cost of capital?
  • Are returns on capital increasing, decreasing, or stable? Why?
  • What is the trend in the company’s investment spending?

C2Lay of the Land

  • What percentage of the industry does each player represent?
  • What is each player’s level of profitability?
  • What have the historical trends in market share been?
  • How stable is the industry?
    • How stable is market share?
    • What do pricing trends look like?
  • What class does the industry fall into—fragmented, emerging, mature, declining, international, network, or hypercompetitive?

C2The First Three of the Five Forces

  • How much leverage do suppliers have?
  • Can companies pass supplier increases to customers?
  • Are there substitute products available?
  • Are there switching costs?
  • How much leverage do buyers have?
  • How informed are the buyers?

C2Barriers to Entry

  • What are the entry and exit rates like in the industry?
  • What are the anticipated reactions of incumbents to new entrants?
  • What is the reputation of incumbents?
  • What is the level of asset specificity?
  • What is the minimum efficient production scale?
  • Is there excess capacity in the industry?
  • Is there a way to differentiate the product?
  • What is the anticipated payoff for a new entrant?
  • Do incumbents have precommitment contracts?
  • Do incumbents have licenses or patents?
  • Are there learning curve benefits in the industry?

C2Rivalry

  • Is there pricing coordination?
  • What is the industry concentration?
  • What is the size distribution of firms?
  • How similar are the firms in incentives, corporate philosophy, and ownership structure?
  • Is there demand variability?
  • Are there high fixed costs?
  • Is the industry growing?

C2Disruption and Disintegration

  • Is the industry vulnerable to disruptive innovation?
  • Do new innovations foster product improvements?
  • Is the innovation progressing faster than the market’s needs?
    • Have established players passed the performance threshold?
    • Is the industry organized vertically, or has there been a shift to horizontal markets?

C2Firm Specific

  • Does analysis of the value chain reveal what activities a company does differently than its its rivals?
  • Does the firm have production advantages?
    • Is there instability in the business structure?
    • Is there complexity requiring know-how or coordination capabilities?
    • How quickly are the process costs changing?
  • Does the firm have any patents, copyrights, trademarks, etc.?
  • Are there economies of scale?
    • What does the firm’s distribution scale look like?
    • Are assets and revenue clustered geographically?
    • Are there purchasing advantages with size?
    • Are there economies of scope?
    • Are there diverse research profiles?
  • Are there consumer advantages?
    • Is there habit or horizontal differentiation?
    • Do people prefer the product to competing products?
    • Are there lots of product attributes that customers weigh?
    • Can customers only assess the product through trial?
    • Is there customer lock-in? Are there high switching costs?
  • Is the network radial or interactive?
  • What is the source and longevity of added value?
  • Are there external sources of added value (subsidies, tariffs, quotas, and competitive or environmental regulations)?

C2Firm Interaction—Competition and Coordination

  • Does the industry include complementors?
  • Is the value of the pie growing because of companies that are not competitors? Or, are new companies taking share from a pie with fixed value?

C2Brands

  • Do customers want to “hire” the brand for the job to be done?
  • Does the brand increase willingness to pay?
  • Do customers have an emotional connection to the brand?
  • Do customers trust the product because of the name?
  • Does the brand imply social status?
  • Can you reduce supplier operating cost with your name?

VCC3

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Forbes Transcript: Mohnish Pabrai on Checklists

“No wise pilot, no matter how great his talent and experience, fails to use his checklist.”—Charlie Munger, Poor Charlie’s Almanack

“So you know, and all of these questions are not questions I created out of the blue. What I did is I looked at businesses where people had lost money.”—Mohnish Pabrai

Steve Forbes Interview With Mohnish Pabrai

A few years back, in 2010, Steve Forbes interviewed Mohnish Pabrai. This interview is about half an hour long, and among the topics discussed, checklists was one of them. The interview is available on YouTube, and there’s also a transcript available at Forbes’ – see here.

Below is an excerpt of the part of the discussion where Steve and Mohnish talk about checklists. Emphasis added by me.

“Make Checklists

Forbes: So in the first quarter of 2010, did you add any positions?

Pabrai: Yeah, actually, we did. We did find. In fact, there’s one I’m buying right now. But I found two businesses, but they’re anomalies. They were just, you know, businesses that had distress in them because of specific factors. And I think we’ll do very well on both of them. They’ll go nameless here. But no, I think, for example, in the fourth quarter of 2008 or the first quarter of 2009, you could have just thrown darts and done well. And that is definitely not the case today.

Forbes: And finally, telling you about mistakes, one of the things I guess an investor has to realize, they cannot control the universe. Delta Financial: You had done the homework, you fell and then events took it away from you.

FI1Pabrai: Well Delta Financial was a full loss for the firm, for the fund. We lost 100% of our investment. It was a company that went bankrupt. And we’ve learned a lot of lessons from Delta. And one of the lessons was that Delta was, in many ways, a very highly levered company and they were very dependent on a functioning securitization market. And when that market shut down, they were pretty much out of business. And they were caught flat-footed. And so there’s a number of lessons I’ve obviously learned from Delta.

It’s easier to learn the lessons when you don’t take the hits in your own portfolio. But when you take the hits in your own portfolio, those lessons stay with you for a long time.

Forbes: So that gets to, you’re a great fan of The Checklist Manifesto. And you now have checklists. You said one of the key things is mistakes, in terms of a checklist, so you don’t let your emotions get in the way of analyzing. What are some of the mistakes on your checklist now that you go through systematically, even if your gut says, ‘This is great. I want to do it.’

Pabrai: Yeah, so the checklist I have currently has about 80 items on it. And even though 80 sounds like a lot, it doesn’t take a long time.

It takes about 30 minutes to go through the checklist. What I do is when I’m starting a business, I go through my normal process of analyzing the business. When I’m fully done and I’m ready to pull the trigger, that’s when I take the business to the checklist. And I run it against the 80 items. And what happens the first time when I run it, there might be seven or eight questions that I don’t know the answer to, which is great, which what that means is, ‘Listen dummy, go find out the answer to these eight questions first.’ Which means I have more work to do. So I go off again to find those answers. When I have those answers, I come back and run the checklist again. And any business that I look at is going to have some items on which the checklist raises red flags. But the good news is that you’re looking in front of you with all your facilities at the range of things that could possibly cause a problem.

And when you look at that list, you can also compare it to how those factors correlate with the rest of your portfolio. And at that point, kind of, you have a go, no-go point, where you can say, ‘I’m comfortable with these risk factors here. I’m comfortable with probabilities. And I’ll go ahead with it.’ Or you can say, ‘I’m just going to take a pass.’

And one of the things that came out of running the checklist was I used to run a 10×10 portfolio, which is when I’d make a bet, it was typically 10% of assets. And after I incorporated the checklist and I started to see all the red flags, I changed my allocation. So the typical allocation now at Pabrai Funds is 5%. And we’ll go as low as 2%, if we are doing a basket bet.

And once in a blue moon, we’ll go up to 10%. In fact I haven’t done a 10% investment in a long time. And so the portfolio has become more names than it used to have. But since we started running the checklists, which is about 18 months ago, so far it’s a zero error rate. And in the last 18 months, it’s probably been the most prolific period of making investments for Pabrai Funds. We made a huge number of investments, more than any other period, any other 18-month period in our history. So with more activity so far, and it’s a very short period, we have a much lower error rate.

I know in the future we will make errors. But I know those errors, the rate of errors will be much lower. And this is key. The thing is that Warren says, ‘Rule No. 1: Don’t lose money. Rule No. 2: Don’t forget rule No. 1.’ OK, so the key to investing is downside protection. The upsides will take care of themselves. But you have to make sure that your losers are few and far between. And the checklist is very central to that.

Forbes: Can you give a couple of the things that are on your 80 [item] checklist?

C2Pabrai: Oh yeah, sure. The checklist was created, looking at my mistakes and other investors’ mistakes. So for example, there’s questions like, you know, ‘Can this business be decimated by low-cost competition from China or other low-cost countries?’ That’s a checklist question. Another question is, ‘Is this a win-win business for the entire ecosystem?’ So for example, if there’s some company doing, you know, high-interest credit cards and they make a lot of money, that’s not exactly, you know, helping society. So you might pass on that. Also, a liquor company or tobacco company, those can be great businesses, but in my book, I would just pass on those. Or a gambling business, and so on.

C2So the checklist will kind of focus you more toward playing center court rather than going to the edge of the court. And there’s a whole set of questions on leverage. For example, you know, how much leverage? What are the covenants? Is it recourse or non-recourse? There’s a whole bunch of questions on management, on management comp, on the interests of management. You know, just a whole–on their historical track records and so on. So there’s questions on unions, on collective bargaining.

C2So you know, and all of these questions are not questions I created out of the blue. What I did is I looked at businesses where people had lost money. I looked at Dexter Shoes, where Warren Buffett lost money. And he lost it to low-cost Chinese competition. So that led to the question. And I looked at CORT Furniture, which was a Charlie Munger investment. And that was an investment made at the peak of the dot-com boom, where they were doing a lot of office furniture rentals. And the question was, ‘Are you looking at normalized earnings or are you looking at boom earnings?’ And so that question came from there. So the checklist questions, I think, are very robust, because they’re based on real-world arrows people have taken in the back.”

OLYMPUS DIGITAL CAMERADisclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Checklist for Assessing Capital Allocation Skills

Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance

Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance is another great paper written by Michael J. Mauboussin and Dan Callahan, both currently at Credit Suisse. See here for yesterday’s post.

CA1Capital Allocation: The Problem

Let’s us start with an excerpt from the paper and a quote from Warren Buffett about the problem of capital allocation, i.e., that the heads of many companies are not skilled in capital allocation.

“…our focus here is on how companies spend money.

The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital effectively. Warren Buffett, chairman and CEO of Berkshire Hathaway, describes this reality in his 1987 letter to shareholders. He discusses the point of why it is beneficial for Berkshire Hathaway’s corporate office to allocate the capital of the companies it controls. Buffett is worth quoting at length:

‘This point can be important because the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie [Munger] and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.

In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)'”

Checklist for Assessing Capital Allocation Skills

In the end of the paper the authors share a Checklist for Assessing Capital Allocation Skills. This checklist is reproduced below.

Past Spending Patterns

  • Have you analyzed how companies have spent money in the past, separating operating uses from return of capital to claimholders?
  • How has the company funded its investments?
  • Identify the prime use of capital. Do you know if management thinks about that use of capital properly?
  • Have there been shifts in the pattern of spending?
  • If there is new management, has spending changed?
  • Who makes which capital allocation decision?
  • How does the company conduct its budgeting process?

Calculate ROIC and ROIIC

  • Have you calculated ROIC over time and observed a trend?
  • Examine composition of ROIC through a DuPont analysis—does this suggest a consumer or production advantage?
  • Have you compared the company’s results to those of its peers?
  • Have you calculated ROIIC for one year and rolling three- and five-year periods?

Incentives and Governance

  • How is the company’s incentive compensation structured?
  • How much stock does senior management own?
  • Is total shareholder return calculated on a relative basis?
  • Have you examined the company’s incentive score?
  • Are the measures in place to encourage management to think for the long term?

Five Principles of Capital Allocation

  • Does the company use zero-based capital allocation or is it dominated by spending inertia?
  • Is the company focused on funding strategies or projects?
  • Does the company have a “scarce but free” attitude about capital, or “abundant but costly?”
  • Does the company prune businesses with poor prospects for creating value?
  • Does the company know how to calculate the value of its assets and does it act accordingly?

Philip A. Fisher: The Fifteen Things to Look for in a Common Stock

“I sought out Phil Fisher after reading his “Common Stocks and Uncommon Profits”. When I met him, I was impressed by the man and his ideas. A thorough understanding of a business, by using Phil’s techniques … enables one to make intelligent investment commitments.” Warren Buffett

Background

Philip A. Fisher began his career as a securities analyst in 1928, and founded Fisher & Company, an investment counseling business, in 1931. He is known as one of the pioneers of modern investment theory.

Common Stocks and Uncommon Profits

Fisher put down his philosophies about business analysis and investing in Common Stocks and Uncommon Profits. The book was first published in 1958 and has since become appreciated by many investors as a must-read.

Philip A. Fishers Checklist: The Fifteen Things to Look for in a Common Stock

T1T2T34567789101112131415Some Articles to Read

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.

Checklist: Singleton’s Aquisition Standards

Henry Singleton’s Standards for Acquisitions

HS1In the earlier post The Great Man Behind Teledyne: Henry Singleton and the recording The Manual of Ideas on Business Leader Henry Singleton, Founder of Teledyne, there is a part starting at 1:12:31 that describes the standards that Singleton had for deciding whether or not a company was a good acquisition candidate for his Teledyne.

The questions that Teledyne asked when analyzing and considering potential acquisitions were:

  • Is the company profitable?
  • Do they have a good balance sheet?
  • Is their profit and loss statement accurate?
  • Do they have a clean inventory?
  • Is their backlog realistic and well documented?
  • Is their management on top of their operations?
  • Would management be willing to stay if acquired?
  • Have they made long ranged plans to maximize their profit in a sell out?
  • Does the business have growth potential?
  • Is there opportunity for growth in profit?
  • Can cash be taken from the company for use elsewhere?
  • How is depreciation counted and is it a significant percentage of profits?
  • What is the condition of their physical plant?
  • Would this company be a good fit within Teledyne organization and its goal?

See here for a review of the book Distant Force A Memoir of the Teledyne Corporation and the Man Who Created It.

This book is also mentioned in the article What Would Value Investing 101 Look Like? written by Geoff Gannon at GuruFocus.com.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. This article is informational and is in my own personal opinion.

Seth Klarman Defines What Constitutes a Good Business

What constitutes a good business?

Let’s turn to Seth Klarman for some advice.

GB3

In other words, a good business is one that enjoys the following characteristics:

  • Strong barriers to entry
  • Limited capital requirements
  • Reliable customers
  • Low risk of technological obsolescence
  • Abundant growth possibilities
  • Significant and growing free cash flow

Keep these six characteristics in mind as a mini-checklist when thinking about and analyzing a certain business, trying to decide if the business in question meets these requirements for what constitutes a good business.

Checklist: A List of Things…

Here comes some thoughts about checklists, and why it might be a good thing to use one, but also on how to build your own and from were to get your inspiration.

The Cambridge Dictionaries Online defines a checklist as “a list of things that you must think about, or that you must remember to do.” 

Actually, you don’t need to look up the word “checklist” in a dictionary to know its meaning. But I think that it’s always good to get a simple definition to read through and just look at.

Anyway, I didn’t really think a lot about checklists until I read the 1977 Letter to Shareholders written by Warren Buffett. In it Warren simply lays out the four things that Charlie and he look for when evaluating a business.

We select our marketable equity securities in much the same 
way we would evaluate a business for acquisition in its entirety.  
We want the business to be (1) one that we can understand, (2) 
with favorable long-term prospects, (3) operated by honest and 
competent people, and (4) available at a very attractive price.

These four criteria captures pretty much everything one should consider when evaluating a business. They may not look like much at first, but there is a lot of sublevels in each of them.

What then is the best way to learn about the four points and their content? A good start is to read all letters to shareholders that’s been published so far. You’ll find them at Berkshire Hathaway’s homepage. All of them are great reads and I recommend everyone to read them. 

These are some of the best business texts ever written for someone who wants to improve knowledge about business analysis and investing. And they’re available for free! 

In my next post I will write about two books I have read about checklists. Until then, get inspired by Mohnish Pabrai’s presentation The ChecklistMohnish Pabrai - The Checklist

Also, feel free to share your insights regarding checklist. Do you use an investment checklist? If you do, how do you use it and how did you compile it?