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Putting a Super-Investor to the Test
A lot of people believe that old-school, Ben Graham-style value investing is dead. That it’s nothing more than a once-profitable artifact of the Great Depression — with little to no relevance to investors today.
So, is Wall Street right? Is Grahamian value investing just a quaint, old-fashioned approach that only worked once upon a time?
Let’s find out…
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A Quick History Lesson
Benjamin Graham, alternately known as the dean of security analysis and the godfather of value investing, made his name (and riches) in the aftermath of the Great Crash of 1929. He sifted through the wreckage of Wall Street, using careful scrutiny of balance sheets to unearth beaten-down companies trading far below their intrinsic value.
In those days, such discoveries were not exactly rare. During the Great Depression, the overall sentiment towards investing and stocks was dubious at best, reflecting the fear and distrust felt by a penniless populace that had just lost everything.
Anyone willing to go against the crowd, though, could make a killing. And that’s just what Ben Graham did.
Back then, companies routinely traded below net working capital (i.e. cash, inventory, and receivables minus current liabilities), which pretty much guaranteed a favorable financial outcome for the intelligent investor. In effect, Graham had found a way to exploit the (often large) difference between a company’s share price and its actual asset value.
But, as the United States emerged from the Depression as a resurgent economic superpower, these types of bargains almost completely dried up. As a result, Graham even updated his approach to focus more on book value as opposed to net working capital.
It’s from this investing school of thought that Warren Buffett built both his initial partnership and, later, Berkshire Hathaway. With Berkshire, though, Charlie Munger convinced Buffett to move beyond this deep-value analysis and instead consider blue-chip companies that might appear overvalued from a strictly Grahamian perspective.
Obviously, that’s worked out pretty well for Messrs. Buffett and Munger — as well as all of those long-term Berkshire Hathaway shareholders.
In his later years, even Graham himself expressed skepticism about the future efficacy of his deep-value approach:
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, forty years ago, when our textbook was first published; but the situation has changed a great deal since then.
In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies, but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I’m on the side of the “efficient market” school of thought now generally accepted by the professors. (1976 Financial Analysts Journal)
Of all the Graham acolytes, one in particular stuck to his mentor’s methods more than the others. Walter Schloss learned his trade at the Graham-Newman investment firm (even sharing an office with Buffett at one point), before striking out on his own in 1955.
Schloss, like Graham, played a completely different game than most of his contemporaries. He hunted for “cigar butt” stocks, named for their resemblance to discarded cigar butts that nevertheless still had one last puff of smoke in them. These could often be had at rock-bottom prices, with Schloss hoping to catch any run-up in price before flipping them for a profit.
This wasn’t Warren Buffett with his preferred holding period of forever. Schloss played a purely quantitative game of arbitrage and unloaded his positions as soon as the price imbalance corrected itself.
And it worked.
During five decades running his own investment firm, Schloss achieved 16% compounded annual returns (after fees) for his partners. And he did it all without a computer, choosing to analyze newspapers and Value Line reports instead.
Fun fact: At the height of the dot-com bubble, Schloss shorted both Amazon and Yahoo — allowing his fund to outpace the S&P 500 by 37% in 2000 and 24% in 2001. What a legend.
An Experiment… With Two Caveats
While reading a February 11, 2008 Forbes interview with Walter Schloss, I was surprised to see that the super-investor actually discussed several investment opportunities that he was considering for his personal fund.
So, in an effort to see for myself if Schloss’s by-the-books Grahamian style still worked as late as 2008, I did a little research to see how these various investments would have turned out in the ensuing years. Using the S&P 500 as a benchmark, I’ll compare the compounded returns earned (with dividends reinvested) from these individual securities to what could have been gained by investing in the market at large instead.
The two caveats:
(1) While Walter Schloss hinted at what price level he would purchase the following stocks, he did not discuss his exit strategy. Therefore, I will assume some level of competence and patience from the legendary investor, meaning that he would not panic sell at the first downturn or try to hold onto a cigar butt forever.
(2) Schloss named five companies on his watchlist, but I’ve only analyzed three of them. Why? Dow Chemical and Tecumseh Products were both involved in mergers after the 2008 article and I could not find the appropriate pre-merger historical data to crunch all of the numbers.
So, without further ado, let’s dig in and see if the Graham/Schloss approach has really gone the way of the dodo or if it deserves a fresh look in the new millennium.
Bassett Furniture Industries
This furniture manufacturer and retailer, battered and bruised by the collapsing housing market, had fallen to just 60% of book value when Schloss highlighted it in Forbes.
But he wasn’t buying quite yet.
Schloss felt that Bassett Furniture’s hefty 7% dividend would soon come under pressure and be cut — and that’s when he advised readers to jump in.
Surprise, surprise: That’s exactly what happened later in 2008. Then, the following year, Bassett Furniture did it one better and eliminated the dividend altogether. The stock crashed, dropping under $1 per share at one point, before steadily (though slowly) regaining its value. As Bassett Furniture’s outlook improved, the company even reinstated its dividend.
For anyone who strictly followed Schloss’s advice and purchased BSET after the 56% dividend cut was announced on October 16, 2008, here’s what happened:
21.9% compounded annual returns if sold in July 2012 (vs. 11.9% for S&P 500)
27.1% compounded annual returns if sold in July 2013 (vs. 14.6% for S&P 500)
25.1% compounded annual returns if sold in Nov. 2014 (vs. 15.5% for S&P 500)
34.9% compounded annual returns if sold in July 2015 (vs. 14.5% for S&P 500)
27.8% compounded annual returns if sold in July 2017 (vs. 13.6% for S&P 500)
Near the end of 2017, Bassett Furniture stock turned wild — with both huge drops and gains in sharp succession. But anyone following the Schloss/Graham playbook would have cashed out long before this. With a massive profit.
Schloss spotted this insurer in the midst of a big fall, trading at just 8x earnings and 90% of book value. But CNA had little debt and Schloss noted that 89% of the company’s voting stock was owned by Loews Corp. (controlled by the billionaire Tisch family).
“I can’t say people will get rich on it, but I would rather be safe than sorry,” Schloss told Forbes. “If it falls more, I won’t worry about it. Let the Tisches worry about it.”
And fall it did.
From February 2008 to February 2009, CNA’s stock price dropped 71% — bottoming out under $8 per share.
For anyone who strictly followed Schloss’s advice and purchased CNA as soon as it got cheaper (which happened almost immediately), I will calculate the results from a start date of February 20, 2008. Here’s what happened:
4.3% compounded annual returns if sold in April 2011 (vs. 1.8% for S&P 500)
6.0% compounded annual returns if sold in May 2013 (vs. 6.0% for S&P 500)
8.9% compounded annual returns if sold in April 2014 (vs. 7.6% for S&P 500)
Like Schloss said — CNA wasn’t going to make anybody rich, but the insurer did beat the S&P 500 benchmark over a number of years. Chalk another one up for the super-investor.
Superior Industries International
Unlike the others, Schloss was already buying SUP when he spoke to Forbes in February 2008. He liked that the car-wheel maker traded at 80% of book value, paid out a 3% dividend, and had no debt.
On the downside, Superior’s earnings had fallen for five consecutive years and the company got 75% of its sales from GM and Ford (both suffering during the financial crisis). Those negatives overwhelmed the solid fundamentals and caused the stock price to drop to a level that Schloss found attractive.
Since Schloss had already started buying SUP before his interview, I will calculate the returns from a start date of February 11, 2008 (publication date of the article) to mimic a typical reader’s results. Here’s what happened:
118% compounded annual returns if sold in May 2008 (vs. 17.5% for S&P 500)
This is extrapolated out to a full year since the results only cover three months. Forbes readers (and Walter Schloss) could have made a very profitable quick flip of SUP after its price rose sharply in early May 2008.
14.6% compounded annual returns if sold in April 2011 (vs. 1.8% for S&P 500)
Another home run for the out-of-touch dinosaur.
While not exactly an exhaustive analysis, the above results certainly suggest that Wall Street may have been a touch too hasty in pronouncing the death of Grahamian value investing.
I personally prefer the Buffett approach of identifying stalwart blue-chip companies, waiting for the stock price to dip, and then buying and holding forever. But it’s pretty cool to know that, in the right hands, old-school techniques still have a little life left in them.
At least in investing, there’s more than one way to get to heaven.
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Disclosure: This is not financial advice. I am not a financial advisor. Do your own research before making any investment decisions.