October 29, 2023
Walter Schloss generated one of the best investment track records of all time—close to 21% (gross) annually over 47 years—by investing exclusively in cigar butts (deep value stocks). Cigar-butt investing usually means buying stock at a discount to book value, i.e., a P/B < 1 (price-to-book ratio below 1).
The highest returning cigar butt strategy comes from Ben Graham, the father of value investing. It’s called the net-net strategy whereby you take current assets minus all liabilities, and then invest at 2/3 of that level or less.
- The main trouble with net nets today is that many of them are tiny microcap stocks—below $50 million in market cap—that are too small even for most microcap funds.
- Also, many net nets exist in markets outside the United States. Some of these markets have had problems periodically related to the rule of law.
Schloss used net nets in the early part of his career (1955 to 1960). When net nets became too scarce (1960), Schloss started buying stocks at half of book value. When those became too scarce, he went to buying stocks at two-thirds of book value. Eventually he had to adjust again and buy stocks at book value. Though his cigar-butt method evolved, Schloss was always using a low P/B to find cheap stocks.
(Photo by Sky Sirasitwattana)
One extraordinary aspect to Schloss’s track record is that he invested in roughly 1,000 stocks over the course of his career. (At any given time, his portfolio had about 100 stocks.) Warren Buffett commented:
Following a strategy that involved no real risk—defined as permanent loss of capital—Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type. A few big winners did not account for his success. It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.
Schloss was aware that a concentrated portfolio—e.g., 10 to 20 stocks—could generate better long-term returns. However, this requires unusual insight on a repeated basis, which Schloss humbly admitted he didn’t have.
Most investors are best off investing in low-cost index funds or in quantitative value funds. For investors who truly enjoy looking for undervalued stocks, Schloss offered this advice:
It is important to know what you like and what you are good at and not worry that someone else can do it better. If you are honest, hardworking, reasonably intelligent and have good common sense, you can do well in the investment field as long as you are not too greedy and don’t get too emotional when things go against you.
I found a few articles I hadn’t seen before on The Walter Schloss Archive, a great resource page created by Elevation Capital: https://www.walterschloss.com/
Here’s the outline for this blog post:
- Stock is Part Ownership; Keep It Simple
- Have Patience; Don’t Sell on Bad News
- Have Courage
- Buy Assets Not Earnings
- Buy Based on Cheapness Now, Not Cheapness Later
- Boeing: Asset Play
- Less Downside Means More Upside
- Multiple Ways to Win
- History; Honesty; Insider Ownership
- You Must Be Willing to Make Mistakes
- Don’t Try to Time the Market
- When to Sell
- The First 10 Years Are Probably the Worst
- Stay Informed About Current Events
- Control Your Emotions; Be Careful of Leverage
- Ride Coattails; Diversify
STOCK IS PART OWNERSHIP; KEEP IT SIMPLE
A share of stock represents part ownership of a business and is not just a piece of paper or a blip on the computer screen.
Try to establish the value of the company. Use book value as a starting point. There are many businesses, both public and private, for which book value is a reasonable estimate of intrinsic value. Intrinsic value is what a company is worth—i.e., what a private buyer would pay for it. Book value—assets minus liabilities—is also called “net worth.”
Follow Buffett’s advice: keep it simple and don’t use higher mathematics.
(Illustration by Ileezhun)
Some kinds of stocks are easier to analyze than others. As Buffett has said, usually you don’t get paid for degree of difficulty in investing. Therefore, stay focused on businesses that you can fully understand.
- There are thousands of microcap companies that are completely neglected by most professional investors. Many of these small businesses are simple and easy to understand.
HAVE PATIENCE; DON’T SELL ON BAD NEWS
Hold for 3 to 5 years. Schloss:
Have patience. Stocks don’t go up immediately.
Things usually take longer to work out but they work out better than you expect.
Don’t sell on bad news unless intrinsic value has dropped materially. When the stock drops significantly, buy more as long as the investment thesis is intact.
Schloss’s average holding period was 4 years. It was less than 4 years in good markets when stocks went up more than usual. It was greater than 4 years in bad markets when stocks stayed flat or went down more than usual.
Have the courage of your convictions once you have made a decision.
(Courage concept by Travelling-light)
Investors shun companies with depressed earnings and cash flows. It’s painful to own stocks that are widely hated. It can also be frightening. As John Mihaljevic explains in The Manual of Ideas (Wiley, 2013):
Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows. In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values. After all—the reasoning of a scared investor might go—what is an asset really worth if it produces no cash flow?
A related worry is that if a company is burning through its cash, it will gradually destroy net asset value. Ben Graham:
If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price. The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.
It’s true that an individual cigar butt (deep value stock) is more likely to underperform than an average stock. But because the potential upside for a typical cigar butt is greater than the potential downside, a basket of cigar butts (portfolio of at least 30) does better than the market over time and also has less downside during bad states of the world—such as bear markets and recessions.
Schloss discussed an example: Cleveland Cliffs, an iron ore producer. Buffett owned the stock at $18 but then sold at about that level. The steel industry went into decline. The largest shareholder sold out because he thought the industry wouldn’t recover.
Schloss bought a lot of stock at $6. Nobody wanted it. There was talk of bankruptcy. Schloss noted that if he had lived in Cleveland, he probably wouldn’t have been able to buy the stock because all the bad news would have been too close.
Soon thereafter, the company sold some assets and bought back some stock. After the stock increased a great deal from the lows, then it started getting attention from analysts.
In sum, often when an industry is doing terribly, that’s the best time to find cheap stocks. Investors avoid stocks when they’re having problems, which is why they get so cheap. Investors overreact to negative news.
BUY ASSETS NOT EARNINGS
(Illustration by Teguh Jati Prasetyo)
Try to buy assets at a discount [rather] than to buy earnings. Earnings can change dramatically in a short time. Usually assets change slowly. One has to know much more about a company if one buys earnings.
Not only can earnings change dramatically; earnings can easily be manipulated—often legally. Schloss:
Ben made the point in one of his articles that if U.S. Steel wrote down their plants to a dollar, they would show very large earnings because they would not have to depreciate them anymore.
BUY BASED ON CHEAPNESS NOW, NOT CHEAPNESS LATER
Buy things based on cheapness now. Don’t buy based on cheapness relative to future earnings, which are hard to predict.
Graham developed two ways of estimating intrinsic value that don’t depend on predicting the future:
- Net asset value
- Current and past earnings
Professor Bruce Greenwald, in Value Investing (Wiley, 2004), has expanded on these two approaches.
- As Greenwald explains, book value is a good estimate of intrinsic value if book value is close to the replacement cost of the assets. The true economic value of the assets is the cost of reproducing them at current prices.
- Another way to determine intrinsic value is to figure out earnings power—also called normalized earnings—or how much the company should earn on average over the business cycle. Earnings power typically corresponds to a market level return on the reproduction value of the assets. In this case, your intrinsic value estimate based on normalized earnings should equal your intrinsic value estimate based on the reproduction value of the assets.
In some cases, earnings power may exceed a market level return on the reproduction value of the assets. This means that the ROIC (return on invested capital) exceeds the cost of capital. It can be exceedingly difficult, however, to determine by how much and for how long earnings power will exceed a market level return. Often it’s a question of how long some competitive advantage can be maintained. How long can a high ROIC be sustained?
As Buffett remarked:
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
A moat is a sustainable competitive advantage. Schloss readily admits he can’t determine which competitive advantages are sustainable. That requires unusual insight. Buffett can do it, but very few investors can.
As far as franchises or good businesses—companies worth more than adjusted book value—Schloss says he likes these companies, but rarely considers buying them unless the stock is close to book value. As a result, Schloss usually buys mediocre and bad businesses at book value or below. Schloss buys “difficult businesses” at clearly cheap prices.
Buying a high-growing company on the expectation that growth will continue can be quite dangerous. First, growth only creates value if the ROIC exceeds the cost of capital. Second, expectations for the typical growth stock are so high that even a small slowdown can cause the stock to drop noticeably. Schloss:
If observers are expecting the earnings to grow from $1.00 to $1.50 to $2.00 and then $2.50, an earnings disappointment can knock a $40 stock down to $20. You can lose half your money just because the earnings fell out of bed.
If you buy a debt-free stock with a $15 book selling at $10, it can go down to $8. It’s not great, but it’s not terrible either. On the other hand, if things turn around, that stock can sell at $25 if it develops its earnings.
Basically, we like protection on the downside. A $10 stock with a $15 book can offer pretty good protection. By using book value as a parameter, we can protect ourselves on the downside and not get hurt too badly.
Also, I think the person who buys earnings has got to follow it all the darn time. They’re constantly driven by earnings, they’re driven by timing. I’m amazed.
BOEING: ASSET PLAY
(Boeing 377 Stratocruiser, San Diego Air & Space Museum Archives, via Wikimedia Commons)
Cigar butts—deep value stocks—are characterized by two things:
- Poor past performance;
- Low expectations for future performance, i.e., low multiples (low P/B, low P/E, etc.)
Schloss has pointed out that Graham would often compare two companies. Here’s an example:
One was a very popular company with a book value of $10 selling at $45. The second was exactly the reverse—it had a book value of $40 and was selling for $25.
In fact, it was exactly the same company, Boeing, in two very different periods of time. In 1939, Boeing was selling at $45 with a book of $10 and earning very little. But the outlook was great. In 1947, after World War II, investors saw no future for Boeing, thinking no one was going to buy all these airplanes.
If you’d bought Boeing in 1939 at $45, you would have done rather badly. But if you’d bought Boeing in 1947 when the outlook was bad, you would have done very well.
Because a cigar butt is defined by poor recent performance and low expectations, there can be a great deal of upside if performance improves. For instance, if a stock is at a P/E (price-to-earnings ratio) of 5 and if earnings are 33% of normal, then if earnings return to normal and if the P/E moves to 15, you’ll make 900% on your investment. If the initial purchase is below true book value—based on the replacement cost of the assets—then you have downside protection in case earnings don’t recover.
LESS DOWNSIDE MEANS MORE UPSIDE
If you buy stocks that are protected on the downside, the upside takes care of itself.
The main way to get protection on the downside is by paying a low price relative to book value. If in addition to quantitative cheapness you focus on companies with low debt, that adds additional downside protection.
If the stock is well below probable intrinsic value, then you should buy more on the way down. The lower the price relative to intrinsic value, the less downside and the more upside. As risk decreases, potential return increases. This is the opposite of what modern finance theory teaches. According to theory, your expected return only increases if your risk also increases.
In The Superinvestors of Graham-and-Doddsville, Warren Buffett discusses the relationship between risk and reward. Sometimes risk and reward are positively correlated. Buffett gives the example of Russian roulette. Suppose a gun contains one cartridge and someone offers to pay you $1 million if you pull the trigger once and survive. Say you decline the bet as too risky, but then the person offers to pay you $5 million if you pull the trigger twice and survive. Clearly that would be a positive correlation between risk and reward. Buffett continues:
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.
Most brokers don’t recommend buying more on the way down because most people (including brokers’ clients) don’t like to buy when the price keeps falling. In other words, most investors focus on price instead of intrinsic value.
MULTIPLE WAYS TO WIN
A stock trading at a low price relative to book value—a low P/B stock—is usually distressed and is experiencing problems. But there are several ways for a cigar-butt investor to win, as Schloss explains:
The thing about buying depressed stocks is that you really have three strings to your bow: 1) Earnings will improve and the stocks will go up; 2) somebody will come in and buy control of the company; or 3) the company will start buying its own stock and ask for tenders.
But lots of times when you buy a cheap stock for one reason, that reason doesn’t pan out but another reason does—because it’s cheap.
HISTORY; HONESTY; INSIDER OWNERSHIP
Look at the history of the company. Value line is helpful for looking at history 10-15 years back. Also, read the annual reports. Learn about the ownership, what the company has done, when business they’re in, and what’s happened with dividends, sales, earnings, etc.
It’s usually better not to talk with management because it’s easy to be blinded by their charisma or sales skill:
When we buy into a company that has problems, we find it difficult talking to management as they tend to be optimistic.
That said, try to ensure that management is honest. Honesty is more important than brilliance, says Schloss:
…we try to get in with people we feel are honest. That doesn’t mean they’re necessarily smart—they may be dumb.
But in a choice between a smart guy with a bad reputation or a dumb guy, I think I’d go with the dumb guy who’s honest.
Finally, insider ownership is important. Management should own a fair amount of stock, which helps to align their incentives with the interests of the stockholders.
Speaking of insider ownership, Walter and Edwin Schloss had a good chunk of their own money invested in the fund they managed. You should prefer investment managers who, like the Schlosses, eat their own cooking.
YOU MUST BE WILLING TO MAKE MISTAKES
(Illustration by Lkeskinen0)
You have to be willing to make mistakes if you want to succeed as an investor. Even the best value investors tend to be right about 60% of the time and wrong 40% of the time. That’s the nature of the game.
You can’t do well unless you accept that you’ll make plenty of mistakes. The key, again, is to try to limit your downside by buying well below probable intrinsic value. The lower the price you pay (relative to estimated intrinsic value), the less you can lose when you’re wrong and the more you can make when you’re right.
DON’T TRY TO TIME THE MARKET
No one can predict the stock market. Ben Graham observed:
If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.
(Illustration by Maxim Popov)
Or as value investor Seth Klarman has put it:
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.
Perhaps the best quote comes from Henry Singleton, a business genius (100 points from being a chess grandmaster) who was easily one of the best capital allocators in American business history:
I don’t believe all this nonsense about market timing. Just buy very good value and when the market is ready that value will be recognized.
Singleton built Teledyne using extraordinary capital allocation skills over the course of more than three decades, from 1960 to the early 1990’s. Fourteen of these years—1968 to 1982—were a secular bear market during which stocks were relatively flat and also experienced a few large downward moves (especially 1973-1974). But this long flat period punctuated by bear markets didn’t slow down or change Singleton’s approach. Because he consistently bought very good value, on the whole his acquisitions grew significantly in worth over time regardless of whether the broader market was down, flat, or up.
Of course, it’s true that if you buy an undervalued stock and then there’s a bear market, it may take longer for your investment to work. However, bear markets create many bargains. As long as you maintain a focus on the next 3 to 5 years, bear markets are wonderful times to buy cheap stocks (including more of what you already own).
In 1955, Buffett was advised by his two heroes, his father and Ben Graham, not to start a career in investing because the market was too high. Similarly, Graham told Schloss in 1955 that it wasn’t a good time to start.
Both Buffett and Schloss ignored the advice. In hindsight, both Buffett and Schloss made great decisions. Of course, Singleton would have made the same decision as Buffett and Schloss. Even if the market is high, there are invariably individual stocks hidden somewhere that are cheap.
Schloss always remained fully invested because he knew that virtually no one can time the market except by luck.
WHEN TO SELL
Don’t be in too much of a hurry to sell… Before selling try to reevaluate the company again and see where the stock sells in relation to its book value.
Selling is hard. Schloss readily admits that many stocks he sold later increased a great deal. But he doesn’t dwell on that.
The basic criterion for selling is whether the stock price is close to estimated intrinsic value. For a cigar butt investor like Schloss, if he paid a price that was half book, then if the stock price approaches book value, it’s probably time to start selling. (Unless it’s a rare stock that is clearly worth more than book value, assuming the investor was able to buy it low in the first place.)
If stock A is cheaper than stock B, some value investors will sell A and buy B. Schloss doesn’t do that. It often takes four years for one of Schloss’s investments to work. If he already has been waiting for 1-3 years with stock A, he is not inclined to switch out of it because he might have to wait another 1-3 years before stock B starts to move. Also, it’s very difficult to compare the relative cheapness of stocks in different industries.
Instead, Schloss makes an independent buy or sell decision for every stock. If B is cheap, Schloss simply buys B without selling anything else. If A is no longer cheap, Schloss sells A without buying anything else.
THE FIRST 10 YEARS ARE PROBABLY THE WORST
John Templeton’s worst ten years as an investor were his first ten years. The same was true for Schloss, who commented that it takes about ten years to get the hang of value investing.
STAY INFORMED ABOUT CURRENT EVENTS
(Photo by Juan Moyano)
Walter Schloss and his son Edwin sometimes would spend a whole day discussing current events, social trends, etc. Edwin Schloss said:
If you’re not in touch with what’s going on or you don’t see what’s going on around you, you can miss out on a lot of investment opportunities. So we try to be aware of everything around us—like John Templeton says in his book about being open to new ideas and new experiences.
CONTROL YOUR EMOTIONS; BE CAREFUL OF LEVERAGE
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.
Quantitative investing is a good way to control emotion. This is what Graham suggested and practiced. Graham just looked at the numbers to make sure they were below some threshold—like 2/3 of current assets minus all liabilities (the net-net method). Graham typically was not interested in what the business did.
On the topic of discipline and controlling your emotions, Schloss told a great story about when Warren Buffett was playing golf with some buddies:
One of them proposed, “Warren, if you shoot a hole-in-one on this 18-hole course, we’ll give you $10,000 bucks. If you don’t shoot a hole-in-one, you owe us $10.”
Warren thought about it and said, “I’m not taking the bet.”
The others said, “Why don’t you? The most you can lose is $10. You can make $10,000.”
Warren replied, “If you’re not disciplined in the little things, you won’t be disciplined in the big things.”
Be careful of leverage. It can go against you. Schloss acknowledges that sometimes he has gotten too greedy by buying highly leveraged stocks because they seemed really cheap. Companies with high leverage can occasionally become especially cheap compared to book value. But often the risk of bankruptcy is too high.
Still, as conservative value investor Seth Klarman has remarked, there’s room in the portfolio occasionally for a super cheap, highly indebted company. If the probability of success is high enough and if the upside is great enough, it may not be a difficult decision. Often the upside can be 10x or 20x your investment, which implies a positive expected return even when the odds of success are 10%.
RIDE COATTAILS; DIVERSIFY
Sometimes you can get good ideas from other investors you know or respect. Even Buffett did this. Buffett called it “coattail riding.”
Schloss, like Graham and Buffett, recommends a diversified approach if you’re doing cigar butt (deep value) investing. Have at least 15-20 stocks in your portfolio. A few investors can do better by being more concentrated. But most investors will do better over time by using a quantitative, diversified approach.
Schloss tended to have about 100 stocks in his portfolio:
…And my argument was, and I made it to Warren, we can’t project the earnings of these companies, they’re secondary companies, but somewhere along the line some of them will work out. Now I can’t tell you which ones, so I buy a hundred of them. Of course, it doesn’t mean you own the same amount of each stock. If we like a stock we put more money in it. Positions we are less sure about we put less in… We then buy the stock on the way down and try to sell it on the way up.
Even though Schloss was quite diversified, he still took larger positions in the stocks he liked best and smaller positions in the stocks about which he was less sure.
Schloss emphasized that it’s important to know what you know and what you don’t know. Warren Buffett and Charlie Munger call this a circle of competence. Even if a value investor is far from being the smartest, there are hundreds of microcap companies that are easy to understand with enough work.
(Image by Wilma64)
The main trouble in investing is overconfidence: having more confidence than is warranted by the evidence. Overconfidence is arguably the most widespread cognitive bias suffered by humans, as Nobel Laureate Daniel Kahneman details in Thinking, Fast and Slow. By humbly defining your circle of competence, you can limit the impact of overconfidence. Part of this humility comes from making mistakes.
The best choice for most investors is either an index fund or a quantitative value fund. It’s the best bet for getting solid long-term returns, while minimizing or removing entirely the negative influence of overconfidence.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: email@example.com
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.