Walter Schloss: 16 Rules of Value Investing

Walter J. Schloss (August 28, 1916 – February 19, 2012) was a well-regarded value investor, as well as a notable disciple of the Benjamin Graham school of investing.Warren Buffett named him as one of The Superinvestors of Graham-and-Doddsville, who disproved the academic position that the market was efficient, and that beating the S&P 500 was “pure chance”.
Warren Buffett had this to say about Schloss:

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.

The original title for this set of 16 rules is Factors Needed to Make Money in the Stock.

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 the weaknesses in your thinking. Buy on a scale down 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 see. 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 rations high. If the stock market historically high. Are people very optimistic etc?

10. When buying a stock, I find it heldful 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 yeas 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. Earning can change dramatically in a short time. Usually assets change slowly. One has to know much more about a company if one buys earnings.

12. Listen 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 inconnection with purchase and sale of stocks.

14. Remember the work 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 stock over bonds. Bonds will limit your gains and inflation will reduce your purchasing power.

16. Be careful of leverage. It can go against you.

John Maynard Keynes Quotes on Investing

As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.

  • Letter to Francis Scott, August 1934, The Collected Writings of John Maynard Keynes XII: 57

We have not proved able to take much advantage of a general systematic movement out of and into ordinary shares as a whole at different phases of the trade cycle”

  • The Collected Writings of John Maynard Keynes XII: 106

In truth , the gold standard is already a barbarous relic.

  • Monetary Reform (1924), p. 172

“Markets can remain irrational a lot longer than you and I can remain solvent.”

  • A. Gary Shilling, Forbes (1993) v. 151, iss. 4, pg. 236.

It is generally agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.

  • The General Theory of Employment, Interest and Money (1935),Book 4, Chapter 12, Section 6, p. 159

There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough;—human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money—a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.

  • The General Theory of Employment, Interest and Money (1935), Chapter 12

What Discount Rate to Use in Stock Valuation

To calculate the intrinsic value of a company or its stock, we discount the future dividends or free cash flows to their present value. That interest rate used to discount the future cash flows is usually referred to as discount rate. What discount rate should investors use in stock valuation models such as Dividend Discount Model or Discounted Free Cash Flow?

Warren Buffett said in the 1998 Berkshire Hathaway Shareholder Meeting,

“In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.”

Buffett also used to say that he prefers to use “the long term normalized interest rate for Treasuries” as the discount rate. So the average of U.S. 10 year treasury rates seems appropriate to serve as the discount rate.

It is important to remember that equity investors should use the same discount rate across all companies, whether it is a great business or an ordinary one. Don’t use a higher discount rate to value a company with higher risk, be more conservative with its free cash flows instead.

Difference between Book Value and Liquidation Value

What is the difference between a company’s book value and liquidation value? Ben Graham, father of value investing, has written about their difference in his book The Interpretation of Financial Statements.

“If the company were actually liquidated the value of the assets would most probably be much less than their book value as shown on the balance sheet. An appreciable loss is likely to be realized on the sale of the inventory, and a very substantial shrinkage is almost certain to be suffered in the value of the fixed assets. In practically every case the adverse conditions which would lead to a decision to liquidate the business would also make it impossible to obtain anywhere near cost or reproduction price for the plant and machinery.

The book value really measures, therefore, not what the stockholders could get out of their business (its liquidating value), but rather what they have put into the business, including undistributed earnings. ”

Book Value per Share

How to calculate book value per share of common stock?

Book value per share of common stock is calculated as total assets (excluding intangible assets) minus total liabilities and stock issues ahead of the common such as preferred stocks, then divided by the number of shares.

Book value per share = (Total assets – intangible assets – total liabilities – preferred stocks) / Number of shares