5 Tips to Choosing Stocks from Walter J Schloss

"Walter J. Schloss was an American investor, fund manager, and philanthropist. He was a well-regarded value investor, as well as a notable disciple of the Benjamin Graham school of investing. Schloss averaged a 15.3% compound return over the course of four and a half decades. Warren Buffett named him as one of The Superinvestors of Graham-and-Doddsville." - Wikipedia

Walter was known to have owned a hundred stocks at once, focusing on the valuation and to a lesser extent the business economics compared to that of Warren Buffett's concentrated holdings. Walter enjoyed buying companies trading at their new lows. However, because these companies usually have issues, he would look for downside protection. This meant companies with low debt.

While different from Li Lu, Walter would not engage management as he did not believe he was a good judge of character. As he believe management could portray their companies in a brighter light than they actually were in. After all, who would follow a pessimistic CEO? Through the annual reports and proxy statements filed to the SEC and made available on SEC.gov, we can see the statistics of the company and whether or not management owned a fair amount of stock. In addition, you could learn about the company's history. 

The bottom line is to do everything in your power to not lose money. 

Summary of Key Points 

1) Look for opportunities where stocks have made new lows.
2) Avoid companies with large amounts of debt.
3) Review the company's annual reports and proxy and then make a judgment about the company.
4) Unless you are a good judge of people's character, don't talk to management because they could portray the company in a light different from reality.
5) Don't lose money.  

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3 Steps to Valuing Hidden Asset Companies

Hidden Asset Value Companies

Companies like Coca-Cola are relatively easy to value. As we all know Coca-Cola sells various drinks. You can judge the market size, the growth, and their margins. In short, you can get a pretty good handle on its estimated valuation.

Companies that are not as easy to value are commonly referred to as hidden asset value companies. They tend to be a bit more complicated to value because of their different initiatives, financial characteristics, when their net operating losses expire, or what happens when there is a takeover. Basically, you’d have to do a lot of custom detailed research and it takes a long time to work through. You have to untangle the story.

One way of doing this custom research is to:

1) Define the company’s different lines of businesses. 
2) Separate the components and identify the business drivers of each. 
3) Value each of the components. 

When you do this there will be a bunch of offsets like pension liability, debt, and other hidden liabilities. Ultimately, you get to a net asset value of the company.

While it is not necessary to value all companies this way, this is one way to value a complex business.
 

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What Does it Take to become a Contrarian Value Investor?

How do you become a contrarian if most of us, if not all, are innately born to follow the crowd? For starters, some of you may have that mutated gene to be a contrarian. Aside from possessing that mutated gene, being a value investor depends on how you view risk.

Charlie Munger has always said that one of the best ways to solve a problem is to invert it. It gives you a different perspective. While most of us are focused on the upside of investments, take the time to invert your perspective and look at what you can lose.

Ask yourself, what can I lose and what would cause the pain. Focus on mitigating your undesirable outcome will keep you in the game longer.

When the group gave the right answer, Tony agreed. And when everyone gave the wrong answer -- Tony still agreed.

Unwittingly, Tony had demonstrated Berns' point precisely. The group's influence on Tony profoundly altered the results: He went from 90 percent on his written test to 10 percent when he heard the others' answers.

Most investors can recant their losses better than their gains. While losses are inevitable, it is how you continually refine your strategy that defines you. The more you learn from your mistakes the closer you get to developing into a stronger value investor.

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How to Scale a Business - Netflix CEO Reed Hastings

How does Netflix hire?

Netflix doesn't try to hire perfectly. If instinctively the manager feels like there is potential or would like to give the employee a try, the company will make the hire. You use a lot of data when picking stocks; but when you pick a spouse, you don't use a lot of data. The more emotional gut feeling involved then the less useful data is. And they use Linkedin for references. If within a certain period of time, they discover it isn't a good fit then they move them out. When doing so, it is important to be upfront and honest with the person.

When Netflix hires, they are looking for first principal thinkers. People who question things, are curious, and self-confident. 

During the on-boarding of new employees, management would go over a 100 slide PowerPoint deck. At the end of it, 2 out of 3 employees would understand what it all meant. But because there were some forward remarks in there, the other 33% would not. Some forward remarks included "adequate performance gets you a severance package" or "we are a team not a family". To those who didn't get it, they were slightly taken aback. It was as if they were ambushed. 

The decision was made to make the information available to every candidate. That way they are upfront with the culture. If every candidate got it then it would essentially be public. So that is what Netflix did. Netflix decided to just make it public. In addition, when something is written down it allows for more debate, which could lead to more collaboration and improvement. 

Reed attunes hiring and employment similar to that of running a professional sports team. Every year you compete for your position. For the company/team to be great, you need to have great people in their respective positions. When people were no longer good fits for the company, he would proactively provide them with severance packages. If he didn't do this, then the employee would probably undergo a three month behavior correction program and then when all of that is documented then that person would be let go. Either way there is a cost. There are three benefits to this methodology. First would be that the employee doesn't feel as bad because a minimum of 4 months pay is doled out. It is almost a bribe to the manager letting that person go, so he or she doesn't feel as bad either. Thirdly, there are no employee lawsuits because of the severance. 

What kind of culture should you build?

Strong cultures work regardless of what kind of culture they are. Weak cultures are essentially diverse cultures whereby people don't understand each other. 

Netflix didn't approach culture with "what is the most theoretical efficient culture?". Instead it was about the group of people working there and what they valued most. That was working with talented people. 

When the company was forced to downsize after the dot com crash, Reed thought that they would barely be surviving. Instead they got more productive because there was less "dummy proofing necessary" and everyone could focus on doing it right and fast. 

When Netflix became publicly traded, the employees were worried about less freedom and more control. However, quite the opposite happened. The company's managers focused on setting context to issues. They inspired and led people rather than micromanaged them. This involved explaining what they were trying to do. What constraints there were. Whether or not they needed to do it 100% precise or if there could be room for an approximation and then tidy it up afterwards. If you set it up this way there is less micromanaging. 

What is the role of the CEO?

The role of the CEO varies at different stages of the company. The first couple years you do everything from washing the dishes to coding to marketing and dealing with investors. You have so many disadvantages that you have to make up for it with talent and brute force. At every 5x or 10x you have to adapt to be more strategic, but still be a great leader. On Reed's scale, he is looking at whether or not they should focus globally or original content. But, he doesn't pick which country to be in or what shows. He delegates that down.

What are scale businesses versus network businesses? 

The bigger get scale economic businesses get the lower the marginal customer cost. Examples of this include Amazon and Netflix. You do have to run up losses to some extent before you start to make a profit. When Amazon and Netflix were smaller, they grew at great rates such as 80% and eventually down to 25%. These are good growth rates. A company can start 2-3 years before you do, but with scale you can knock them out.

Linkedin and Facebook are network effect businesses. The prize of being first is much larger than a scale business. For example, it could be worth selling 90% of the business to raise a billion dollars. It is a winner takes all business. In these kinds of businesses, you get these crazy practices where you grow by 300% to maximize opportunity. 

In network effect you get more of the first is forever because of the barriers to entry. Think of a barrier as how much pricing power you have. A ton of pricing power means you can raise prices and it is still hard to come after you.  

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Invest with the House - Hacking the Top Hedge Funds by Mab Faber - Book Review

About Mab Faber

Mab Faber is a co-founder and the Chief Investment Officer of Cambria Investment Management. Faber is the manager of Cambria’s ETFs, separate accounts, and private investment funds. Mr. Faber has authored numerous white papers and five books including Invest with the House - Hacking the Top Hedge Funds. He is a frequent speaker and writer on investment strategies and has been featured in Barron’s, The New York Times, and The New Yorker. Mr. Faber graduated from the University of Virginia with a double major in Engineering Science and Biology. He is a Chartered Alternative Investment Analyst (CAIA) and Chartered Market Technician (CMT).

Overview and Thoughts about the Book

Invest with the House - Hacking the Top Hedge Funds is one of Meb Faber's more recently published books about investing. Meb begins the book illustrating the difficulties in picking great stocks. He cites statistical data such as 64% of stocks underperformed the broad stock market and 25% of stocks were responsible for all of the market's gains. This makes the game of investing seem especially difficult. On top of this, you are playing in a zero-sum game (your gain is someone else' loss) against the top most talented investors in the world.

Suppose you were able to put down bets with the house? In Vegas the house is the casino; in investing, top hedge funds are considered house. Suppose you were able to buy the same stocks as the top hedge fund managers. Faber goes through in-depth how to track the top hedge funds' picks and use that information to create your own portfolio.

One tool that Faber suggests using is reviewing SEC filings of 13F. Large hedge funds are required to disclose their holdings quarterly to the public. Most of these investors have a long-term investment horizon. Therefore, even though there is a forty-five day delay in reporting their 13F, you'd still be able to get a good idea of what stocks they own at a point in time. Here is a sample of LSV Asset Management's 13F.

"I believe in the discipline of mastering the best that other people have ever figured out. I don't believe in just sitting there and trying to dream it up all yourself. Nobody's that smart. " - Charlie Munger

Perhaps one of the most insightful pieces is Faber goes through a endless in-depth discussion of successful hedge fund managers and their stock picking tendencies and styles. For example, you have Glenn Greenberg, who follows a concentrated investment style. He prefers positions where the business has strong management, demonstrates significant competitive advantage, and strong potential at "unjustifiable" low prices. Then you have Ricky Sandler who at age 25 co-founded an investment fund whereby his $28 million of seed money exploded into $350 million with a net annual return of 31%. 

Final Word

Beyond Warren Buffet and Charlie Munger there are a whole host of successful hedge fund managers. Faber breaks each of them down with their background stories, investment style and strategy, and provide a snapshot of their performance. In addition, he shows their holdings and how a cloned portfolio based on 13Fs would have performed compared to the market. Each of which, beat the the market by large margins. Mab summarizes all the great investors and their styles into one compact book. This is a must read for any investor looking to broaden their knowledge and learn from the very best. Most people are not managing huge sums of money and therefore should be able to compound at greater percentages than those managing billions. While I wished he would've went more in depth on the beginning years of the fund managers, he did a great job accentuating their successes. 

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Learn to Understand the Economics of the Business

You've just figured out how much a business cost. What else do you need to understand? Another important aspect of value investing is understanding the business. What are the economics behind the business. In other words, how does the business make money in its marketplace and what does it cost to run the business?

If you own a residential rental property, you will have repairs and maintenance costs. Once a month you may have a gardener mow the lawn and trim the bushes. Every ten years you may need to replace the roof. If there is a water leak you may need to have your handyman come and fix it. If you are lucky, generally these costs will be manageable. These are all necessary costs to keep the property in a condition that is livable for your tenant. In addition, you could have interest payments on your mortgage and house insurance. We can call these operating costs.

How does your rental property make money? You collect rent from your tenant on a monthly basis for as long as they are living there. Usually tenants sign one year lease, which means if they do not renew after a year, you'll need to find someone else to fill your property. You won't be generating cash flow during the time between tenants, but you will likely still need to maintain the property. In addition, there may be repairs you'll need to make to get it ready for a new tenant that you wouldn't have had to make otherwise. For example, applying new paint to the place will attract more potential tenants.

Remember the goal for investing is putting away money now for more money later. In order to have positive cash flow, you'll want your operating costs to be less than your cash flow in. There are thousands upon thousands of businesses out there that range from simple to understand businesses to complex. The key is to focus on those that you do understand and forget about the ones you don't. In value investing, we call this your circle of competence.

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How Do You Figure Out How Much a Business Cost

When you buy a stock, you are purchasing a piece of a business. You are not buying some ticker symbol that fluctuates up and down every minute of the day. That is the first difference between how a value investor and a speculator looks at stocks. Those who speculate believe someone else is willing to pay a higher price than what they've paid for a stock and could careless about how the business itself functions.

If a stock represents partial ownership in a business, how do you value the business? Ideally we want to pay less for what the business is worth. The key is to think about how much the business can produce.

Let's say you want to purchase an investment property. You see that there is a three bedroom and two bath 2,500 Sq Ft. house selling for $500,000 in Los Angeles, CA. Suppose the average rent in the area is $3,500 per month or $42,000 a year. You also put a down payment of 20% or $100,000. Let's also factor in your costs including property tax ($5,000), repairs and maintenance fees ($800), home insurance ($1,200), and mortgage payment ($23,000), which total $27,000 for the first year. Assuming no vacancy in your first year, we estimate a cash profit of $12,000 or $42,000 (rental income) less $30,000 of costs. This means that on your $100,000 down payment investment you earn about a 12% return in the first year.

The key is to think about how much the business can produce.

We look at businesses the same way; we want to see how much the return is on our investment. With stocks, we can look at it as if we are buying the entire business. How do we know how much a business cost? You can calculate how much the stock market is valuing a company by taking the number of outstanding shares and multiplying it by price of each share. That will give you the market capitalization or market cap. Meaning if you wanted to buy all the shares of that company, it would cost you the market cap. You can find the outstanding shares count on the first page of the company's latest 10-Q or 10-K filing. The 10-Q or 10-K can be found on the SEC.gov website or at the company's investor relations page.

Now if you purchased 100 shares of a company that has a market cap of $1,000,000 and the cash profit of that company was $100,000 that year then you would've effectively earned a 10% return. The same would be if you purchase 20,000 shares at a market cap valuation of $1M.

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Arnold Van Den Berg - Exponential Wisdom - Google Talk Summary

Arnold founded Century Management in 1974. He is the CEO and chairman of the CM Advisors Family of Funds Board of Trustees. Born in 1939, Arnold survived the Holocaust as one of Holland’s “hidden” Jewish children. His parents both survived Auschwitz and the family immigrated to America when he was 10. These struggles led him to an extensive study of the subconscious mind, which he believes is the key to unlocking an individual’s potential.

Arnold Van Den Berg's parents hid for two and a half years in an attic during the Holocaust. However, they developed one major problem. The problem was that they kept two small children. Arnold was two and a half years old and his brother was five and a half. It was difficult hiding with children. If Arnold's parents kept the children and were caught they would be sent to Auschwitz concentration camp, which they eventually were. At Auschwitz, they didn't keep women and children. It was a big risk if the children were caught with the parents because it usually meant the end of the parents.

Another alternative was to send the children through the German lines to get on a train to an orphanage. The only problem was you needed a German passport. But if you were Jewish you didn't have a passport. They had fake passports, but they weren't very good so it was sort of a last resort. Arnold's parents got with the Dutch underground and they worked out a plan that there would be a 19 year old girl who would bring him on the train and there would be an individual situated in front the Nazi to keep the officer busy until the whistle blew. So, that was exactly what happened. It was just the most dramatic moment when the whistle blew because the girl knew she would be okay. 

"The most important thing to achieve anything in life is to be totally focused."

Years later, Arnold would ask himself why would this girl who didn't even know him risk her life to save his. How could the girl's whole family risk their lives? If caught, the 19 year old girl would have had to spend her entire life in an concentration camp. What would motivate her to do this? Later in life, he found his way to a psychiatrist. He decided to ask the psychiatrist why anyone would do that. The psychiatrist said, well the answer is very simple.

It's all about principals; these were people who had deep beliefs and their principals were more important than life. If your life is more important than your principals then you sacrifice your principals. 

Arnold Van Den Berg eventually found his way to mutual funds. He was curious about why during the stock market crash in the early 1970s, some funds went down less than others. Eventually, he discovered that the funds that were down less were doing better because they focused on value investing. The secret to understanding value investing is figuring out what a business is worth just like when you buy real estate. Then you basically buy that at a "wholesale" or discounted price.

The most important thing to achieve anything in life is to be totally focused. Arnold Van Den Berg's father explained the most difficult thing in an concentration camp was when they had to go on these death marches from one camp to another. It was a 20 mile walk and you would get two slices of bread and then you would march for 24 hours. If you went on your knees, the Nazi officers would whip you and if you didn't get up then they would shoot you. His father was 5'7 and 85 pounds - all skin and bones. You really have to focus to get through all of that.

What Arnold's dad learned was how incredibly powerful the mind was when you are tested in extreme circumstances. When your life is on the line, you have to clear your mind. You couldn't think about how cold or hungry you were. You can think of nothing else but to move forward and to keep your focus. You'll realize you have strength that you don't even understand. When asked what his father could attribute that to, he said the subconscious mind. There is no way you can keep moving one leg after the other in that type of situation without extreme focus.

Five Lessons from Arnold Van Den Berg 

1. Always seek the truth

2. Develop your own set of principles for which you are willing to make sacrifices

3. Be totally focused

4. By practicing your principals you will develop the faith and courage to carry on during tough times

5. Never give up 

What do you do with your cash when you don't have any good value stock options? 

Over the 40 years, Arnold's average cash position was 20% of his portfolio even when there was good value because there are great opportunities. Even if cash doesn't make money, it's better to hold cash then to lose money. Patience pays off. You will always find value if you are patient. You might have to wait a year and a half or two years.

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