4 Golden Rules to Invest Well

Walter Schloss is one of my personal investing heroes. He started working under the great Benjamin Graham in 1946 before eventually managing other people’s money on his own in 1955.

From 1956 to 2000, a long period of 44 years, Schloss’s fund had generated compound annual returns of 15.3% as compared to ‘just’ 11.5% for the broader U.S. stock market.

For some perspective on how incredible that achievement is, every $1,000 entrusted to Schloss in 1956 would have become more than $525,000 in 2000. Meanwhile, the same $1,000 that’s plonked into the U.S. stock market would have grown into ‘only’ $111,000.

What’s fascinating about Schloss to me is he did not require fancy math, arcane valuation models, or a divination of the stock market’s future to invest. All he did was to find and invest in cheap stocks. His office is a rented closet space; his only other colleague’s his son, Edwin, who joined the business in the 1970s.

In 1994, Schloss had prepared a short memo titled (link opens PDF) Factors needed to make money in the stock market. The memo contained 16 factors which Schloss had relied upon to generate his outsized returns. Here are four of those golden rules along with my comments.

Rule No.1: “Price is the most important factor to use in relation to value.”

A stock’s price alone means nothing. What’s more important is the price in relation to the stock’s intrinsic value. There are many ways in which this value can be determined, with some common methods involving a comparison of a stock’s price with its earnings, free cash flow, or asset value.

This is how the commonly seen metrics, PE, PFCF, and PB (price-to-earnings, price-to-free-cash-flow, and price-to-book respectively), come about. In general, the lower the numbers, the better.

Rule No.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.”

Investors often get into trouble when they forget that stocks represent part-ownership of a company.

Back in October 2013, there was the infamous penny stock debacle in Singapore which involved a trio of stocks. Mining outfit Blumont Group Ltd (SGX: A33) was part of the group.

Over the course of slightly more than a year from August 2012 to September 2013, Blumont’s shares soared nearly 4,000% from S$0.06 to a high of S$2.45. At some time near its peak, Blumont was valued at 500 times its earnings and 60 times its book value.

Those are egregiously high valuations that could not be backed up by any sort of business fundamentals whatsoever. Investors who forgot that there’s a business behind a stock would end up paying the price with Blumont – today, shares of the firm are trading at less than S$0.01 each.

Rule No.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).”

In here, Schloss shares his preference for using a stock’s assets as a basis for determining its value. He also highlights his disdain for debt.

Leverage is a double-edged sword for both investors and corporations alike. London-listed mining giant Glencore PLC is a great example of the troubles that can result due to the use of debt. After letting its borrowings swell over the past few years, the firm had to undertake a host of tough measures recently – including cutting its dividends and selling its assets – in order to strengthen its balance sheet after its business ran into trouble with the falling prices of many commodities globally.

Investors who are interested in Schloss’s approach – shares which have low borrowings and which are priced cheaply to their assets – may find the following shares to be worthy of a deeper study: Wing Tai Holdings Limited (SGX: W05), Perennial Real Estate Holdings Limited (SGX: 40S), Hongkong Land Holdings Limited (SGX: H78), UOL Group Limited (SGX: U14), and Jardine Strategic Holdings Limited (SGX: J37).

Wing Tai, Perennial, Hongkong Land, UOL, Jardine Strategic, PB ratios

Source: S&P Capital IQ (data as of 6 October 2015)

As the table above shows, the quintet all have PB ratios of less than 0.75 and have low levels of leverage as evidenced by their total debt to equity ratios of less than 48.5%.

Rule No. 4: “Have patience. Stocks don’t go up immediately.”

Even the best investments take time to materialise and we can see that in a story involving Warren Buffett – who’s arguably an even better investor than Schloss (interestingly, the two men were long-time friends) – and one of his best investments ever.

Buffett had first bought shares of the Washington Post (now known as Graham Holdings Company) in 1973. By the end of 2007, his investment in the company had gone up by more than 10,000%. Beyond the tremendous returns, what’s worth pointing out here is that shares of the Washington Post had declined by 20% after Buffett had bought and stayed there for three years.

“The stock market is designed to transfer money from the active to the patient,” Buffett once said. How true indeed.

If you'd like more investing insights as well as the latest news about Singapore's stock market, you can get both from The Motley Fool's free investing newsletter, Take Stock Singapore. Written by David Kuo, Take Stock Singapore can help you grow your wealth in the years ahead. So, come sign up here.

The Motley Fool's purpose is to help the world invest, better. Like us on Facebook to follow our latest news and articles.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.