Feb 25 2020 - The Schloss Portfolio: A New Start

Episode 1 of my new value investing portfolio.

My portfolio is based on the work and readings of Walter Schloss.

I will share my portfolio and my new strategy.

I also discuss some of my main holdings.

During 2018, I wrote two articles on my value investing portfolio. While I found these kinds of articles interesting to write, the tally stopped at two. During 2019, I struggled with how I wanted to construct my portfolio. I, therefore, decided to halt the portfolio articles till I had a portfolio strategy that I felt comfortable with and that was useful to present on Seeking Alpha. I think I have found such a strategy. Now, I just hope this portfolio series will actually run well into the double digits instead of a mere 2.

What went wrong in 2019?

I started value investing in the summer of 2017, 2.5 years ago. I was aware that many mistakes would have to be made to become a better investor. But so many mistakes, really? Yes, 2019 was year of mistakes for me. The good thing about mistakes is that they teach you a lot. In this initial portfolio post, I first want to touch briefly upon my mistakes and how they helped me define my new portfolio strategy based upon the timeless wisdom of ultra-value investor Walter Schloss. Secondly, I will provide an overview of my portfolio.

The mistakes

As a value investor, I'm almost guaranteed to invest in companies that have plenty of financial or business issues. Personally, I think it is the most fun thing to do in investing. Sorting through the 'garbage bin' of discarded and disliked companies in the hunt for some mispriced bargain. Unfortunately, I picked quite a few stocks in 2019 that ended up rightfully belonging in the garbage bin instead of being a bargain. While some failures were inevitable, most were self-inflicted in 2019. So, what went wrong:

1. No disciplined allocation strategy. Bought too much shares of some companies, too little of others.
2. My margin of safety for stocks based on perceived undervaluation of cash flows was too low.
3. I thought too highly of my ability to judge business performance.
4. Many other little things in terms of analysis, bad thinking process, psychological mistakes.

1. No disciplined allocation strategy. Bought too much shares of some companies, too little of others.

This was not a mistake of making bad/good calls on stocks, but more doubling down too much on companies or holding a small position in companies I should have added to. I tend to seek out deep value stocks that I believe are worth a while I'm paying just 50 cents. One of the traits of many of those companies is that they are lousy businesses, their industry is in decline, or they made bad business decisions in the past and are attempting a turnaround. Benjamin Graham always cautioned for too much concentration when he spoke about his net-net portfolio. I read it, agreed with it and then… did not act on it. After researching some of these companies, I became so convinced they were huge bargains I averaged down so much that a lousy deep value stock sometimes made up 15% of my total portfolio. My prime example of this mistake is CSS Industries (NYSE:CSS). I wrote an extensive article in November 2018 on this company. I argued it was deeply undervalued and had a lot of asset protection for investors. The company was valued at around a share during that time. I made my first purchase at a share. The company basically deteriorated ever since I made my first purchase, and the share price declined all the way down to a share. Frankly, I still think the thesis was not too bad. The company had a ton of asset protection and the company was profitable when I made my investment and I wrote my article. I believe this is one of those inevitable losers in a value portfolio where you expect it least. The business performance declined so rapidly in 2019 that the margin of safety just shriveled away. A great value investor would not have been hurt too much. At a maximum, they would have put in maybe 5% of their portfolio into CSS. They would have realized their loss of maybe 50% and moved on. Is that what I did? Not really. I averaged down all the way to a share. In the end, holding approximately 15% of my value portfolio in CSS. I made a couple of big mistakes here. First and foremost, I should have never put so much of my portfolio in a lousy business just because it seemed to be very cheap. This caused the most pain. 2. Because I kept on averaging down, I did not pay enough attention to the deteriorating performance. It was basically a classic trap, "confirmation bias". I bought more, thought more highly of my analysis, and did not critically assess the new facts. In the end, I got lucky. CSS got bought out at .35 a share a month ago. Did I deserve this luck? You guessed it, no I did not. In the end, I still made a big loss on CSS, but a lot less bad than it could have been.

2. My margin of safety for stocks based on perceived undervaluation of cash flows was too low.

This issue was a mistake that was least self-inflicted and is, I think, more part of a learning curve you have to go through. I don't think it is a surprise that Walter Schloss and Benjamin Graham were so keen on bargains that were valued at less than tangible book value/net current assets. Asset figures are just way less volatile than profit and cash flow numbers. However, I do think value investors in the current time can do very well by focusing on cash flow undervaluation. Personally, I think Bed Bath & Beyond (NASDAQ:BBBY) is a great example of that. I did burn myself a few times this year by thinking cash flow at certain companies was more stable than it turned out to be. I made this mistake, for example, with Francesca's (NASDAQ:FRAN), a small women's clothing retailer. Their (comparable) sales were declining rapidly, and business was deteriorating. I focused almost solely on their solid net cash position and their stable history of free cash flow. It was true that FRAN was undervalued if this history would also have been the future. It wasn't, and the stock steadily declined. Luckily, I realized my mistake rather quickly there, and I did not make the same mistake as with CSS by averaging down.

3. I thought too highly of my ability to judge business performance.

I noticed that, during my first 2.5 years in investing, I made quite a few business calls that were wrong. My main problem in this aspect is that I valued my own business insights too much. Companies like CSS and Francesca's are examples, but also a Chico's FAS (NYSE:CHS), Newell Brands (NASDAQ:NWL), and Summer Infant (NASDAQ:SUMR) belong in this category. It is not that all these investments turned out to be very bad financially, but I did notice that I did not do a good job in predicting how well these businesses were going to perform. Something I thought I could do relatively well when I made the investment. I think I am generally doing better when I have to value companies like BBBY, Office Depot (NASDAQ:ODP), or Macy's (NYSE:M). Also, companies that require a turnaround or business improvements, but their business is easier to grasp, and the margin of safety is way higher. I would argue the financial analysis was more important with the latter three than with the ones I made mistakes on. Of course, the distinction is not clear cut, but I hope you get the idea. These mistakes made me realize two things. First of all, if an investment is based mostly on a prediction of its future business success, I should downplay my own judgement and only invest if I feel the facts line up very strongly in favor of an investment. Secondly, I should adhere even more to a strict discipline on how much I should invest in these kinds of companies.

4. Many other little things in terms of analysis, bad thinking process, psychological mistakes.

Besides these three specific issues above, this last one is more generic, and I believe it applies to every investor (or human being in general) in some way. I sometimes make mistakes of commission or omission; sometimes, I buy too much or too little. I misjudge a company's management or its business performance. It is all part of this game. Therefore, my future mistakes will have a significant role in these portfolio articles. I will try to discuss the mistakes I make, why I made them, and how I am going to try to avoid them in the future.

Walter Schloss

(Source: Vintage Value Investing)

I have thought extensively about the things above and how to improve myself during the last few months of 2019. I started rereading texts from Graham, Buffett, and others to maybe find the necessary improvements for my portfolio there. I also reread the work of Walter Schloss, and his ideas were exactly what I needed. For everyone who is unfamiliar with Walter Schloss as an investor, I will provide a brief overview. Schloss started his investment career working for Benjamin Graham right after World War II. When Graham shut down his partnership, Schloss founded his own and basically continued in the same way he worked at Graham's firm. Schloss had a statistical method of identifying very cheap stocks mainly based on an undervaluation in assets. He looked for the famous net-nets or 'cigar butts', and when it started to disappear, he loosened his standards a bit to search for companies selling for less than tangible book value. As Graham once said: "try to buy your securities like you buy your groceries, not like you are buying your perfume" whether you agree or not, Schloss adhered to this mantra till his last day as a security analyst. He ran a little value investment firm well into his 1990s. He had a portfolio of 100+ stocks that were all statistically cheap, and he used the law of large numbers to ensure his statistical advantage would work out. I believe Schloss's portfolio strategy fits me very well since I look for the same sort of stocks as he did. So, what did Schloss right that I have not so far (a lot of course, but let's not list them all):

1. Schloss had strict limits on how much of his portfolio he would put in a single holding.
2. Schloss did not try to predict future business performance. He was more interested make in a margin of safety that was sufficiently large.
3. Schloss was well-diversified and spent not too much time reviewing each of his holdings.
4. Schloss's two main goals were to avoid loss of principal and to sleep well at night.

The Schloss Portfolio

Based on his readings and ideas, I decided to reshape my portfolio and my strategy according to the ideas of Schloss. My first step was to create two separate portfolios for my investments. Besides the Schloss portfolio, I also created my "dividend income portfolio". In short, the latter is a portfolio still solely based on value investing, but the focus is on dividend-paying stocks. I wanted to have such a portfolio because my personal situation has been changing, and I wanted to have a bigger part of my portfolio in companies with solid, high-yield dividends which can compound over time. I don't know yet if this portfolio is interesting enough to write about on SA, but time will tell. For now, I focus on my other portfolio based on Walter Schloss. I decided to allocate about one-third of my investment money to this portfolio with the other two-third in the dividend portfolio.

In 1993, Schloss gave a concise but great overview of how simple his approach is when looking for investments:

(Source: The Walter Schloss Archive, 1993 seminar at Columbia Business School (see PDF))

It is a good reminder for me personally when I'm analyzing a stock to just look at Schloss simple list. Sometimes, you are in so deep that every little detail seems to matter a great deal. I try to check Schloss's list at least once during every investment analysis, just to make sure I'm focusing most on what matters most. With regard to my portfolio strategy, I basically copied Schloss's one paragraph strategy.

My strategy

• Have a well-diversified portfolio of value stocks.
• Have strict upper limits on how much of the portfolio to invest in a single company.
• Have multiple tiers in how much to invest per stock to ensure mistakes of commission and omission are limited.
• Keep the analysis mainly financial and statistical. Take the business performance into account, but not a lot. Especially, do not invest when the financials indicate no, but own business analysis is favorable.
• Buy mostly stocks that are undervalued on a tangible book/asset basis or cash flow basis.
• Don't invest more than 50% of the portfolio in a single industry/sector.

The portfolio right now

I started working on my new portfolio since December 2019. Right now, I am in the early stages of building the portfolio. For example, because the initial amount for the portfolio is relatively low, the amount invested per company is elevated right now. Furthermore, diversification is not yet as substantial as I want it to be. Some positions I already held from before I started with this portfolio strategy. These include Kirkland's and Build a Bear. I also have two fairly large positions in GameStop (NYSE:GME) and a Dutch company called Beter Bed (OTCPK:BBEDF). These two don't fit in my two portfolios and are long-term turnarounds that I currently have big paper losses on. I exclude these from the portfolio since they don't fit in the Schloss strategy (or dividend income) as such, but I do want to retain these positions. When I sell them, I will add the money to the Schloss portfolio. So, what is in the portfolio right now? Let us have a look:

Holdings:

(Source: Own portfolio, table by author. Figures and numbers are in the European number format. For U.S. readers, periods and commas are used differently)

Renault (OTC:RNSDF)

My largest holding right now is Renault. I wrote an article on this French car company last year in January when the company was trading at around 55 euros a share. During my first holding period, I sold my stock during the summer of 2019 after my reverse to the mean thesis did not work out. However, since then, the company has kept on sliding and is currently trading at around 32 euros a share. I believe Renault is massively undervalued. Does it have problems? Oh yes, absolutely. The alliance with Nissan (OTCPK:NSANY), Renault is far from efficient, and the company will, at best, hit its 2020 guidance of positive (automotive) free cash flow. Why am I so bullish? The company owns 43% of Nissan, has an (automotive) net cash position, and has a very solid line-up of new models, in my opinion. The current market cap of Renault is just 8.8 billion euro. I am positive that, over the long term, just Renault's share in Nissan is probably worth twice this amount. At this price, you get Renault for free. What does that include:

- a tangible book value of more than a 100 euro a share

- flourishing discount brand Dacia

- iconic market leader brand in Russia, Lada

- large, profitable automotive bank that finances cars for Renault, Nissan, and Mitsubishi (OTCPK:MMTOF)

Fossil Group (NASDAQ:FOSL)

A holding I want to point out because this fits a company that I selected because of undervaluation based on its cash holdings and cash flows. I bought Fossil when it had a market cap of 0 million. The company has been quite profitable on a free cash flow basis, but revenue has been declining rapidly. They had a huge growth period from around 2011 to 2015 that has deflated just as quickly. Current revenue is a little above 2010 levels just before the massive growth started. It seems these 4-5 years were just outliers in a positive way. In the meantime, the company has consistently generated 0-200 million in free cash flow since revenues started declining after 2015. The company has been paying of its debt and should have a net cash position at the end of fiscal 2019. With a market cap of around 0 million, the company just needs to repeat their historical performance to trade at an EV/FCF multiple of 2x. Investors seem to price in a perpetual 10% YoY decline in revenues that will erode cash flow over time. I believe that assumption is overly pessimistic. Management has high insider ownership and has been responsible for the huge increase in revenue during 2011-2015, as well as the normalization right now. Their cost cutting has proven in the past that it can preserve cash flows. I deem it very unlikely that a well-known and successful brand like Fossil that had an abnormal rise in revenue from 2011 to 2015, will be in a perpetual decline till zero from now on. Very little has to go right here to make this stock shoot up at least 100%, in my opinion. These are the kinds of cash flow-based stocks I want to find for my Schloss portfolio. Rapidly paying off their debt, high historic free cash flow, and a market cap so low that even a more gradual decline should already be a catalyst.

Conclusion

These are just two of my holdings I wanted to point to show a little of my reasoning of how I am setting up this portfolio. I plan to update my portfolio every quarterly to show my mistakes, changes, and other insights. On top of that, in the next update, I will include a quarterly performance of the portfolio benchmarked against the S&P. Because, ultimately, that is the most important through the years. However, I also hope that, by providing my holdings and discussing my reasoning, I can have an insightful discussion with you all in the comments. And above all, maybe some others will not make some mistakes I have made and will make by showing them here.

Disclosure: I am/we are long FOSL, ARC, RNSDF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long all stocks in the Schloss portfolio. BBBY, ODP, M, GME and BBEDF are not in the Schloss Portfolio, but I am long these stocks.