Adapting a Graham Disciple's Approach: AAII's Walter J. Schloss Screen
Individual investors can adapt Walter Schloss’ investing approach for their own use. AAII’s Walter J. Schloss screen was developed using AAII’s Stock Investor Pro fundamental stock screening and research database program. Stock Investor Pro covers a universe of over 9,500 NYSE, Amex, and NASDAQ stocks.
First, we excluded over-the-counter stocks as well as American depositary receipts (ADRs). Since Schloss preferred exchange-listed U.S. companies, we excluded all ADRs.
Schloss did not explicitly exclude any sector in his portfolio. However, because he uses the price-to-book-value ratio to evaluate companies, we excluded stocks in the financial sector because their balance sheets are not comparable to those in other industries. Book value tells you the accounting value of a firm after it pays all of its debt.
Schloss wanted companies to have at least a 10-year history. Most screening programs and Web sites do not have 10 years of historical data. Stock Investor Pro keeps seven years of financial statement data; therefore, for use in our screen, we looked for companies that had a stock price greater than zero seven years ago to correspond with the seven years of financial data.
When the price per share was below the book value per share, Schloss saw a potential bargain. Book value represents a company’s liquidation value and the share price reflects the current market value. When the share price is less than book value per share, you are paying less to buy the stock than you would theoretically have to pay if the company liquidated all of its assets and paid off its debt. We screened for companies with a current price below its book value per share.
In addition, Schloss liked to find good companies whose stock price was reaching or was close to a new low. Schloss felt that a stock’s price can be dragged down by factors other than the company’s own financial strength. For example, a strong company in the oil and gas sector might see its share price pulled down when another player in that sector makes a negative announcement. We quantified this factor by finding stocks that were trading within 10% of their 52-week lows.
However, some stocks might be fairly valued at a very low price. It is essential to determine whether the stock’s price has fallen due to a fundamental shift in the company’s finances or its core business, or because it has been a victim of overall sector or market weakness.
The companies that Schloss liked had no long-term debt, to help ensure financial stability. Interest on debt must be paid in good times or bad. However, this screen tends to favor firms that can’t raise debt—smaller capitalization companies and firms with volatile earnings. Our screen eliminated all stocks with any long-term debt in the most recent quarter and fiscal year.
Finally, Schloss wanted a company’s managers and decision makers to hold shares in the company. He felt this aligned their motives with shareholders.
One indicator of whether company management thinks the current stock price is over- or undervalued is the number of shares bought by insiders. Typically, if insiders are buying significant shares, this sends the signal that they believe the stock is undervalued at the current price. For use in Stock Investor Pro we looked for stocks with higher insider ownership percentage than the median database ownership.
Figure 1 shows the performance of the Schloss screen compared to four benchmarks: the S&P 500, S&P MidCap 400, S&P SmallCap 600 and all exchange-listed stocks. The Schloss screen has outperformed each of the benchmarks cumulatively. From December 31, 1997 through August 31, 2009, the Schloss screen has gained 433.4%, while the S&P 500 has gained only 5.2%.
While the overall performance of the screen looks good, it is important to note that the very nature of the Schloss screen has its pros and cons. When the market was, for the most part, posting negative returns from 2000 to 2002, the Schloss screen was gaining ground. Specifically, in 2002, when each of our benchmarks shows a loss, the Schloss screen ended the year only slightly negative with a loss of 0.1%. However, in 2004, when the market experienced a mild recovery, the Schloss screen shows a disappointing loss of 26.6%.
The Schloss screen is designed to pick out-of-favor stocks. During times of market meltdowns, the Schloss screen apparently was able to pick up companies whose prices had fallen due to circumstances possibly outside of their control.
However, during times of market recovery, the Schloss screen appeared to pick up stocks whose prices were close to their lows, but perhaps these stocks were priced correctly and were meant to underperform. It will be interesting to see how the screen performs during the current market recovery.
The Schloss screen also has a higher standard deviation compared to the benchmarks in Figure 1. Standard deviation is a measure of total risk that indicates the degree of variation in the actual returns relative to the average return over the period (three years in our figures); the higher the standard deviation, the greater the total risk.
Profile of Passing Firms as of June 30, 2009
Currently, there are NO COMPANIES that meet all of the Schloss screen criteria. The criterion that states the price must be within 10% of its 52-week low seems to be tripping up the screen.
In fact, the Schloss screen has had no passing companies since June 30, 2009, and in that time (June 30 to August 31) the S&P 500 has gained 11%. Thus, the Schloss screen missed out on the market’s bounce over the two months because it was effectively out of the market.
To illustrate the types of companies meeting the screen recently, we list the two stocks that passed the Schloss screen as of June 30, 2009 in Table 1.
New Dragon Asia (NWD) mills, sells and distributes flour, instant noodles, seasonings and soybean products. O.I. Corporation (OICO) develops and manufactures instruments used to detect, measure, analyze and monitor chemicals in liquids, solids, and gases.
NOTE: NO COMPANIES CURRENTLY PASS THE SCHLOSS SCREEN
Passing Companies as of June 30, 2009
|Company (Exchange: Ticker)||
|EPS||Sales||13 Wk||53 Wk|
|New Dragon Asia (A: NWD)||nmf||1.0||35.1||10.6||-24.6||9.9||-33.0||-65.0||flour & related prods|
|O.I. Corp. (M: OICO)||54.1||7.4||27.8||12.7||-7.5||2.8||-41.0||-35.0||chemical analysis prods|
Exchange Key: A = American Stock Exchange; M = NASDAQ
Source: AAII’s Stock Investor Pro/Thomson Reuters/I/B/E/S. Data as of 6/30/2009.
Both companies have seen their stock prices fall dramatically over the past year (from June 30, 2008, to June 30, 2009). NWD shares lost 75.4% over the year while OICO shares lost 53%. Both stocks also have high insider ownership and no long-term debt.
Table 2 lists various characteristics of the two passing companies (as of June 30) compared to all exchange-listed stocks. Not surprisingly, the Schloss stocks have lower price-to-book ratios, on average, than is typical of exchange-listed stocks. The two Schloss stocks also have lower historical sales and earnings growth rates.
Perhaps these two passing companies are not just stocks that have gone out of favor due to the market or their respective industries. It could be that these companies have fallen on hard times and are priced correctly—it is up to the investor to decide.
|Portfolio Characteristics (Median)||
|Price-earnings ratio (X)||54.1||14.6|
|Price-to-book-value ratio (X)||0.4||1.3|
|Price-to-sales ratio (X)||0.4||1.0|
|Price-earnings-to-EPS est growth (X)||0.0||1.4|
|Sales 5-yr. historical growth rate (%)||6.4||12.7|
|EPS 5-yr. historical growth rate (%)||-16.1||3.0|
|EPS 3-5 yr. estimated growth rate (%)||0.0||12.0|
|Market cap. ($ million)||11.7||288.4|
|Relative strength vs. S&P (S&P=0) (%)||-50||-3|
|Data as of June 30, 2009.|
|Average no. of passing stocks||13|
|Highest no. of passing stocks||45|
|Lowest no. of passing stocks||0|
|Monthly turnover (%)||53.9|
|Data as of August 31, 2009.|
Table 2 also details the characteristics of the Schloss screen as a whole. On average, 13 companies pass per month, but as illustrated over the last two months, the screen will, at times, be effectively out of the market when no stocks meet the criteria. The average monthly turnover is almost 54%, which is on the high side compared to other AAII stock screens. The Schloss screen’s highest number of passing companies at one time was 45.
The Schloss technique appears to be effective in finding smaller stocks with very low price-to-book-value ratios, prices near a 52-week low and a much higher level of insider ownership than the average exchange-listed stocks. The current market situation illustrates the flaws of the selection criteria as well.
It is important to research each stock before purchasing it. Schloss was a successful investor because he laid out criteria, studied the facts and ignored emotion. He showed that the key to any successful stock screening strategy is additional research.
Blindly buying stocks that meet a small number of criteria does not equal great performance. A stock can be “cheap” for a number of reasons. It is up to investors to discover the reasons and invest based on solid research and analysis of the company’s financial state.
What It Takes: Applying the Schloss Philosophy
- Company must be exchange-listed
- ADR stocks are excluded
- Companies in the financial sector are excluded
- Stock has been trading for at least seven years
- Price-to-book-value ratio is below one
- Current share price is within 10% of its 52-week low
- Long-term debt for the most recent quarter and fiscal year equals zero
Percentage of insiders owning shares is higher than the median insider ownership percentage for the entire database