Walter Schloss' 16 Factors Needed to Make Money in the Stock Market

Today we present rules of investing from Walter Schloss, founder of Walter & Edwin Schloss Associates LP.  He was one of the best investors of our time with over 15% CAGR between 1956 and 2000 and unfortunately passed away early this year.

In an old document dated March 10, 1994, Schloss outlined the following principles for becoming better investors


16 Factors Needed to Make Money in the Stock Market


1.  "Price is the most important factor to use in relation to value."  

Warren Buffett's famous quote is the perfect complement: "price is what you pay, value is what you get."


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." 

Indeed, Warren Buffett has long preached this principle as it's important to set your frame of mind and how you look at things.


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." 

Value investors everywhere live by this adage but many prominent long/short hedge funds also focus on the concept of 'time arbitrage': waiting for the market to come to the same realization you have regarding the valuation/opportunity of a specific security.


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."

Modern hedgies might argue against that last sentence because sometimes bad news is a warning sign of more impending problems at a company.  At the very least, bad news usually merits further due diligence. 

Leon Cooperman of Omega Advisors takes this concept one step further by outlining his rules for portfolio managers: if you have conviction in a name and it's down, buy more.


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 weaknesses in your thinking.  Buy on a scale and sell on a scale up."

The key in this rule is to look for weaknesses in your thinking.  As Warren Buffett's partner Charlie Munger says, "invert, always invert."  Examine the variant perception and the bear case if you're long a company.  The best investors focus on the downside even more-so than the upside.


7. "Have the courage of your convictions once you have made a decision."

A very important and often under-mentioned aspect of investing.


8. "Have a philosophy of investment and try to follow it.  The above is a way that I've found successful."

Warren Buffett obviously says to "stick to your circle of competence" and Peter Lynch says to "invest in what you know" in his golden rules of investing.


9. "Don't be in too much of a hurry to sell.  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 ratios high.  If the stock market historically high.  Are people very optimistic etc?"


10. "When buying a stock, I find it helpful 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 years 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.  Earnings can change dramatically in a short time.  Usually assets change slowly.  One has to know how much more about a company if one buys earnings."


12.  "Listens 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."

This is what MarketFolly.com strives to provide on a daily basis.  There are many great investors out there, so why not at least see what they're up to and use it as a starting point to do further research?
 

13. "Try not to let your emotions affect your judgment.  Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks."

Surprised this rule isn't higher up on his list, but then again he was a patient value investor so this probably wasn't a problem for him.  This was our top answer for advice for new investors.


14.  "Remember the word 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 stocks over bonds.  Bonds will limit your gains and inflation will reduce your purchasing power."


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

Example: see the financial crisis of 2008 as the perfect example: Look at where Lehman Brothers' 31:1 leverage landed them.


For those of you who want a copy of Schloss' original document from 1994, it's embedded below:




For more wisdom on becoming a better investor, see these great resources we've compiled:

- Top 25 Warren Buffett quotes

- Peter Lynch's golden rules of investing

- Leon Cooperman's 14 attributes that make a good portfolio manager

- George Soros' best investment advice

- Lessons Dan Loeb learned as an investor

- Bruce Berkowitz's checklist for investing

- Peter Lynch on using your edge

David Einhorn's Recommended Reading List

David Einhorn is the manager of hedge fund firm Greenlight Capital. He has returned 21.5% annualized and is well-respected in investing circles. At a recent event, Einhorn interestingly admitted that he did not read books all that often, but he did have a few suggestions for investors. Here is David Einhorn's recommended reading list:

- You Can Be a Stock Market Genius by Joel Greenblatt: Einhorn joins the copious amount of other hedge fund managers that have recommended this book. It takes a look at catalyst-based investing including spin-offs, mergers, risk arbitrage, and more.

- Margin of Safety by Seth Klarman: This hard-to-find and out-of-print book is a must for aspiring investment aficionados. It is written by one of the most successful hedge fund managers of our time and so it's no surprise that Einhorn recommended it.

- Liar's Poker by Michael Lewis: This is an insider's account of what really happens on Wall Street and is one of the most popular financial books out there.

- Fooling Some of the People All of the Time by David Einhorn: While Einhorn did not recommend his own book, we wanted to include it as it details his short selling battle with Allied Capital and features a foreword by Joel Greenblatt. After all, there's only a handful of books out there penned by prominent hedge fund managers.


For recommended reading lists from other top hedge fund managers, be sure to check out these other resources:

- Seth Klarman's recommended reading list

- Books recommended by Dan Loeb

- Hedge Fund Blue Ridge Capital's recommendations

- Warren Buffett's recommended reading list

Diversification Is Dead: Free Special Report From MarketClub

The team over at MarketClub have put together a special report entitled, "Diversification is Dead." Adam, the president of MarketClub says that he's been a big fan of diversification but he questions the common perception that it lowers portfolio risk. You can receive the free 10 page .pdf document here.

Hendry, Taleb & Faber: How To Invest $100 Million In 2010

At the recent Russia 2010 conference, an interesting question was posed: how would you invest $100 million for 12 months? The panel included hedge fund manager Hugh Hendry, black swan-er Nassim Taleb, and Marc Faber, among others.

Taleb presented a few ideas that he would allocate to the 'risky' portion of the portfolio. He likes a short of the S&P 500 and a long of precious metals (gold, silver, platinum) in a fixed ratio of around 1.5 to 1. He also suggests to buy an out of the money option on hyperinflation through a basket of instruments on gold, treasuries, etc. He doesn't care about inflation, he wants to possibly game the slim chance of hyperinflation. He says you will probably lose money on the play, but if you're right and hyperinflation hits, you can win huge. Lastly, he also says that you should be shorting US treasuries, something we've seen numerous prominent hedge fund managers recommend.

Hendry then took the mic and was his usual entertaining self. He focused on how everyone at the conference had a different opinion and he was sick of opinions, saying "Who cares about that opinion? You pay people for what they do with that opinion." And he brings up a very good point. It's one thing to have a trade idea or research, but it is quite another thing to execute it. We've postulated that this could potentially be the problem over at Peter Thiel's global macro hedge fund Clarium Capital as they've had a rough past two years.

Hendry says that he doesn't even need to spend all the $100 million to invest, but rather just a tiny amount of it. He simply underwrites the risk that the Bank of England will cut rates further. He takes the proceeds from this and uses it to cheapen an option that bets against the English central bank raising interest rates over the next four months. If they raise rates, all he loses is his premium, which is not a lot. However, if nothing happns, he can make five times his money. It's all about the risk/reward skew. He also mentioned that he had a John Paulson-esque play where you could make 75 times your money and only risk a tiny amount, but he teased the audience and said he'd save that for another time. We've previously covered some of Hendry's hedge fund commentary on the site as he's been the resident deflationist.

Some of the answers from other panelists were also intriguing as they favored emerging market consumer plays. They also recommended avoiding: credit, real estate (especially commercial) in the western world, as well as western financial institutions.

We highly recommend watching the video of the hour-long panel here.

Bill Gates' Annual Letter 2010

Presented without comment is Bill Gates' annual letter for 2010. Today is 'wisdom Wednesday' here at Market Folly as we look to share a plethora (yes, a plethora) of insightful resources. The letter is embedded below and you can also download the .pdf here.

Hedge Fund Managers & Poker - Texas Holdem Hedgies

The following is a guest post by John (aka The Masked Financier) who writes at TexasHoldemInvesting.com.

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The hedge fund literature is full of references to the poker exploits of some of the great hedge fund managers. This part of hedge fund lore is one of the main inspirations for the Texas Holdem Investing theory. The comments of successful hedge fund managers often refer to the relevance of poker as useful training for investing. This provides a firm basis for the thesis that poker can teach investing.

The following examples of the poker connections of some well known hedge fund managers provide some background on the link between the two fields:


- David Einhorn (Greenlight Capital) – Einhorn (pictured right at the World Series of Poker) demonstrated the link between poker and investing in reverse. After setting up Greenlight and achieving extraordinary investment returns over a 10 year period, Einhorn decided to learn poker. Within a few years he had mastered the game and finished 18th in the World Series of Poker. After his victory, Einhorn outlined many of the similarities between investing and poker.

- James Simons (Renaissance Technologies) – Simons just retired from Renaissance (which he founded in 1977) and has one of the top hedge fund returns track records, resulting in Simons making some huge performance fee paychecks. Simons was an avid poker player at MIT, and according to Rachel Ziemba in the book Scenarios for Risk Management and Global Investment Strategies (The Wiley Finance Series) Simons started Renaissance with a focus on gambling related concepts which were retained in the trading models that underpinned Renaissance’s returns. To complete the link between poker, investing, and education in the case of Simons, apparently he started the “Math for America” program over a game of poker with some fellow investment heavyweights in New York. Math for America is focused on improving math education in America.

- Steve Cohen (SAC Capital) – Along with James Simons, Ken Griffin, and John Paulson, Cohen is one of the top hedge fund managers of the past 20 years. Cohen played poker frequently in high school, often playing through the night. According to his brother, Cohen excelled at poker and would have lots of cash stored at his desk. Cohen eventually quit his part time job to focus on poker and says that it taught him how to take risks. Cohen continued to play poker successfully at Wharton while earning his economics degree and developing a fascination with the stock market. One of SAC’s own investors was in awe of Cohen’s poker skills – perhaps it was a factor in making the investment in SAC. Cohen’s poker skill can be discerned in the few public comments he has made on trading. A notable example of his thinking appeared in Market Wizards: Interviews with Top Traders where he stated that 90% of trading is about containing losses – as is the case in poker where most of your time will be spent deciding why not to play a hand to avoid losses.

- Jeff Yass (Susquehanna) – Jeff Yass founded Susquehanna with some of his poker playing friends and has turned it into one of the largest options trading firms in the world. Susquehanna is effectively a hedge fund that specialises in options as its asset class. Poker is now infused throughout the entire hiring and education processes at Susquehanna. The firm has hosted poker tournaments to identify potential employees, and it uses poker as an education tool when training its traders.

- Andy Beal (Beal Bank) – Beal is a long time poker player who participated in one of the most epic games of poker with some of the greatest professionals in recent times. The game was immortalised in the book The Professor, the Banker, and the Suicide King: Inside the Richest Poker Game of All Time. Beal Bank, which is effectively a credit hedge fund that focuses on property loans, has generated extraordinary returns since the recent credit bubble burst. However, Andy Beal had to wait through “a very long run of awful pocket cards” while the banking world boomed around him for almost 5 years while he made no investments because no opportunities fit his criteria. However, when the bust hit Beal felt vindicated and it must have felt like he was being dealt a lot of full houses. Since the downturn Beal has moved into the Forbes 400 of wealthy Americans through the implementation of a poker-like attitude in the world of credit investing.

- Carl Icahn (Icahn Partners) – Icahn apparently generated his first investing stake by winning $4,000 playing poker while in the US Army after graduating from Princeton. He still plays poker at high stakes in Las Vegas. Icahn now uses the skills he learned whilst playing poker to make big activist bets with Icahn Enterprises on companies while looking to read the intentions of both management teams and other investors.

Daniel Strachman takes the comparison one step further in his book The Fundamentals of Hedge Fund Management: How to Successfully Launch and Operate a Hedge Fund. Strachman notes that tracing the explosive growth of the hedge fund industry is analogous to the growth in popularity of Texas Holdem poker over the last 25 years.

Strachman also draws some interesting parallels between Texas Holdem and hedge fund management.

· The barriers to entry are low in both fields. A budding hedgie can have a fund set up and launched for $50,000 all-in (excuse the pun). Although theoretically a Texas Holdem player could start with far less, to start in the Texas Holdem arena aiming for success would require a reasonable bankroll - $10,000 would be a good starting point. Also, from a regulatory standpoint setting up a hedge fund is considerably easier than starting a mutual fund. As for the regulatory situation in Texas Holdem – well there is none unless you’re the person that wants to open a casino. And in some ways it is ironic that getting approved by the Nevada Gaming Board to run a casino may well be more difficult than becoming a market maker (the Wall Street equivalent of the “house” in the casino).

· Hedge fund management and Texas Holdem poker both offer great wealth to successful players in each field. The scales are different, because hedge fund managers can accumulate vast wealth by leveraging off their clients money (as Bruce Kovner said) but good Texas Holdem poker players can earn many millions of dollars.

· Both fields started to gain critical mass in the early 1990s and then took off into the stratosphere in the early 2000s.

The hedge fund industry benefited significantly from the crash of 1987 as many investment managers and support services personnel were laid off and then began to move into the hedge fund arena. The hedge fund concept was quite old at that point, given that Alfred Winslow had started the first hedge fund in 1957. However, clever individuals in Wall Street repackaged the concept with slick marketing and the perception of privileged access. And at the same time some of the best investors on Wall Street moved into the hedge fund space such as George Soros, Julian Robertson, and Bruce Kovner. But the supernova “moment” came after the dotcom crash occurred in early 2000. As general stock markets (and markets of many other kinds) tanked the hedge fund industry in general managed to either not lose money for investors, or even make money. Suddenly funds poured into the industry from 2002-3 onwards until the inevitable happened in 2007 and even the hedge fund industry found it hard to cope with the global recession.

The Texas Holdem market started to grow rapidly during the 1980s as the World Series of Poker got larger and larger. Then clever casino executives started to package the whole Texas Holdem experience with slick marketing, and moved it away from the backroom smoke filled rooms into bright casinos and onto popular TV properties such as the Travel Channel. Texas Holdem had its own “lift off” moment in 2003 that, like hedge fund performance during the dotcom crash, demonstrated the money that could be made from Texas Holdem. This occurred when the complete unknown Chris Moneymaker won the World Series of Poker and a $2.5 million payoff. New “fish” players swarmed to the offline and online casinos. But as with hedge funds even Texas Holdem’s popularity waned with the rest of the casino word in the face of the 2007 global downturn.

Having reflected on these similarities I have added some further points to Strachman’s list which emphasise the connection between the fields of investing and poker, albeit with a cautionary final point.

· Texas Holdem and the hedge fund arena are two of the most capitalistic activities in the world. The score is kept brutally in financial terms, and at the end of each day neither the Texas Holdem player nor the hedge fund manager can hide from the results.

· The capital preservation mindset of both fields is similar – avoiding losses is a vital element of success. With Texas Holdem one of the key objectives is to minimise losses during bad runs of cards and so have maximum bankroll to benefit from successful situations. Hedge funds don’t focus on the benchmarks that plague the mutual fund industry – the main objective is not to lose investors money, even if it means underperforming the broad market in good years.

· Although seemingly glamorous occupations in reality they are very difficult and stressful. It is easy for an outsider to look in and see the ease of sitting at a poker table or a Bloomberg terminal and speculating with large sums of money with the click of a mouse or flick of a chip. But mentally both professions exert tremendous strain on the participants. Human nature is such that the negative emotional effects of monetary losses are much greater than the positive effects of gains. The fortitude required to endure protracted periods of Texas Holdem or investing losses is immense.

· While the upside of both hedge fundery and Texas Holdem can be quick and massive, the downside can be equally fast and quite devastating. One year of a bad run of cards with poor money management will bankrupt even the most successful Texas Holdem player. One year of poor returns and mass client redemptions can hit even the best hedgies, as the impressive managers at Drake Management and Ospraie Management found out in 2008. Some of the fortresses of the hedge fund world also had scary moments in 2008 such as Ken Griffin at Citadel.

The strong connection between investing, trading, and poker is demonstrated by the examples cited in this article. And a final key similarity between both fields is the part played by luck. It is important, but over the long run the good investors and players can outperform the randomness of the market and the cards.

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The above was a guest post by John (aka The Masked Financier) who writes at TexasHoldemInvesting.com.


If you're serious about your poker chips look no further than PokerChips.com for the best poker chips on the web!

Recommended Investing Books: Fundamental Analysis & Valuation

We've been getting some requests from readers for some good books to read when it comes to investing. So we're posting up a list of recommendations for learning fundamental analysis and valuation. Without further ado:


The Intelligent Investor by Benjamin Graham. If you had to own one book about fundamental investing, this would most likely be it. Benjamin Graham was a legendary investor who helped pioneer the ways of value investing and taught Warren Buffett a lot of what he knows today.  It is definitely number one on the list. If you haven't read it, pick it up immediately.

Security Analysis by Benjamin Graham. This is the second of Graham's must-read books. The book features the value investing philosophies of Graham and Dodd and a foreword by Warren Buffett. If you're lacking in understanding how to perform fundamental analysis, then this is the book for you. After you've finished reading, you'll be able to tackle balance sheets like none other.  It's a must-read for anyone interested in the fundamental analysis related to investing.

Margin of Safety by Seth Klarman.  Written by one of the greatest investors of all time, this book is nearly impossible to find a physical copy of since it's no longer being produced.  Click the link above to see if there's one available.

You Can Be A Stock Market Genius by Joel Greenblatt.  The title is cheesy, but the book's contents are not.  It will teach you catalyst-based investing techniques that exploit market inefficiencies such as risk arbitrage, spin-offs, etc.

The Art of Short Selling by Kathryn Staley.  While the above books teach you how to invest (go long), this book teaches you how to hedge/go short, an important tactic used by most hedge funds.



That concludes the fundamentals list.  For you traders out there, we've also posted up a recommended reading list for technical analysis and charts as well.

Investing in Wine (Even Wine Funds Are Popping Up Now?!)

I always have my eye out for interesting investment opportunities. And, this idea would definitely diversify your portfolio. Invest in wine. That's right, wine. I'm not really sure if this is just a temporary phenomenom or a secular trend building. But, I've certainly noticed a lot of hype and interest surrounding wine these days. Do note that I'm not necessarily recommending investing in wine, but I'm certainly paying attention to the trend. Are palettes around the world swapping beer for wine? It looks that way to me (albeit slowly but surely). And, I'm sure the consumer slump/recession in the U.S. will have something to say about that. But, over the past few months, I've seen more and more information popping up regarding investing in some choice wines. And, as I noticed recently in a WSJ Deal Journal article, a former UBS banker has even started up a $50 million 'wine fund' named The Bottled Asset Fund.

And, this next video is slightly older but I wanted to include it because it plays right into the investing in wine theme. If you missed it, Jim Cramer and Gary Vaynerchuk (wine guru) got together to discuss investing in wine, as seen on Vaynerchuk's Wine Library TV Show.


Lots of media attention around wine investing lately! We'll check back in a year to see if this was just a fad or if this actually has staying power.