Walter Schloss Part Three: The Magic OfCompounding

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This is part three of a multi-part series on Walter Schloss, legendary value investor. To ensure you donot miss the rest of the series sign up for our free newsletter. Parts one and two can be found at therespective links below.

1. Part one2. Part two

Walter Schloss Part three: The Magic Of CompoundingPart three of this series starts with a letter, typed on February 3rd 1976, from an investor whosereputation had grown to the point where a rumor that the was buying a stock, was enough to shoot itsprice up 10%. This investor was called Warren E. Buffett and what follows is a letter he wrote tomembers of the "Buffett Group" before its Hilton Head conference in 1976:

Warren E. Buffett

1440 Kiewit Plaza

Omaha, Nebraska 68131

February 3rd, 1976

To the Hilton Head Group

Dear Gang,

Normally, when you get a letter from the wife, partner or secretary of Joe Glutz saying,"Of course, Joe is too modest to tell you about this himself, but I know you want to hearthat...", it means that Joe is standing over the writer with a gun at his head, telling himnot to look up from the Xerox Corp (NYSE:XRX) machine until the mailing has beencompleted.

This one is for real.

Today I received the 1975 annual letter of Walter J. Schloss Associates, which includeda 20-year compilation of Walter's record since he left Graham-Newman. You mayremember I went to work for Graham-Newman in 1954.

Walter left in 1955. And ... Graham-Newman closed up in 1956. I would prefer not todwell on the implications of this sequence.

In any event, armed only with a monthly stock guide, a sophisticated style acquiredlargely from association with me, a sub-lease on a portion of a closet at Tweedy,

Browne and a group of partners whose names were straight from a roll call at EllisIsland, Walter strode forth to do battle with the S&P.

On the following page is a re-cap of his yearly performance and calculations I havemade regarding compounded results. The difference between the gross results and thelimited partners' results is accounted for by the fact that, as General Partner, he takes25% of the profits - a quaint, easy-to-calculate method of tribute not entirely foreign tomany of you.

Walter Schloss has had five down years compared to seven for the S&P. His superiorityin such down years would indicate that not only is he a man for all seasons, but that hehas special strength when facing a head wind. Maybe all of you had better watch BenGraham on Wall Street Week this Friday.

As for me, I'm going right out and buy some Hudson Pulp & Paper.

Best,

/s/ Warren

The above letter was not the only time Buffett wrote to his partners commending Walter Schloss' skill.The Oracle of Omaha penned another note nearly two decades later. A copy of both letters, includingSchloss annual returns can be found here.

Its clear from Buffett's correspondence that he had a huge respect for Walter. Both of the legendaryinvestors spent time learning their trade with Benjamin Graham and both understood the true meaningof deep-value investing.

Indeed, both Buffett and Walter Schloss were cast from the same deep-value Benjamin Graham mold,but by the late 70s, early 80s the two investors were moving in different directions. Buffett for examplewas looking for quality at a reasonable price, buying Coke and Gillette, while Schloss stuck to hisdeep-value principles.

The Power of CompoundingFor the 33 years ended 12/31/88, Walter J. Schloss Associates earned a compound annual return of21.6% per year on equity capital vs. 9.8% per year for the S&P 500 during the same period. Buffett incomparison returned 23% per annum for the 24 years to 1988. As covered in part two, Schloss wasunder no illusion, he was not Buffett, and surprisingly, even though his returns were only 1.4% perannum lower than those of Buffett over two decades, Walter Schloss didnt try to mimic Buffett, changehis strategy, or really do anything out of the ordinary.

In fact, Schloss made it clear to investors that he wasnt Buffett. Instead, as I covered in part two of thisseries, Walter Schloss made it clear that over time, while his returns may not be earth shattering, thepower of compounding would accelerate returns over the long-term.

Peter Lynch visited literally thousands of companies and did a superb job in hispicking. I never felt that we could do this kind of worktherefore, went with a morepassive approach to investing which may not be as profitable but if practiced longenough would allow the compounding to offset the fellow who was running aroundvisiting managements

And when you compare the returns of Walter Schloss, Buffett and Munger over the period 1962, to1975, you can see that even though Schloss returns were erratic, (significantly more so than Buffett)the power of compounding over the period was the driving force behind Walter Schloss' performance.Thanks to ValueInvestingWorld and this ValueWalk author for the chart below.

And here are Walter Schloss' returns vsthe S&P 500 from inception through to2000. Another scenario wherecompounding shines through.

However, Schloss' returns were not powered by compounding in the traditional sense. Indeed, Schloss'fund actually returned a huge amount of cash to investors every year, [screenshot showing thedistributions made throughout the life of the Schloss partnership] unlike Buffett and these distributionshad not been made, it's likely that Schloss' returns would have been even greater than those reportedabove.

Still, even though Schloss' returns were not driven by compounding in the traditional sense, hisoutperformance over the years is down to the fact that he knew steady growth over time and not losingmoney, were the two keys to long-term success. As quoted above, Schloss called this thecompounding effect.

It's No SecretThe power of compounding is no secret. Indeed, the power of compounding was said to be deemed theeighth wonder of the world but there are still plenty of investors, both institutional and private that fail tomake use of this carefree method of wealth creation. Indeed, respected value investors such as SethKlarman and Charles Brandes have recently noted that the market is now focused on short-termperformance only, failing to recognize the long-term benefits of compounding or growth.

Hedge Funds, mutual funds and private investors still try and outperform the market on a quarter-by-quarter basis and this is where many investors could learn from Schloss. Walter Schloss understoodthat he would never be the worlds best investor; he would never be able to consistently outperform themarket. Therefore, Schloss stuck to what he knew and understood, only buying stocks, whichconformed to deep-value criteria. The rest he left to the power of compounding.

That's all for part three but stay tuned for part four, Walter Schloss' 16 Factors Needed to Make Moneyin the Market.

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Walter Schloss Part Three: The Magic Of CompoundingWalter Schloss Part three: The Magic Of CompoundingThe Power of CompoundingIt's No Secret