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How to beat the market, with patience and ugly stocks

You don't need special sources of information or cutting-edge analysis to make money in the market. It helps, though, if you have patience and the willingness to buy stocks that other people despise.

For proof, look to the career of Walter Schloss.

Mr. Schloss, who passed away earlier this year at the age of 95, came from humble beginnings, never went to college, but nevertheless produced stellar results over nearly five decades as a money manager.

He fell into the securities business as a teenager in the 1930s, when he was hired as a Wall Street 'runner' to deliver stock certificates and other documents by hand. But his real education began when he took a couple of investing classes from Benjamin Graham, Warren Buffett's mentor. After serving in the Second World War, he went to work for Mr. Graham's partnership in New York, where he received a thorough grounding in practical value investing.

When Mr. Schloss decided to open his own modest partnership in the 1950s, he found space in the offices of Tweedy Browne, another value-oriented investing firm in Manhattan. He sat between the front door and the water cooler. If someone wanted a drink, Mr. Schloss had to scrunch up to let them by. He eventually moved into a modest office where he worked without a secretary, clerk or bookkeeper until he was joined by his son Edwin.

Mr. Schloss's research materials included company financial reports and second-hand copies of Value Line, an investment advisory service. He didn't travel to see companies or talk to management. Instead he relied on public information and his own judgment.

Despite lacking a unique investing edge, he trounced the stock market. His investment partnership gained an average of 16 per cent a year between 1955 to 2002 - and that was after deducting Mr. Schloss's performance fee of 25 per cent of profits.

He generated these outstanding returns by methods that seem almost painfully straightforward. He started by looking for stocks trading at new lows both over the last year and over the last several years. He then winnowed down these candidates by looking for companies with simple, understandable business models and little debt that were trading below book value. He reviewed each company's financial statements over the last 10 to 15 years and tried to avoid firms with greedy or unethical management and those with products that seemed likely to fail.

Mr. Schloss never bet the house on any single stock. He often held more than a hundred of them. He knew that a broadly diversified portfolio could still produce good results even if one or two of its holdings failed, and his whole approach was aimed at minimizing the risk of losing money.

Budding value investors may want to give Mr. Schloss's method a try. After all, finding stocks with light debt loads that trade below book value doesn't require fancy calculations, insider knowledge or expensive software. But it does demand gumption and more than a little patience. You have to be prepared to do the research needed to identify promising companies and you have to stick with them, just as Mr. Schloss did.

Given his outstanding results, why doesn't everyone follow in his footsteps? It's a good question. Over the decades since Mr. Buffett first highlighted Mr. Schloss's record in his famous 1984 article, 'The Superinvestors of Graham-and-Doddsville', relatively few people have emulated his simple value-hunting style.

The problem may be people's reluctance to buy stocks that aren't obvious winners. The outlook for value stocks is generally poor and most people won't buy unprofitable companies after they've declined.

Take a look yourself by heading over to the stock screener and searching for stocks trading at less than book value that are near their five-year lows. I can guarantee the list of companies that will turn up will look less than appealing. Remember, though: This is just the starting point for your research. If Mr. Schloss's track record is any indication, some of these despised companies will turn out to be winners.

In the months ahead, I'll look for opportunities to discuss a few stocks that might appeal to a Schloss-style investor in my Strategy Lab columns. For now, you can get some inspiration by visiting The Ben Graham Centre for Value Investing and listening to a lecture Mr. Schloss gave to students in early 2008. His message remains well worth hearing.

First published in the Globe and Mail, September 26 2012.

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