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Small Value Stocks: The Expert’s Guide to 1000% Returns

Investing in small value stocks has been the source of several fortunes. 

Mark Twain is reputed to have once said that “History may not repeat itself but it does rhyme.” Things may not work exactly as they did in the future as they did in the past but there is a good chance it will all develop in a similar fashion. This is particularly true in the stock market where the combination of economic, demographic, social and psychological factors that drive buying and selling activity is pretty much hard wired into the way the world works. 

In fact, several of the world’s most successful investors began their career taking advantage of the bargains found in smaller stocks. These are the same types of stocks that Wall Street ignores, that we want to focus on and are likely to be the source of similar life changing profits in the future.

Warren Buffett

When we think of Warren Buffett today, we think of Berkshire Hathaway and all the great stock he owns like Wells Fargo (WFC), Coca-Cola (KO) and other large cap stocks. But, while holding larger stocks like these and buying entire businesses has indeed helped Warren grow Berkshire Hathaway (BRK.A) over the years, it is not how he got rich in the first place.

Buffett started his investing career working for a man who had been his professor at Columbia University. It just happened to be Benjamin Graham, the Father of Value Investing. Warren worked for as an analyst for the Graham-Newman Partnership, an early hedge fund, which averaged about 20% annual returns during the period it was in business from 1936-1955.

The fund was not investing in the larger better-known companies of its time. The management favored companies that traded prices that were less than their net current asset values, which is a proxy for the liquidation value of the company. 

A look at the Graham-Newman Partnership’s shareholder report for 1948 shows holdings in companies like Carriers and General, The Aldred Investment Trust, Federal Light and Traction and other lesser-known companies of the day. Mr. Graham was the original small cap value investor, and Warren Buffett was his ardent student.

In 1956, Benjamin Graham decided he wanted to retire to California and he closed the partnership. Warren decided to head back to his hometown of Omaha, Nebraska and open his own series of investment partnerships. He did things a little differently than Graham and, instead of limiting himself exclusively to companies that were trading for less than liquidation value, he bought small companies that he thought were deeply undervalued. Through this investing philosophy, he ended up owning companies like Sanborn Map, Philadelphia Reading and Coal, National American Fire Insurance, Union Street Railway and many other lesser-known companies that he determined sold for far less than the actual business was worth.

He continued to use a small capitalization value approach through the life of the partnerships. His final shareholder letter in 1969 shows that Buffett earned a compound annual return of 31.6% from 1957 through the end of 1968, when he closed the partnership and focused on running the small textile company he had purchased a few years earlier. This, of course, was Berkshire Hathaway. And, although this was the end of the Buffett partnerships, it was by no means the end of Warren Buffett’s career as a small-cap value investor.

When he took over Berkshire Hathaway, he began to look for ways to diversify the business away from the textile business, which even then was in sharp decline. He began buying shares of small banks, insurance companies, newspapers and retail-oriented companies in order to diversify Berkshire’s assets. 

This approach worked very well, and today that tiny, regional textile manufacturer has a $400B+ market cap.

Buffett remained a dedicated small-cap value investor until Berkshire grew so large he could no longer invest in smaller companies. Buying large blue chip stocks and holding for a long period have helped his stay rich but they are not what made him rich in the first place. He got rich by investing in small-cap value stocks and so can we.

This hasn’t changed his attitude toward small-cap value stocks, though.

In 1999 he told Business Week: 

“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

John Templeton

John Templeton is another famed investor who started out as a small-cap value investor. 

In 1939 the world was on the verge of World War II and the mood was dark. Hitler was making aggressive moves in Europe and Japan was moving to take over large parts of Asia. Investors everywhere were panicked at the prospects of widespread destruction.

Mr. Templeton, though, was not panicking.

He believed that the war would not be as damaging to the U.S. economy as everyone else in the market seemed to think, and he put his money where his mouth was, borrowing $10,000 to buy shares of every stock on the New York Stock Exchange that sold for less than $1. There were 140 such stocks at the time, and he bought into each and every one of them. Over the next four years just four of them failed, and the rest rose in value as the industrial might of the U.S. came into play, growing the economy as the result of wartime spending. 

He eventually sold the portfolio for more than four times his original investment and went on to become a billionaire thanks to his value investing approach to the markets.

Templeton believed in the importance of looking at stocks differently than other investors. He once said, “If you want to have a better performance than the crowd, you must do things differently from the crowd.” During his career, he was constantly looking for bargain stocks, and he often found them among smaller companies no one else had even heard of. When everyone else was looking at the large well know stocks he was looking for smaller companies that traded at bargain prices that he could hold for several years until the rest of the market recognized their value and bid the price up.

Peter Lynch

Peter Lynch is another famed investor whose success was in large part driven by small-cap value investing. 

He is often thought of as a growth investor but if we examine what he owned and what he has said over the years, much of the incredible performance he racked up as the head of the Fidelity Magellan Fund can be attributed to his fondness for buying smaller companies off Wall Street’s radar that traded at low price to earnings ratios.

He also was a big buyer of thrift and savings and loans at bargain prices, and they were a big part of the 29% annual returns he delivered as head of the fund from 1977 to 1990. He spent much of his time searching for those smaller companies that he thought could become ten baggers over a long period and during his career this small-cap value focus helped become one of the top performing mutual fund managers of all time.

One of the most famous stories about Peter Lynch involves Hanes, a company that made pantyhose for women. In the 1970s, Hanes came out with a product called L’Eggs, high quality pantyhose that were sold in egg-shaped packaging in supermarkets and drug stores. His wife loved them, and some research on Lynch’s part revealed that she was not the only one.

Until then, high-quality pantyhose were only sold in department stores, so Hanes was radically disrupting the market by selling their product in drug stores and groceries. The egg packaging was just a gimmick, but the pantyhose themselves were a huge hit and the company soon dominated their market.

But Wall Street could care less about some little pantyhose company, and the stock was still reasonably priced when Lynch first noticed Hanes, so he started buying up shares when the market cap was around $40 million. He ended up making six times his money when the company was sold to Consolidated Foods in 1979.

Lynch also made an enormous amount of money by participating in thrift conversions during his tenure at Magellan Fund. A thrift conversion is when a small mutual saving bank decides to go public and sell shares to the public. The money they take in from the IPO doubles the net worth of the bank so original buyers and those who bought soon after the offering made fortunes. Many of these tiny banks end up being taken over by a larger bank after a few years and shareholder cash in for several times their original investment. Lynch owned hundreds of these during his career, and these tiny stocks no one had ever heard of in New York made him and his investors huge profits.

Peter Lynch became one of the best fund managers in history largely by focusing on small stocks in sound financial condition at prices he felt were a bargain. He then held them for a long time until they were fully or overpriced. He didn’t trade or try to time the market. He bought quality companies at bargain prices and let time and value do all the heavy lifting.

Tweedy Browne

Tweedy, Browne opened its doors in the 1920s as a market maker in small, thinly traded stocks. These were little companies no one had ever heard of, and Tweedy, Browne was one of the few places interested investors could buy them. As a market maker Tweedy Browne was the broker that clients looking for these little stocks would turn to for assistance in finding shares to buy.

One of the firm’s biggest client was a fund down the hall called Graham-Newman. The Graham part of the firm was none other than Benjamin Graham, the author of “Security Analysis” and the father of what we now know as value investing. Other Tweedy, Browne clients over the years included Warren Buffett and Walter Schloss, two investors who both learned from Graham and went on to build their fortunes as small-cap deep value investors.

Tom Knapp joined the firm in 1957 after learning the craft of value investing from Graham. He convinced the partners at Tweedy, Browne that instead of just trading small, undervalued companies for clients they should be buying little companies for their account as investors. They formed an investment partnership to own deeply undervalued securities that performed very well over the next several decades.

Ed Anderson joined Tweedy, Browne after a stint at the Atomic Energy Commission and a period working for Charlie Munger as an analyst. He convinced the firm to take the next step, and in 1969 they started managing investments for outside investors.

Chris Browne stopped by the firm in 1969 on his way home from Army Reserve training to borrow $5 off his father Howard, who was one of the firm’s partners. He needed cash for the train ride home to New Jersey. While there he got into a discussion about investing in small, undervalued companies with a few of the staffers and, by the end of the day, he was the firm’s newest employee.

He eventually became the public face of the firm and gained widespread notoriety as the author of “The Little Book of Deep Value Investing,” a classic book in the industry and one that helped me outline much of the approach I use today.

In 1993 Tweedy, Browne offered its first mutual funds to the public and since then both the firm’s Value Fund and Global Value Fund have outperformed the market. Today the firm manages more than $20 billion of client money using this deep value approach.

Warren Buffett spoke about the firm’s track record in his famous 1984 presentation at Columbia University, which formed the basis for his article “The Superinvestors of Graham and Doddsville.” He noted that by using the deep value small-cap approach to investing the firm had compounded returns of 20% before fees since they started taking outside money. 

Times may have changed and the firm has grown, but much like Warren Buffett, it was small-cap deep value investing that made the original partners of Tweedy, Browne wealthy men.

Charles Royce

Charles Royce took control of Quest Advisory Corporation in 1972 and started managing the Royce Pennsylvania Mutual Fund shortly thereafter. 

It was a heady time and what were known as the “Nifty Fifty” were still all the rage. These were the 50 giant corporations that Wall Street and much the investing public considered stocks that could be bought and held forever regardless of the price. The Nifty Fifty list included stocks like McDonald’s (MCD), Avon Products (AVP), Pfizer (PFE), Coca-Cola (KO) and other giants that investors assumed would grow forever.

As a result of this attitude, these stocks got pushed to heady multiples with many of them trading at 40, 50, and 60 times earnings or more.

As one might expect from such lofty valuations, this didn’t end well for this who bought into the Nifty Fifty concept. By the end of 1973, the economy had turned and we entered an environment of stagflation coupled with Watergate and a rapidly worsening situation in Vietnam. The high flyers crashed back to earth, and the losses were staggering as Nifty Fifty stocks fell by 50%, 60% and more. 

Avon fell by more than 80%, and even McDonald’s was down more than 70% from its earlier peak.

During this difficult market period, Royce began to develop his philosophy of investing that was heavily focused on preserving capital. He realized that the best way to consistently outperform the indexes was to lose less in bad markets and perform at least as well (if not a little bit better) as the broader market in bull markets. He also came to the conclusion that, because of the lack of institutional influence, these results could be best achieved in smaller stocks.

His conclusions turned out to be correct. 

Over the last 40 years, his Royce Pennsylvania Mutual Fund has averaged returns of over 13% per year, easily outperforming the broader market. He compiled this track record by investing in small companies with strong balance sheets and solid prospects. He approached these companies like a private equity investor who was considering buying the whole company and was only willing to pay a price that offered a high long-term rate of return.

Royce Funds has grown into a leading small cap value firm with over $30 million in assets under management. All of its funds are managed using the approach that Royce developed back in the turbulent days of the 1970s, and they favor small- and micro-cap stocks for the funds they manage. 

Charles Royce was one of the pioneers of small-cap value investing, and we stole more than one of our ideas about investing from him over the decades.

Walter Schloss

Walter Schloss is a legend among value investors. 

He built a 47-year track record of returning 20% annually before fees for his investors. He never had a fancy office, and for most of his career there was no computer on his desk. He relied on the Standard and Poor’s Stock Guide and Value Line to help develop stock ideas, and he operated out of space in the office of Tweedy, Browne that used to be a closet. 

I’m not making any of this up.

Schloss focused on buying smaller companies for less than their asset values, and he simply held them until they worked out. That was his entire “secret system.”

Like so many other of the first deep value small-cap investors, Schloss started out working for Ben Graham after taking his classes at Columbia University. When Graham retired in 1955, an investor approached Walter and said that if he opened a fund he would invest in it, and the rest is investment history.

Schloss looked for companies that had real assets and little to no debt that could be purchased for less than his calculation of the value of the assets. He favored those companies where management owned a meaningful amount of stock in the company and executives did not pay themselves unreasonable salaries at shareholder expense. 

Like most small-cap deep value investors he tended to hold stocks longer than most other. His average holding period was about four years.

In the “Superinvestors of Graham and Doddsville” speech, Warren Buffett talked about Walter Schloss saying: 

“He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again.”

Most people had never heard of the small companies that Schloss purchased for his clients, including such tiny names as Hudson Pulp and Paper, New York Trap Rock Company, Southdown Easy Washing Machine, and Diamond T Motor. 

When asked to describe his approach Schloss simply said, “Basically we like to buy stocks which we feel are under-valued, and then we have to have the guts to buy more when they go down. And that’s the history of Ben Graham. That’s it.”

Walter Schloss passed away in 2012 but he left a legacy that we can use to become better small-cap deep value investors.

Shelby Cullom Davis

Shelby Cullom Davis was a small-cap stock investor who specialized one particular industry: insurance.

In 1944, eventual presidential candidate Thomas Dewey (remember the “Dewey Defeats Truman” headline?) rewarded Davis for his assistance in his reelection campaign for governor of New York by appointing him the deputy superintendent of the state’s insurance commission. As a result of this job, Davis received an in-depth education about the insurance industry and figured out that solid insurance companies could be wonderful investment capable of delivering outstanding long-term returns.

In 1947 he left the state job and opened an investment firm using $50,000 from his wife to fund the new enterprise.

His timing could not have been better. The postwar boom was about to kick into high gear and insurance companies were able to grow at a very high rate as returning GI’s bought homes and cars that all needed insurance policies. They were starting and growing families, so there was a growing need for life insurance as well. 

Since the insurance business was considered a backwater by Wall Street at this time, Davis was able to buy a sizeable collection of small insurance companies for less than book value, and then he simply held onto them. Many were eventually taken over by large insurers, and he would get stock in the acquiring company. He kept those shares as well. 

He bought cheap solid insurance companies, many of which were growing at a good pace and paid high dividends, and then he simply owned them and let time and value do all the heavy lifting for him.

To say it worked would be something of an understatement. 

By the mid-1950s, Davis was a millionaire thanks to his “buy cheap and hold” approach to insurance stocks. 

He discovered that when you buy assets and earnings cheaply, eventually the assets and earnings grow enough that investors are willing to pay higher multiples for them, thus driving the stock even higher than the underlying growth rate would suggest. He called this the Davis Double Play and when he passed away in 1994 that original $50,000 was worth over $900 million.

Most of his fortune was given to charities, but don’t feel too bad for his neglected heirs. While they didn’t get money from their father and grandfather, they did learn the art of buying companies at low multiples of earnings and asset and holding long enough for the Davis Double Play to drive the stock price significantly higher. 

Armed with this information, son Shelby founded Davis Investment Advisors which today manages over $27 billion in client assets. More than $2 billion of it belongs to members of the family. Two grandsons of the first Mr. Davis, Andrew and Chris, manage funds at the company today still using the concepts passed down by their grandfather.