(Image: Zen Buddha Silence by Marilyn Barbone.)
June 25, 2017
John Maynard Keynes is one of the greatest economists of all time. But when he tried to invest on the basis of macroeconomic predictions, he failed. Twice. When he embraced focused value investing, he was wildly successful.
It is well known that Warren Buffett and Charlie Munger are two of the greatest value investors, and that they both favor a focused approach. What is not as well known is that the world’s most famous economist, John Maynard Keynes, independently embraced a value investing approach similar to that used by Buffett and Munger.
The story of Keynes’ evolution as an investor has been told many times. One book in particular – Justyn Walsh’s Keynes and the Market (Wiley, 2008) – does a great job.
Keynes did very well over decades as a focused value investor. His best advice:
- Buy shares when they are cheap in relation to probable intrinsic value;
- Ignore macro and market predictions, and stay focused on a few individual businesses that you understand and whose management you believe in;
- Hold those businesses for many years as long as the investment theses are intact;
- Try to have negatively correlated investments (for example, the stock of a gold miner, says Keynes).
Now for a brief summary of the book.
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Keynes was born in 1883 in the university town of Cambridge, where his father was an economics fellow and his mother was one of its first female graduates. After attending Eton, in 1902 Keynes won a scholarship to King’s College at Cambridge. There, he became a member of a secret society known as “the Apostles,” which included E. M. Forster, Bertrand Russell, and Wittgenstein. The group was based on principles expressed in G. E. Moore’s Principia Ethica. Moore believed the following:
By far the most valuable things, which we know or can imagine, are certain states of consciousness, which may be roughly described as the pleasures of human intercourse and the enjoyment of beautiful objects. (pages 6-7)
Upon graduation, Keynes decided to become a Civil Servant, and ended up as a junior clerk in the India Office in 1906. Keynes was also part of the Bloomsbury group, which included artists, writers, and philosophers who met at the house of Virginia Woolf and her siblings. Walsh quotes a Bloomsbury:
We found ourselves living in the springtime of a conscious revolt against the social, political, moral, intellectual, and artistic institutions, beliefs, and standards of our fathers and grandfathers. (page 8)
WORLD WAR I – PEACE TERMS
Keynes strongly disagreed with the proposed peace terms following the conclusion of World War I. He wrote The Economic Consequences of the Peace, which was translated into eleven languages. Keynes predicted that the vengeful demands of France (and others) against their enemies would inevitably lead to another world war far worse than the first one. Unfortunately, Keynes was ignored and his prediction turned out to be roughly correct.
KEYNES THE SPECULATOR
After resigning from Treasury, Keynes needed a source of income. Given his background in economics and government, he decided that he could make money by speculating on currencies (and later commodities). After a couple of large ups and downs, Keynes ended up losing more than 80% of his net worth in 1928 to 1929 – from 44,000 pounds to 8,000 pounds. His speculative bets on rubber, corn, cotton, and tin declined massively in 1928. Eventually he realized that value investing was a much better way to succeed as an investor.
Keynes made a clear distinction between speculation and value investing. He described speculation as like the newspaper competitions where one had to pick out the faces that the average would pick as the prettiest:
It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice fourth, fifth and higher degrees.
KEYNES THE ECONOMIST
Another famous economist, Irving Fisher, who had also done well in business, made his famous prediction in mid-October 1929:
Stock prices have reached what looks like a permanently high plateau…. I expect to see the stock market a good deal higher… within a few months.
After the initial crash that began in late October 1929, Fisher continued to predict a recovery.
Keynes, on the other hand, was quick to recognize both the deep problems posed by the economic downturn and the necessity for aggressive fiscal policy (contrary to the teachings of classical economics). Keynes said:
The fact is – a fact not yet recognized by the great public – that we are now in the depths of a very severe international slump, a slump which will take its place in history amongst the most acute ever experienced. It will require not merely passive movements of bank rates to lift us out of a depression of this order, but a very active and determined policy. (page 43)
Keynes argued that the economy was at an underemployment equilibrium, with a large amount of wasted resources. Only aggressive fiscal policy could increase aggregate demand, thereby bringing the economy back to a healthy equilibrium. Classical economists at the time – who disagreed forcefully with Keynes – thought that the economy was like a household: when income declines, one must spend less until the situation corrects itself. Keynes referred to the classical economists as “liquidationists,” because their position implied that everything should be liquidated (at severely depressed and irrational prices) until the economy corrected itself.
Franklin Delano Roosevelt seemed to agree with Keynes. Roosevelt said “this Nation asks for action, and action now.” Roosevelt argued that, if necessary, he would seek “broad Executive power… as great as the power that would be given to me if we were in fact invaded by a foreign foe.” (page 51)
In The General Theory of Employment, Interest and Money, Keynes disagreed with the conventional doctrine that free markets always produce optimal results. Much later, even Keynes’ opponents agreed with him and admitted that “we are all Keynesians now.”
In the 1970’s, however, when stagflation (slow growth and rising prices) reared its ugly head, neoclassical economics was revived and Keynesian economics became less popular. But by the late 1970’s, another part of Keynes’ views – “animal spirits” – became important in the new field of behavioral economics.
KEYNES THE VALUE INVESTOR
Keynes held that there is an irreducible uncertainty regarding most of the future. In the face of great uncertainty, “animals spirits” – or “the spontaneous urge to action rather than inaction” – leads people to make decisions and move forward. (page 65)
Because the future is so uncertain, many investors extrapolate the recent past into the future, which often causes them to make investment mistakes. Moreover, many investors overweight the near term, leading to stock price volatility far in excess of the long-term earnings and dividends produced by the underlying companies. Keynes remarked:
Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market.
Keynes lamented the largely random daily price fluctuations upon which so many investors uselessly focus. Of these fluctuating daily prices, Keynes said that they gave:
… a frequent opportunity to the individual… to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week. (page 73)
Warren Buffett has often quoted this statement by Keynes. Indeed, in discussing speculators as opposed to long-term value investors, Keynes sounds a lot like Ben Graham and Warren Buffett. Keynes:
It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. (page 75)
Keynes also noted:
… it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.
Because many fund managers are judged over shorter periods of time – even a few months – they typically worry more about not underperforming than they do about outperforming. With so many investors – both professional and non-professional – focused on short-term price performance, it’s no surprise that the stock market often overreacts to new information – especially if it’s negative. (The stock market can often underreact to positive information.) Nor is it a surprise that the typical stock price moves around far more than the company’s underlying intrinsic value – asset value or earnings power.
In a nutshell, investor psychology can cause a stock to be priced almost anywhere in the short term, regardless of the intrinsic value of the underlying company. Keynes held that value investors should usually simply ignore these random fluctuations and stay focused on the individual businesses in which they have invested. As Ben Graham, the father of value investing, said in The Intelligent Investor:
Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
Graham also wrote:
The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.
Or as Buffett said:
Fear is the foe of the faddist, but the friend of the fundamentalist.
Buffett later observed that Keynes “began as a market-timer… and converted, after much thought, to value investing.” Whereas the speculator attempts to predict price swings, the value investor patiently waits until irrational price swings have made a stock unusually cheap with respect to probable future earnings. Keynes:
… I am generally trying to look a long way ahead and am prepared to ignore immediate fluctuations, if I am satisfied that the assets and earnings power are there. (page 105)
MARGIN OF SAFETY
Ben Graham, the father of value investing and Warren Buffett’s teacher and mentor, wrote the following in Chapter 20 of The Intelligent Investor:
In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too will pass.’ Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.
Keynes used the phrase “safety first” instead of “margin of safety.” Moreover, he had a similar definition of intrinsic value: an estimate based on the probable earnings power of the assets. Keynes realized that a lower price paid relative to intrinsic value simultaneously reduces risk and increases probable profit. The notion that a larger margin of safety means larger profits in general is directly opposed to what is still taught in modern finance: higher investment returns are only achievable through higher risk.
Moreover, Keynes emphasized the importance of non-quantitative factors relevant to investing. Keynes is similar to Graham, Buffett, and Munger in this regard. Munger:
… practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. (page 98)
Or as Ben Graham stated:
… the combination of precise formulas with highly imprecise assumptions can be used to establish, or rather to justify, practically any value one wishes… in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom. (page 99)
UNCERTAINTY AND PESSIMISM CREATE BARGAINS
The value investor often gains an advantage by having a 3- to 5-year investment time horizon. Because the future is always uncertain, and because so many investors are focused on the next 6 months, numerous bargains become available for long-term investors. As Keynes mentioned:
Very few American investors buy any stock for the sake of something which is going to happen more than six months hence, even though its probability is exceedingly high; and it is out of taking advantage of this psychological peculiarity that most money is made. (page 115)
Pessimism also creates bargains. During the 1973-1974 bear market, many stocks became ridiculously cheap relative to asset value or earnings power. Buffett has explained the case of The Washington Post Company:
In ’74 you could have bought The Washington Post when the whole company was valued at $80 million. Now at that time the company was debt free, it owned The Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington, D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the International Herald Tribune, and probably some other things I forgot. If you asked any one of thousands of investment analysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $400, $500, $600 million. (page 121)
MARKET LEADERS OR HIGHER QUALITY COMPANIES
Keynes had a policy of buying the best within each chosen investment category:
It is generally a good rule for an investor, having settled on the class of security he prefers – … bank shares or oil shares, or investment trusts, or industrials, or debentures, preferred or ordinary, whatever it may be – to buy only the best within that category. (page 117)
Buffett, partly through the influence of Charlie Munger, evolved from an investor in quantitatively cheap stocks to an investor in higher quality companies. Munger explains the logic:
Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold if for… 40 years, you’re not going to make much different than 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result. (page 118)
FOCUSED AND PATIENT
Keynes was a “focused” value investor in the sense of believing in a highly concentrated portfolio. This is similar to Buffett and Munger (especially when they were managing smaller amounts of money).
Keynes was criticized for taking large positions in his best ideas. Here is one of his responses:
Sorry to have gone too large in Elder Dempster… I was… suffering from my chronic delusion that one good share is safer than ten bad ones, and I am always forgetting that hardly anyone else shares this particular delusion. (page 136)
If you can understand specific businesses – which is easier to do if you focus on tiny microcap companies – Keynes, Buffett, and Munger all believed that you should take large positions in your best ideas. Keynes called these opportunities “ultra favourites” or “stunners,” while Buffett called them “superstars” and “grand-slam home runs.” As Keynes concluded late in his career:
… it is out of these big units of the small number of securities about which one feels absolutely happy that all one’s profits are made… Out of the ordinary mixed bag of investments nobody ever makes anything. (page 138)
One way that the best ideas of Keynes, Buffett, and Munger become even larger positions in their portfolios over time is if the investment theses are essentially correct, which eventually leads the stocks to move much higher. Many investors ask: if your best idea becomes an even larger part of the portfolio, shouldn’t you rebalance? Here is Buffett’s response:
To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team. (page 143)
The decision about whether to hold a stock should depend only upon your current investment thesis about the company. It doesn’t matter what you paid for it, or whether the stock has increased or decreased recently. What matters is how much free cash flow you think the company will produce over time, and how cheap the stock is now relative to that future free cash flow. What also matters is how cheap the stock is relative to your other ideas.
Keynes again on concentration:
To suppose that safety-first consists in having a small gamble in a large number of different directions…, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy. (page 145)
As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. (page 146)
Conducting research on a relatively short list of candidates and then concentrating your portfolio on the best ideas, is a form of specialization. Often the stocks in a specific sector will get very cheap when that sector is out of favor. (This happened with oil-related companies in early 2016 when oil briefly touched $26.) If you’re willing to invest the time to understand the stocks in that sector, you may be able to gain an edge.
Moreover, if you’re an individual investor, it makes sense to focus on tiny microcap companies, which are generally easier to understand and can get extremely cheap because most investors completely ignore them.
Ben Graham often pointed out that patience and courage are essential for contrarian value investing. Cheap stocks are usually neglected or hated because they have terrible short-term problems affecting their earnings and cash flows. Similarly, Keynes held that huge short-term price fluctuations are often irrational with respect to long-term earnings and dividends. Keynes:
… the modern organization of the capital market requires for the holder of quoted equities much more nerve, patience, and fortitude than from the holder of wealth in other forms. (page 158)
Keynes’ experiences on the stock market read like some sort of morality play – an ambitious young man, laboring under the ancient sin of hubris, loses almost everything in his furious pursuit of wealth; suitably humbled, our protagonist, now wiser for the experience, applies his considerable intellect to the situation and discovers what he believes to be the one true path to stock market success. (page 162)
Keynes realized that focused value investing is the best way to compound wealth over time. Ignore market and macro predictions, and focus on a few businesses that you can understand and in whose management you believe.
In 1938, in a memorandum written for King’s College Estates Committee, Keynes gave a concise summary of his investment philosophy:
- A careful selection of a few investments (or a few types of investment) having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time;
- A steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchased on a mistake;
- A balanced investment position, i.e., a variety of risks in spite of individual holdings being large, and if possible opposed risks (e.g., a holding of gold shares amongst other equities, since they are likely to move in opposite directions when there are general fluctuations). (page 163)
Walsh writes that Keynes followed six key investment rules:
- Focus on the estimated intrinsic value of a stock – as represented by the projected earnings of the particular security – rather than attempt to divine market trends.
- Ensure that a sufficiently large margin of safety – the difference between a stock’s assessed intrinsic value and price – exists in respect of purchased stocks.
- Apply independent judgment in valuing stocks, which may often imply a contrarian investment policy.
- Limit transaction costs and ignore the distractions of constant price quotation by maintaining a steadfast holding of stocks.
- Practice a policy of portfolio concentration by committing relatively large sums of capital to stock market “stunners.”
- Maintain the appropriate temperament by balancing “equanimity and patience” with the ability to act decisively. (page 164)
The importance of temperament and the ability to maintain inner peace should not be overlooked. As Buffett points out:
Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.
Walsh summarizes Keynes’ performance as a value investor:
Taking 1931 as the base year – admittedly a relatively low point in the Fund’s fortunes, but also on the assumption that Keynes’ value investment style began around this time – the Chest Fund recorded a roughly tenfold increase in value in the fifteen years to 1945, compared with a virtual nil return for the Standard & Poor’s 500 Average and a mere doubling of the London industrial index over the same period. (page 167)
What’s even more impressive is that this performance does not include the income generated by the Chest Fund, all of which was spent on college building works and repayment of loans.
One small mistake Keynes made was holding his “stunners” even when they were overvalued. Keynes made this mistake because he was an optimist. (Buffett made a similar mistake in the late 1990’s.) Here is Keynes sounding like Buffett:
There is nothing to be afraid of. On the contrary. The future holds in store for us far more wealth and economic freedom and possibilities of personal life than the past has ever offered. – Keynes, Essays in Persuasion
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
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There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
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Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.