Keynes and the Market Part 8

(2) a steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until either they have ful. lled their promise or it is evident that they were purchased on a mistake;

(3) 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 . uctuations).

In effect, Keynes proposed a form of stock market jujitsu. Rather than trying to run just ahead of the inconstant mob, attempting to pick the bull and bear tacks of the stock market before they actually happen, Keynes determined that a better approach for disciplined investors was to use the kinetic energy of an irrational market to their own advantage. Instead of contributing to market volatility, caught up in the pendulum swings of sentiment, the value investor stands apart from the wildly . ail-ing market and waits for it to overbalance.When excessive exuberance or pessimism throws up a " stunner " or a " grand - slam home run," the intelligent investor - working within his circle of competence and con-.dent of a wide margin of safety - can act decisively and commit a rela-tively large amount of capital to the transaction.

The Investment Principles Everything interested him because everything in his mind .tted instantaneously into its place in the con.ict between Wisdom and Folly.

-Treasury colleague on Keynes Keynes ' stock market activities were but one aspect of an enormously productive life.As The New York Times noted in its obituary on Keynes, in addition to his better known accomplishments as an economist and statesman, he also cultivated an astoundingly wide range of interests in other . elds: He was a Parliamentary orator of high order, a historian and devotee of music, the drama and the ballet. While at Cambridge University, he founded an arts theatre there because he wanted to go to a good theatre. A successful farmer, he was an expert on development of gra.s.s feeding stuffs.

Drawing on his vast and divergent knowledge base, and emboldened by a refusal to walk the worn paths of convention, Keynes distilled a set of investment principles that not only brought him great personal pros-perity but also provided a template for stock market investors generally.

Keynes ' six key investment rules, which have been embraced by some of the world ' s most successful stock market investors, suggest that the value investor should: 1.

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.

2.

Ensure that a suf.ciently large margin of safety- the difference between a stock ' s a.s.sessed intrinsic value and price - exists in respect of purchased stocks.

3.

Apply independent judgment in valuing stocks, which may often imply a contrarian investment policy.

4.

Limit transaction costs and ignore the distractions of constant price quotation by maintaining a steadfast holding of stocks.

5.

Practice a policy of portfolio concentration by committing relatively large sums of capital to stock market " stunners ."

6.

Maintain the appropriate temperament by balancing " equanimity and patience " with the ability to act decisively.

Keynes ' investment principles are disarmingly simple, and may seem at .rst instance to be little more than applied common sense, especially when compared to the elaborate mathematics and complex concepts of modern .nancial theory. Value investing does not rely on academic eso-terica like " beta," the " capital a.s.set pricing model ," or " optimized port-folios " - rather, it focuses on just two variables: price and intrinsic value. As Warren Buffett has remarked," It ' s a little like spending eight years in divinity school and having somebody tell you that the ten command-ments were all that counted."

Keynes was aware of the insidious power of accepted wisdom, its ability to " ramify . . . into every corner of our minds." Despite recent incursions by new disciplines such as behavioral . nance, orthodox theory obstinately a.s.serts that .nancial markets are broadly ef. cient - as Buffett notes with palpable resignation, " s.h.i.+ps will sail around the world but the Flat Earth society will . ourish." Yet the sustained success of value investors such as Maynard Keynes and, more recently,Warren Buffett is perhaps the most eloquent testimony to the inadequacy of orthodox dogma.

Investment Performance Results must be judged by what one does on the round journey.

-Keynes to a National Mutual board member, March 18, 1938 Keynes ' omnivorous interests in the wider world were matched by those in the .nancial arena. Not only was he involved in investment and speculation in various capacities - on his own account, as College bursar with a large degree of discretion, and as a board member with less in.uence on investment decisions - but his moneymaking activities encompa.s.sed many different types of .nancial a.s.sets, from pig lard to preferred stock. Most importantly for our purposes, Keynes ' investment style also changed radically around the time of the Great Crash - from one of market timing to a more measured policy of value investing.

This eclectic approach, although providing a broad base from which to develop his theories on investment, also highlights the impor-tance of selecting an appropriate benchmark to a.s.sess Keynes ' stock market performance. Some of Keynes ' .nancial ventures, such as the P.R. Finance Company, can be ignored on the basis that they were princ.i.p.ally involved in currency or commodities speculation. Others can be dismissed due to Keynes ' limited tenure as an investment adviser or board member - for example, Keynes left the A.D. Investment Trust, the .rst investment company he founded with Foxy Falk, in late 1927, well before his trans.guration into value investor. Likewise, Keynes effectively absented himself from an active management role at the Independent Investment Company in the mid - 1930s and resigned from his position as Chairman of the National Mutual in 1938.

In some undertakings Keynes was hindered by inst.i.tutional inertia and a stubbornly reactionary mindset.A letter from the Provost of Eton College to Keynes captures the frustrations of group decision - making: I .nd Governing Bodies meetings usually very entertaining. I like to hear the naked covetousness with which you recommend Southern Preferred Stock, the austere puritanism with which Lubbock meets such suggestions and the tergiversation of Ridley, who, agreeing with Lubbock, nevertheless votes with you because it is a poor heart that never rejoices and one must have a . utter sometimes.

Keynes ' advocacy of " buying against the stream " more often than not met with .erce resistance from his fellow board members - as Keynes commented wearily, " All orthodox suggestions are too expensive, and all unorthodox are too unorthodox, so I am rather discouraged about making any further suggestion."

The Chest Fund As regards the Railway Stocks, I am amused that they are at last dear enough for Francis to be inclined to buy them.

-Keynes to his stockbroker, January 1943 There were only two investment concerns that focused on stocks and in which Keynes retained a large measure of decision - making discre-tion. The .rst was the Provincial Insurance Company, a small company " rather in the nature of a family affair," according to Keynes. Donald Moggridge, editor of Keynes ' Collected Writings, notes that: [Keynes] was an extremely active director [of Provincial] throughout the years after 1930 . . . On investments, Keynes had fairly complete discretion within the guidelines set by the board at its monthly meet-ings and successfully persuaded the . rm of the virtues of equities.

As Keynes observed with evident satisfaction in a memorandum for the Provincial board in 1938, the company " gave a good thras.h.i.+ng " to comparable market indices while under his stewards.h.i.+p. Keynes ' in. u-ence on the board declined, however, after 1940, when he was called back to the Treasury.

The best benchmark for a.s.sessing Keynes ' stock market perform-ance is undoubtedly the King ' s College Chest Fund - for not only did it focus on equities, but management of the fund remained with Keynes until his death.The Chest Fund, established in June 1920 and capital-ized at 30,000, was one of the few college funds permitted to invest in stocks, and Keynes exploited this freedom to achieve astonis.h.i.+ng results.Taking 1931 as the base year - admittedly a relatively low point in the Fund ' s fortunes, but also on the a.s.sumption that Keynes ' value investment style began around this time - the Chest Fund recorded a roughly ten fold increase in value in the .fteen 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.

This vast outperformance relative to comparable indices is even more impressive in light of the fact that all income generated by the Chest Fund was spent on college building works and the repayment of loans - in other words, the capital appreciation from 30,000 in 1920 to around 380,000 at the time of Keynes ' death solely comprised capital gains on the portfolio. An empirical study of the performance of the Chest Fund concluded that, although far more volatile than the broader averages, " the Fund ' s performance was clearly superior to that of the market." The authors of the study noted that " on the basis of modern performance evaluation measures, the evidence indicates that Keynes was an outstand-ing portfolio manager,' beating the market ' by a large margin."

The Positives Rule No. 1: Never lose money. Rule No. 2: Never forget Rule 1.

-Warren Buffett Two broad trends are discernible in Keynes ' stock market performance - the .rst is that, as his biographer Robert Skidelsky notes, " the more directly under Keynes ' control the investments were, the better they performed," the second is the marked improvement in investment performance dating from the early 1930s. As Donald Moggridge observes in his a.s.sessment of the performance of Keynes ' personal holdings: Whereas in the 1920s Keynes was generally less successful than the market, after 1929 his investments (treating Wall Street and London separately) outperformed the market on 21 of the 30 available accounting years and did so c.u.mulatively by a large margin.

Keynes attributed his stock market success to " a safety . rst policy " which resulted in " the avoidance of ' stumers ' with which many invest-ment lists are dis. gured." In a letter to a colleague at Provincial, Keynes expanded on the importance of minimizing losses: . . . there had scarcely been a single case of any large - scale loss.There had been big .uctuations in market prices. But none of the main investments had, in the end, turned out otherwise than all right.Thus, against the pro.ts which inevitably acc.u.mulate, there were compar-atively few losses to offset. Virtually all our big holdings had come right.

Keynes ' investment performance con.rms that successful stock market investing is, as Charles Ellis described it in the t.i.tle of one of his books, a " loser ' s game." The key task for the investor is to avoid mistakes- this is done by working within one ' s circle of competence and ensuring that a substantial margin of safety exists in respect of each stock purchase.As Ben Graham commented in The Intelligent Investor," The really dreadful losses . . . were realized in those common - stock issues where the buyer forgot to ask ' How much? ' "

The Negatives I made my money by selling too soon.

-Bernard Baruch (attributed) If some commentators have found fault with Keynes ' investment per-formance, it was in his apparent inability to dispose of overpriced stocks. One academic described Keynes as a " one - armed contrarian who bought at the bottom but could never get out at the top " - an investor who could identify underpriced stocks but was less adroit when it came to jettisoning overpriced paper. Keynes was perhaps aware of his particular susceptibility to holding on to his " pets " even after they had become too expensive based on his own value investing principles. In a post mortem written for King ' s College, he defended himself as follows: One may be, and no doubt is, inclined to be too slow to sell one ' s pets after they have had most of their rise. But looking back I don ' t blame myself much on this score; - it would have been easy to lose a great deal more by selling them too soon.

In early 1936, for example, Keynes noted at the annual meeting of National Mutual unit holders that prices of British industrial shares were very high and presumed: . . . not merely a maintenance of the present industrial activity for an inde.nite period to come but a substantial further improvement. Not that many people actually believe this, but each is hopeful of unload-ing on the other fellow in good time.

Despite this unequivocal view, Keynes held on to most of his stocks and suffered a signi.cant fall in portfolio value when the stock markets experienced yet another severe decline in 1937.

Keynes ' tendency to hold on to some of his pets for too long may have been due to his overwhelmingly optimistic nature - as Clive Bell commented, " Maynard ' s judgment would have been as sound as his intellect was powerful had it really been detached; but Maynard was an incorrigible optimist." All investors are, of course, optimists to some extent - they defer present consumption, commending capital to the uncharted land of the future, in the hope of a return. With rea.s.sur-ing infrequency, Warren Buffett also candidly pleads guilty to the same crime. " I made a big mistake in not selling several of our larger holdings during The Great Bubble," he confessed in the wake of the Internet boom and bust. Keynes ' and Buffett ' s errors of omission in this regard are a reminder to investors that, as Charlie Munger stresses, " If you stick with stocks that are underpriced, you must keep moving or switching them around as they move closer to their true value."

The Wheel Turns

In Was.h.i.+ngton Lord Halifax Whispered to Lord Keynes "It ' s true they ' ve all the money bags.

But we ' ve got all the brains. "

-Note pa.s.sed around among the British loan negotiation team In the summer of 1940, the treadmill of time seemed to have spun full revolution for Keynes. War had been declared the previous year, and once again Keynes found himself back in the Treasury. " Well here am I, like a recurring decimal, doing very similar work in the same place for a similar emergency," he lamented to Russell Lef.ngwell in July 1942. As in the Great War, Britain again found herself a supplicant at the feet of Uncle Sam, and this time Keynes - given " a sort of roving commission " by the Chancellor - was a.s.signed the task of negotiating the American loans.The quintessential Englishman, a man of vast inde-pendent wealth, was dispatched to Was.h.i.+ngton to shake the begging bowl on behalf of his country.

Despite his poor health, Keynes tackled these new responsibilities with vigor and panache.The economist Lionel Robbins, who accom-panied Keynes to the United States for the American loan negotiations, was dazzled by Keynes ' initial performances: . . . Keynes must be one of the most remarkable men that have ever lived - the quick logic, the birdlike swoop of intuition, the vivid fancy, the wide vision, above all the incomparable sense of the . tness of words, all combine to make something several degrees beyond the limit of ordinary human achievement . . . The Americans sat entranced as the G.o.d - like visitor sang and the golden light played round.

Notwithstanding the beati.c vision summoned by Robbins, the hard -nosed U.S. contingent remained largely unmoved by this wizardry. Keynes - who, like Churchill, initially had great faith in the purported brotherhood of " the English - speaking peoples " - became increasingly frustrated with what he perceived to be the harsh conditions its puta-tive ally was seeking to impose on Britain.

Keynes remarked of one U.S. - based Treasury colleague that " he could be silent in several languages."Although professing admiration for the eloquent polyglot silence of his workmate, Keynes possessed no such diplomatic reserve. His arguments with the Americans became increas-ingly heated - Keynes objected to his counterparts " picking out the eyes " of the Empire, while the U.S. contingent was wary of Britain, the cunning Old World fox, whom many Americans believed had " bam-boozled " their nation into the Great War and later had the impudence to default on its war loans. James Meade later noted that Keynes and Harry Dexter White, the co - architect of the IMF and the World Bank, would " go for each other in a strident duet of discord which after a crescendo of abuse on either side leads up to a chaotic adjournment."

After the war Keynes ' task became, if anything, even more dif. cult. The Labor Party won a surprise landslide victory over the British bull-dog, Winston Churchill, in July 1945, and the United States became even more chary of giving money to a newly socialist government. Under this pressure, Keynes reported that his body gave " ominous signs of conking out." His health was so fragile, in fact, that some German newspapers had published his obituary as early as mid - 1944 after news was received that he had suffered another heart attack. As was the case with Mark Twain, reports of Keynes ' death were greatly exaggerated. But after making six exhausting trips to the United States to negoti-ate loans and formulate the structure of a new global monetary scheme, Keynes was fatally weakened. He would not live to see the international monetary system he promoted, the global economic boom his theories forged, nor even the country - saving loan installments he had negotiated.

Laid to Rest Fears and doubts and hypochondriac precautions are keeping us muf-.ed up indoors. But we are not tottering to our graves.We are healthy children.We need the breath of life.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 On May 2, 1946, a memorial service was held for Keynes in that mausoleum to Old England, Westminster Abbey. Joining Lydia and Keynes ' immediate family at the ceremony were representatives from the many different spheres of the man ' s life - the Prime Minister, Bank of England directors, the Provost and fellows of Eton and King ' s College, colleagues from the Arts Council, former students, and surviv-ing members of the Bloomsbury group. Keynes ' " wonky breathing mus-cles," laboring under the strain of ceaseless journeys to the United States to simultaneously avert a " . nancial Dunkirk " and establish a new global monetary body, had .nally given out on Easter Sunday. World War II claimed one of its last victims - as Lionel Robbins remarked, Keynes had died " for the cause as certainly as any soldier on the . eld of battle."

Keynes ' life had turned full circle - the prodigal son returned to the heart of a grateful Establishment. The world was utterly unrecog-nizable from that which had beckoned in the hopeful and carefree days of undergraduate Cambridge and the birth of Bloomsbury. The sun was setting on Britain ' s Empire, which once proudly shaded a quarter of the world ' s landma.s.s in imperial pink.The India Of. ce, Keynes ' . rst taste of public service, would be wound up the following year when the subcontinent freed itself from the British Raj. And only a month before Keynes ' death, the recently deposed Churchill, on a speaking tour of the United States, had warned of an " Iron Curtain " descending on continental Europe.The war - weary world was entering another era, a time of new anxieties and apprehensions.

To untrained eyes, Keynes, too, had changed beyond recognition.The unworldly aesthete had become a rich man and a lord, a promoter of investment companies and an emissary for his country. But this journey from Apostle to apostate was illusory - in many ways, the course of Keynes ' life can be seen as an effort to recapture the Edwardian insou-ciance of his youth, a mythical time when young men lazily punted down the River Cam and discoursed on the .ner things in life. Keynes never lost the optimism, the belief in the perfectibility of society, char-acteristic of that time. " Progress is a soiled creed, black with coal dust and gunpowder; but we have not discarded it," he declared de. antly. Keynes ' efforts in the public arena were designed to solve the economic problem so that mankind could " live wisely and agreeably and well ." In the personal sphere, too, his moneymaking ventures aimed at the same end - as a means of securing the conditions for a well - lived life, and nothing more.

Keynes substantially achieved what he had preached. He brought con.dence and buoyancy to troubled times and, in our .eld of par-ticular interest, showed that investors could embrace uncertainty rather than be cowed by it. Friedrich von Hayek, who during the war shared with Keynes air - raid warden duties at King ' s College, wrote that Keynes " was the one really great man I ever knew " - his success as an investor was but a small part of a richly lived life. And his only regret? Some report that, tallying his achievements and disappointments toward the end of his life, Keynes remarked wistfully," I wish I had drunk more champagne."

Acknowledgments

Maynard Keynes once observed that his creative thinking generally began as a " gray, fuzzy, woolly monster " in his head. Only falteringly, and with much effort, were these thoughts given some semblance of shape and sense.

In the process of writing this book, and wrestling with my own particular species of woolly monster, I have built up substan-tial debts of grat.i.tude to many people. Speci.cally, I would like to thank Steve Johnson of The Intelligent Investor publication and web site, and Dr. David Chambers of Judge Business School, University of Cambridge, for their comments on the ma.n.u.script. My thanks also to Patricia McGuire and Elizabeth Ennion of the Archive Centre, King ' s College, Cambridge, for their unfailing a.s.sistance and good humor.

My experience with John Wiley & Sons has been uniformly reward-ing and productive, from initial pitch through to .nished product. From Wiley, I would particularly like to thank David Pugh, Kelly O ' Connor, Mich.e.l.le Fitzgerald, Stacey Small, and Kevin Holm for their advice and patience.

Finally, I reserve my most heartfelt thanks and appreciation to Carmel, for giving me the support and encouragement to indulge my own - possibly irrational - fascination with Keynes and the stock market.

211

About the Author

Justyn Walsh is a Director at Renaissance Capital, an investment bank, and is based in London and Moscow. Prior to his career in investment banking, he worked as a corporate lawyer and . nancial journalist. Keynes and the Market is his . rst book.