John Maynard Keynes (1883-1946) was a British economist whose ideas and theories are experiencing a revival. An advocate of interventionist economic policies, his ideas have been implemented across the globe as governments and central bankers attempt to halt the recession and create growth.
Not one to limit himself to economics, Keynes was also an active investor who often commented on markets. One of his most famous ideas is the belief that "markets can remain irrational a lot longer than you and I can remain solvent." While a catchy and true statement, equally profound is his concept of the beauty contest.
Keynes described a market by using an analogy of newspaper contest in which entrants are asked to choose the six "most beautiful" women from a collection of photographs. Those who picked the most popular faces would be eligible for a prize. Keynes felt the rationale way to solve this problem "is not a case of choosing those that, to the best of one's judgment, are really the prettiest, nor even those the average opinion genuinely thinks the prettiest, (but)...devote our intelligences to anticipating what average opinion expects the average opinion to be." Translated to the stock market, do not worry about a company's true value, only guess what everyone will think the true value should be.
If Keynes' beauty contest held, investing would be a continual casino where we bet based not on our view of an event, but what everyone else thought the outcome would be.
As a value investor who believes that careful study can unearth out-of-favor investments that sell at attractive prices, I never rush into stocks because I believe everyone else will like them. Instead, I buy what is cheap and await the market's recognition of what I had seen earlier. Relating to the beauty contest, I pick the prettiest faces and then wait for everyone else to see their beauty. Some time the recognition comes quickly, at other times it requires patience, but beauty is eventually awarded.
A recent example is our purchase of Dell (NASDAQ:DELL). On March 29, in my weekly newsletter EPIC Insights I recommended purchasing the stock because it traded at a large discount to fair value. Over the next few days, I had conversations with clients who felt Dell was a boring, low growth stock that was not worthy of our attention or capital. It was clearly not a winner of Keynes' beauty contest.
Not trying to guess if the market would be inspired by the stock, I bought what is cheap and remained patient. Three weeks later, the market ecognized the company's true value and the stock has rallied 17%. Buying what was cheap, as opposed to guessing everyone's actions, proved to be the correct strategy.
When Dell traded near fair value, I recommended selling the shares. After the recent drop, subscribers are happy I did so. Eventually more opportunities will present themselves and selling at fair value allows the flexibility to act when needed.