Towards a Unified Theory of Equity Investment*
--John Keynes’ Unique Contributions to the Field of Security Analysis
Keynes the Money Manager
Keynes’s fame as an economist and his personal success in the markets led to his being offered and accepting positions managing money on behalf of King’s College, Cambridge and the National Mutual and the Provincial Insurance companies. Keynes enjoyed great success managing these portfolios - particularly King’s College’s.
Keynes became first bursar of King’s in 1924, taking on responsibility for the college’s financial well being. He decided to concentrate all of the college’s resources over which he had discretion into a fund called the Chest. He intended using his trading and investing skills to considerably increase the Chest Fund’s value.
His investing philosophy changed over time as Keynes began to doubt his initial belief that he could profit from his broad understanding of economic cycles. He grew to favor making large investments in individual businesses; Keynes was a logical man and individual businesses had balance sheets he could study and they sold products or services whose value he believed he could assess objectively.
The investment strategy Keynes finally adopted is, in many respects, remarkably similar to Warren Buffett’s. Buffett has acknowledged Keynes’s influence on his thinking. In 1991 he said Keynes was a man, “whose brilliance as a practicing investor matched his brilliance in thought.”
Buffett went on to quote a letter from Keynes to a business associate, F. C. Scott, on August 15, 1934 showing how Keynes, in addition to favoring long term investments, had grown to favor limiting these investments to a small number of enterprises:
“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… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.”
Like Buffett, Keynes was sometimes criticized for investing in stocks he believed would prosper in the longer term and then sticking doggedly with his selections despite shorter-term problems. Increasingly, Keynes grew to favor a contrarian style of investing, writing in 1937:
“It is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority. When you find any one agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share, that, I am learning from experience, is the right moment for selling it.”
Benjamin Graham later summarized the contrarian credo:
Mr. Market comes along each day quoting you a variety of prices for assets. He will buy or sell at the quoted price. Often his quotes reflect fair value. Mr. Market is, however, a manic depressive. On some occasions he is depressed and he prices assets too cheaply. Other days he's unreasonably optimistic and his prices are too high. The contrarian's job is to go investing when Mr. Market is depressed and to divest when he's unreasonably optimistic.
Keynes’ view of investing versus speculation was: “Investing is an activity of forecasting the yield over the life of the asset; speculation is the activity of forecasting the psychology of the market.”
Keynes came to view too much speculative activity as economically damaging, famously saying: “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”
Keynes on Concentrated Investment Portfolios
John Maynard Keynes proposed that investors should hold concentrated investment portfolios.
In 1938 he described the principles he believed should underpin this style of investing. These are:
- 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.
Consider the two possible extremes in building a stock portfolio:
- The most dilute portfolio possible is one that includes every stock listed on the stock market. This can be achieved by investing using index-tracking investment trusts and mutual funds. Provided their fees are low, these funds achieve returns closely matching the return of the whole market.
- The most concentrated portfolio consists of a single stock. If an investor chooses a single stock well, its return will greatly exceed that of the general market. A bad choice may result in total loss of the investor’s funds.
The smaller the portfolio, the greater the likelihood that its return will differ significantly from the market average.
Investors who have the competence to analyze a small number of businesses in detail and the ability to identify low-priced, outstanding businesses, will be able to outperform the market dramatically . (For example, John Maynard Keynes and Warren Buffett.)
Investors who lack the skill to select suitable stocks and who build a concentrated portfolio will probably underperform the market dramatically. (For example, any number of hopeful small investors.)
- Skilled investors can maximize their long-term return through deliberate selection of stocks.
- Unskilled investors can maximize their long-term return by adopting a deliberate policy of no selection. (They should invest in the whole market via a low cost index tracking fund.)
A concentrated portfolio consisting of several stocks is immune to the risk of total loss should the value of a single holding fall to zero. Investors, however, still run the risk of large losses if each of the stocks in their portfolio behaves in the same way - if the share prices tend to rise and fall in tandem with one another and they all fall when an unexpected, harmful event happens.
Keynes said that investors should hold investments with opposed risks. A simple example of businesses with opposed risks might be a lender and a debt collection agency. Both can prosper in a booming economy. If interest rates rise strongly, the lender’s business will probably worsen but the debt collection agency’s profits could improve.
Alternatively, a stock investor could lessen his or her exposure to risk by investing in commodities or currencies. For example, an investor decides to buy shares in a car battery manufacturer. The batteries are made using lead metal.
- If lead prices stay low the battery maker will enjoy remarkably high profits.
- If lead prices rise significantly, battery-making profits will suffer badly.
If our investor buys lead, either directly in the commodity markets, or through buying shares in a lead mining company - they will lower their risk of loss, because:
- If lead prices stay low, they will benefit from an outstanding return from the battery manufacturer.
- If lead prices rise sharply, the lower return from the battery maker will be compensated for by a greater profit from the position in lead.
Gathering together attractive but uncorrelated or opposed investments in a single portfolio is the basis of hedge funds. In his development of the Chest Fund, John Maynard Keynes was responsible for creating one of the world’s earliest hedge funds.
(*: This article is primarily based on the materials provided by www.maynardkeynes.org with interpretations and minor enhancements by C.T. Wu, PhD)