I. COMPOUND INTEREST AND THE INDUSTRIAL MACHINE
According to Keynes, well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus, there is an element of compound interest operating in favor of a sound industrial environment. Over a period of years, the real value of the property of a sound industrial company is increasing at compound interest quite apart from the dividends paid out to the shareholder. Thus, an index of shares yields more in the long run than its initial apparent rate of interest.
II. MARKETS, SPECULATION, AND CROWD PSYCHOLOGY
There is considerable evidence that supports some kind of invisible hand as defined by Adam Smith—what some call “the intelligent multitude.” The idea that a group of decision makers can be greater than the sum of its parts. This is now prosaic in terms of the efficient market hypothesis, but an outright rejection of this concept is unsound, just as full acceptance of it is unsound. We operate on a spectrum of information and scenarios. While we depend on some degree of this intelligent multitude, there are also rampant aspects of inefficiency. As a Chinese proverb puts it: “One dog barks at something, and a hundred bark at the bark.”
The Speculator’s Mindset
Keynes described the speculator as an investor who is 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 term ahead of the general public. They are concerned not with what an investment is really worth to a man who buys it for keeps, but with what the market will value it at under the influence of mass psychology, three months or a year hence.
Just as Keynes was quick to comprehend the power of compound interest, his evolution into becoming an investor made him keenly aware of speculative frenzy. Although today, as Keynes would describe, one month or one year could be microseconds, quarters, or weeks.
In the end, when the smart money is swamped by those scrambling aboard the bandwagon, the group is no longer intelligent, and the market forfeits any claim of efficiency. Ralph Waldo Emerson wrote in “Prudence”: “When skating over thin ice, our safety is in our speed.”
This captures the speculator’s dilemma: the lack of knowledge and therefore the need to sell, because there’s no way to confirm or have conviction. If you’re skating over thin ice and you don’t know how thick the ice is, you’re going to move quickly—and you will become, by rational thought, a speculator. The challenge becomes: is it possible to understand how thick the ice is? Those who discover it is very thick may gracefully skate while others move with speed.
The Beauty Contest
An investment approach that requires the individual to anticipate something as capricious as a mob is, as Keynes would later discover, not so easy.
Keynes wrote: “Those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most clearly corresponds to the average preference of the competitors as a whole, so that each competitor has to pick not those faces which he himself finds prettiest but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the exact same point of view. 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 generally thinks the prettiest.
We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be—and there are some, I believe, who practice the fourth, fifth, and higher degrees.”
That was perhaps a perfect prediction of exactly how the world would evolve today in terms of the equity yield curve and those participating at different parts of it. The closer we come to the present, the closer we come to what Keynes called the fifth and sixth dimensions.
III. THE 1929 CRASH AND KEYNES’ TRANSFORMATION
Groucho Marx said of the 1929 crash: “Some of the people I knew lost millions. I was luckier. All I lost was $240,000. I would have lost more, but that was all the money I had.”
F. Scott Fitzgerald wrote in “Echoes of the Jazz Age”: “It was by our time, anyhow, the whole upper tenth of a nation living with the insouciance of Grand Dukes and the casualness of Chorus Girls.”
From Keynes to a fellow economist, August 27, 1935: “I want, so to speak, to raise a dust because it is only out of the controversy that will arise that what I am saying will get understood.”
Arthur Schopenhauer wrote in On the Wisdom of Life: “All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.”
Projection and Present Bias
Often, investors attach greater weight to aspects of a business that they are relatively more confident about or knowledgeable about, even if it might be less relevant or decisive for the investment.
As Keynes put it: “The facts of the existing situation enter, in a sense, disproportionately into the formation of our long-term expectations, our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.”
Or as he wrote elsewhere: “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 claimed that “the shares of American companies which manufacture ice tend to sell at a higher price in the summer when their profits are seasonally high than in the winter when no one wants ice” and that “the recurrence of a bank holiday may raise the market valuation of the British railway system by several million pounds.”
The focus on the shorter term means that investor expectations, and therefore stock prices themselves, are extremely sensitive to new information. That is where the opportunity is.
As Keynes put it: “Faced with the perplexities and uncertainties of the modern world, market values will fluctuate much more widely than will seem reasonable in the light of after events.”
The Radical Inversion
At the end of the day, the realization that there was no method to the market’s madness prompted a radical change in Keynes’ investment approach. Following the Great Crash, he completely inverted his investment principles—which is radical to do, psychologically and behaviorally. But it was remarkable, and he was not a normal person.
He essentially became an investor rather than a speculator—one who focuses on likely future performance rather than past trends, expected yield rather than disposable price, particular stocks rather than the broader index, and relying on his own judgment rather than that of the market. He switched from being a market timer and speculator to being an investor based on fundamentals and underlying value, seeking to profit from the swings in the market rather than participating in them.
IV. VALUE INVESTING AND MR. MARKET
As Keynes described it: “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.”
The Long-Term Investor Under Pressure
Keynes wrote: “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 also very likely in the short run, he will not receive much mercy.”
Like Keynes, Benjamin Graham was also badly burned by the Great Crash, his stock portfolio losing almost three quarters of its value during the slump. And like Keynes, this loss, combined with observations picked up while working on Wall Street, motivated him to rethink deeply about exchanges and their frailties.
As Graham put it: “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.”
Buying Dollar Bills
Keynes to Richard Kahn, a former pupil:
“It is a much safer and easier way in the long run by which to make investment profits to buy $1 notes at 15 pence than to sell $1 notes at 15 pence in the hope of repurchasing them later at 12 pence.”
“I would rather be vaguely right than precisely wrong.”
V. EARNINGS POWER AND INTRINSIC VALUE
Keynes to the chief officer of National Mutual, January 19, 1939: “Unquestionably, the really right policy would be to aim at as high an income as possible and not to trouble too much about capital valuations.”
Keynes: “I am genuinely trying to look a long way ahead and I am prepared to ignore immediate fluctuations if I am satisfied that the assets and earnings power are there. If I succeed in this, I shall simultaneously have achieved safety first and capital profits.”
Keynes to the chairman of Provincial Insurance Company, February 6, 1942: “If one is selling, pressure and distress and the need to sell will never make a good bargain for the seller. Only for the buyer.”
Popularity as Risk
Fred Schwed applied a cynical interpretation to this phenomenon: “Those classes of investments considered ‘best’ change from period to period. The pathetic fallacy is that what are thought to be the best are in truth only the most popular, the most active, the most talked of, the most boosted, and consequently, the highest in price at that time. It is very much a matter of fashion, like hats or mustaches.”
Anatole France is attributed to saying: “If 50 million people say a foolish thing, it is still a foolish thing.” But the reality is that it may take those 50 million people a while to discover how foolish it is.
VI. RETURNS AND BUSINESS QUALITY
Over the long term, it is extremely hard for a stock to earn a better return than the returns of the business that underlies it. Say you have a company and it earns 6% on capital over 40 years and you hold it for 40 years. You’re not going to make much more than 6%, even if you originally bought it at a very large discount. But if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll still end up with a good result.
VII. UNCERTAINTY AND FEAR
Keynes noted: “It is because particular individuals, fortunate in situation or in abilities, are able to take advantage of uncertainty and ignorance that great inequalities of wealth come about.”
J.D. Salinger’s Holden Caulfield in The Catcher in the Rye: “People always clap for the wrong things.”
Time Horizon and Psychology
Keynes in a written note to a colleague: “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 the psychological peculiarity that the most money is made.”
What is remarkable is that this could be applied today, just as it was the case in the 1930s.
Keynes from The General Theory: “Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be, and this national weakness finds its nemesis in the stock market.”
Utilities and Mispricing
At one point, Keynes made quite a lot of money for King’s College. Despite fears that Roosevelt might nationalize electric utilities, Keynes acquired significant shareholdings. He wrote: “Some of the American preferred stocks offer today one of those outstanding opportunities which occasionally occur of buying cheap into what is, for the time being, an irrationally unfashionable market.”
VIII. CONTRARIANISM AND CONVICTION
Keynes to a fellow stock investor, September 28, 1937: “Stock market investing 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 anyone agreeing with you, change your mind. When I can persuade the board of my insurance company to buy a share, I am learning from experience that is the right moment for selling it.”
To a member of the Eaton Finances Committee: “My central principle of investment is to go contrary to general opinion on the ground that if anyone agreed about its merits, the investment is inevitably too dear and therefore unattractive. Now, obviously, I can’t have it both ways. The whole point of the investment is that most people disagree with it. So if others concerned don’t feel enough confidence to give me a run, it is in the nature of the case that I must retire from unequal combat.”
Keynes essentially recognized that you can’t consistently outperform the crowd when one is part of it.
IX. CONCENTRATION VS. DIVERSIFICATION
When Keynes at one point owned a very large percentage of the portfolio in one single company, he responded to an inquiry from one of his colleagues by saying: “Sorry to have gone too large an 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. The price has, I think, now gone up by about six pence, so you can get rid of any surplus without loss that you would like to.”
The Ignorance Tax
From Robert Louis Stevenson’s Treasure Island: “You put it all away some here, some there, and not too much anywheres, by reason of suspicion.”
Keynes himself would concede that scattering one’s investments over as many fields as possible might be the wisest plan for an individual that doesn’t have special knowledge. This would be long before the ETF existed. Diversification is a protection against ignorance, but it’s also a tax for ignorance in the sense that it will ensure an average performance.
Avoiding the Bad
If you have, say, 100 companies in a portfolio, what are the chances that one of those companies is really bad? With some basic understanding, one might say: out of these 100 companies, there is likely one that is almost certainly not good. Simply taking out, let’s say, 10 would lead to a portfolio that would significantly outperform the 100 that you started with.
One of the dangers of diversification is inadvertently investing in a very poor investment. One version of active management, which is a starting point at Marlowe, is simply to avoid the bad.
The Know-Something Investor
Keynes to the chairman of Provincial Insurance Company, February 6, 1942: “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.”
Keynes would call the companies he understood that were incredibly reliable his “ultra favorites.” He never would say the exact number of companies; and one shouldn’t, because the differences in the companies and also given the holding period, the speed with which they appreciate will ultimately determine position sizing. But normally he would say five to ten.
Keynes went on to say: “To carry one’s eggs in a great number of baskets without having time or opportunity to discover how many of those baskets have holes in the bottom is the surest way of increasing loss.”
Loading Up on Stunners
The level of investment risk to Keynes was related to the level of ignorance and uncertainty about that particular investment. If we know very little, it is risky in the bad sense. In the good sense, it is a very attractive risk when we know something about it. Keynes called this “loading up on what he called the stunners.”
X. HOLDING PERIOD AND MARRIAGE
Keynes presented to the King’s College Estate Committee, May 8, 1938: “I believe now that successful investment depends on, among other things, a steadfast holding of fairly large units through thick and thin, perhaps for many years.”
He elaborated: “To make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils, for this would force the investor to direct his mind to the long-term prospects and to those only.”
XI. TAXES AND TRADING
Keynes on taxes: “The avoidance of taxes is the only intellectual pursuit that carries any reward.”
Excessive trading and movements within a portfolio are the equivalent of raising fees on investors and on oneself. These are self-inflicted wounds. Although this will not determine whether or not one is going to own something that can compound for a decade or more, heavy trading is not just something that can lead to error, but actually leads to loss, which can be calculated mathematically and is unquestionable. It’s something like death by a trillion cuts.
The tax system, which leads to reduction in trading, is actually the equivalent, at least for American investors, of adding an additional one, two, or even three percent to compound returns, or alternatively, the equivalent of reducing fees.
XII. MARKET QUOTATIONS AND PSYCHOLOGY
Keynes: “One must not allow one’s attitude to securities, which have a daily market quotation, to be disturbed by this fact or lose one’s sense of proportion. Some bursars will buy, without a tremor, unquoted and unremarkable investments in real estate, which, if they had a selling quotation for immediate cash available at each audit, would turn their hair gray.”
The investor who maintains a “robust faith in the ultimate rightness of a policy based on reason and common sense” can withstand the disconnection from reality that happens during both euphoric bubbles and crazed panics.
Keynes, letter to a fellow stock investor, March 28, 1945: “For my own part, I can certainly claim to be a Buddhist investor in the sense of depending wholly on my own meditations.”
The Danger of Attention
Keynes remarked defiantly: “I do not draw from this the conclusion that a responsible investing body should every week cast panic glances over its list of securities to find one more victim to fling to the bears.”
Keynes: “It seems to me to be most important not to be upset out of one’s permanent holdings by being too attentive to market movements. Of course, it would be silly to completely ignore such things, but one’s whole tendency is to be too much influenced by them.”
The Need for Vigilance
Keynes: “The inactive investor who takes up an obstinate attitude about his holdings and refuses to change his opinion merely because facts and circumstances have changed is one who in the long run comes to grievous loss.”
He required constant vigilance and constant revision of preconceived ideas and constant reactions to changes in the situation in terms of the actual underlying investments.
We’re all more comfortable with absolutes. We hold it forever, or we trade. On the spectrum, evergreen is closer to the solution, provided the business has quality attributes that are sustainable and that we can observe those over time to make sure they are simply sustainable. And when they are not, we sell.
XIII. BEATING THE GUN
Nicholas Davenport, one of Keynes’ advocates on the board of National Mutual, agreed with Keynes’ analysis. In retrospect he said that beating the other fellow to the gun was one of the greatest problems in the stock market. Once one had an idea, one wanted to act on it at once, because if the idea was temporary in nature, then perhaps the move would be temporary in nature.
Davenport elaborated: “I have never known a man so quick off the mark in the stock exchange race.”
But properly understood, there is plenty of time to enter or exit a position that has the prospects, if you have the intention of holding them for those full prospects.
XIV. THE IMPERSONAL MARKET
The market is just a thing. There are various points of price discovery. If it’s raining outside, the weather does not know whether or not you have an umbrella. And if you buy a share of a company, the stock doesn’t know you own it either. There’s an impersonal aspect to it which runs contrary to our tendency for narrative.
XV. AVOIDING STUPIDITY
To paraphrase many investors, Marlowe begins by focusing on avoiding stupidity. Avoiding stupidity is not something one can just do—one must have a system to avoid it. The easier thing to do is to begin by avoiding stupid, and there are very specific things one can do to avoid stupid.
We have seen many intelligent people fail, and those failings go unnoticed because it is human psychology which is the premise of Marlowe’s success and also its challenge of explanation. It is very rare one would talk about the great swimmer who drowned versus the average swimmer who stayed afloat.
XVI. KEYNES’ TRACK RECORD
The Chest Fund recorded a roughly tenfold increase in value in the 15 years to 1945, compared with essentially a flat return for the S&P 500 average and a doubling of the London Industrial Index at the same period of time. This is even more impressive when you consider that the Chest Fund had income that was spent on college building works and repayment of loans. The capital appreciation represented by Keynes’ behavior did not incorporate the full compounding effect due to the need for withdrawals for income.
Keynes: “There will always be fluctuations in market prices, but none of our main investments have in the end turned out otherwise than relatively all right.”
XVII. INDEPENDENCE AND OUTSIDERS
In response to a verdict on a government memorandum, Keynes was able to reply very simply: “I agree with everything in this, if ‘not’ is put in front of every sentence.”
Many of these great investors are outsiders. Although Keynes was born to a high social status and was often embraced by the orthodoxy, he was an independent thinker.
Keynes, in one particular letter when people are asking whether he’s buying railroad stocks like everybody else, responds to a broker in January of 1942: “As regards the railway stocks, I’m amused that they are at last dear enough for Francis to be inclined to buy them.”
XVIII. THE CHALLENGE OF EXPLANATION
Keynes: “All orthodox suggestions are too expensive, and all unorthodox are too unorthodox, so I am rather discouraged about making any further suggestion.”
Contrarianism for contrarian’s sake could just be stupidity, and yet, buying what everybody else is buying will lead to loss of capital. If the outcome ends up being contrarian, so be it.
When one looks at his record as an investor, one must think about the constraints that were put upon him. He would have monthly or quarterly meetings with the board at Cambridge. Keynes was frustrated constantly that he had to use his wonderful communication skills to help the board join him and allow him to do what he thought was the reasonable thing.
His mandate, like all mandates, must be supported by the customer or the client or the custodian. That also brings a discipline to the process and requires explanation. It’s in that persuasion that we’re able to learn quite a lot about his mindset as an investor.