Investing with Keynes

While he was far better known as the architect of governments’ responses to the Great Depression, John Maynard Keynes’ parallel journey as an investor is an object lesson in investment skill.

The Great Depression can safely be judged the end of laissez-faire capitalism. The Industrial Revolution conferred massive wealth on its winners—developers of the steam engine and its derivatives in Great Britain, and those who harnessed the power of electricity and the internal combustion engine in so many forms, primarily in the U.S. The absence of constraints on economic activity allowed the economic growth
that generated massive increases in standards of living, and while it may seem odd in retrospect, it was typically taken for -granted since there had not been concentrations of wealth on such a scale before.

The Depression ended that. The staggering job losses and declines in standards of living suggested to some that things must change, but changes on such a scale not only require an element of urgency, but often a messenger to make a cogent case.

John Maynard Keynes stepped into the breach to do so. A polymath and colorful character as well, his first major publication was The Economic Consequences of the Peace, in which he argued that the Treaty of Versailles that ended World War I, in assessing massive reparations on Germany as the loser and putative initiator, would have consequences that would come at a cost to all concerned. That judgment was, of course, correct and the result was World War II.

As an economist he wrote The General Theory of Employment, Interest and Money, published in 1936, which rejected the consensus that an economy would itself correct a shortfall in demand. He argued instead that government policies could compensate for a failure of demand to generate full
employment. That formed the backbone of a new consensus that gave government a greater role in the economy, which prevailed for three or four decades until the stagflation of the 1970s argued for something new. Keynes was recognized during his life for his contributions in multiple ways, including roles in government from time to time.

A lesser- known part of Keynes’s life was his role as an investor. In it he was spectacularly successful in both investing his own funds, and those of the institutions that he served as advisor. That career is documented in Investing with Keynes by Justyn Walsh, some of the high points of which we shall describe here. Many of them will be familiar to those who are interested in the subject, and are unsurprisingly reminiscent of the investing aphorisms of Benjamin Graham and Warren Buffett. Keynes and Graham were contemporaries; Keynes was born in 1883, Graham in 1894.

The stock market crash of 1929 was a crossing of the Rubicon for Keynes as an investor. Prior to that he had been a rather conventional stock market player, employing a trading approach he called “credit cycling”, which apparently conferred no particular advantage on him. That absence of competitive advantage extended to the commodity markets as well. Quoting Walsh:

Keynes had substantially reduced his exposure to the stock market prior to the Great Crash of 1929.The move was not, however, attributable to any superior foresight on Keynes’ account. Rather, his “terrifying adventures” on the speculative markets—this time, the commodities market—had once again brought him undone. In 1928, after several years of profitable trading, Keynes’ positions in the rubber, corn, cotton and tin markets turned against him, and he was obliged to liquidate the bulk of his equities to cover these losses. The stock exchange upheavals of late 1929 then exacted a heavy toll on what little remained of Keynes’ stock portfolio: his main holding—the Austin Motor Car Company—lost over three-quarters of its value in the final two years of the 1920s.In aggregate, Keynes’ net worth declined by more than 80 percent over this
period—from £44,000 at the start of 1928 to less than £8,000 two years later—and, for the second time in his life, he found himself poised on the precipice of financial ruin. (p. 49)

Shortly after the publication of the The General Theory Keynes bought certain papers of Isaac Newton at auction from a financially pressured seller. Newton was, like Keynes, an alumnus of Cambridge University. Apparently susceptible to a like gravitational pull, Newton lost a substantial sum around 1720 in the bursting of the South Sea Bubble. These observations led Keynes to muse on the fallibility of people in the investing sphere in particular:

Unlike the situation with, say, government bonds—which pay a fixed coupon, and whose present investment value can be determined with reasonable precision—stocks exist in a twilight zone of ambiguity. This uncertainty gap is a blank canvas on which the investor projects his or her most fervent hopes or darkest fears. “Animal spirits”— the “spontaneous urge to action rather than inaction,” as Keynes defined them—embolden individuals and allow them to bridge the uncertainty gap inherent in any investment decision. (p 73)

This assessment of the foibles of human behavior, and the potential for financial danger in the stock market that they imply, led Keynes away from a conventional trading approach. He adopted a more iconoclastic practice of demanding of a stock that its market value was a substantial discount to its longer-term value as a going concern. In this way Keynes saw the route to turning potential jeopardy to his own advantage:

It is largely the fluctuations (of the stock market) which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them. (p 91)

Observers of the stock market will find this familiar. Walsh observes:

(Warren) Buffett owes much of his success to Ben Graham’s insights on stock market behavior… and has also wholeheartedly adopted some of Graham’s other principles, such as ensuring that a significant “margin of safety” exists when purchasing securities. But in many ways Buffett’s stock market philosophy is far closer to that practiced by Keynes decades earlier. Noting that Keynes “began as a market-timer… and converted, after much thought, to value investing,” Buffett often cites his philosophical fellow traveler when musing on the stock market.(p.90)

Walsh has “distilled” Keynes’ investment principles to six in number from letters and memoranda that he wrote while confined beginning in 1937, after his first heart attack. We list them here with brief summaries of each. Those who have studied investing will find them familiar, but Americans in particular may be interested that a Depression-era economist held them in high esteem as did Graham and Buffett.

The first principle is that valuation is central to investment selection. Keynes looked for large discounts to long-term value, which he called “stunners”. Walsh:

As Keynes emphasized, when ascertaining the underlying value of a stock, it is its “ultimate earning power” that is relevant. The “intrinsic” or “fundamental” value of a stock is simply the sum of expected flows from a given security, appropriately discounted for the effects of time. Other measures commonly thought to satisfy value investment precepts—such as low price-to-earnings ratios, low price-to-book value, and a high dividend yield—are, at best, tools for identifying possibly underpriced stocks. Ultimately, however, it is the expected earning power of a stock that counts. (p.104)

Of from Keynes himself in a letter the Managing Director of Provincial Insurance Company, 1940:

I am still convinced that one is doing a fundamentally sound thing, that is to say, backing intrinsic values, enormously in excess of the market price, which at some utterly unpredictable date will in due course bring the ship home. (p. 105)

The second is to err on the side of conservatism, demanding a valuation discount that rises with the uncertainty resident in the candidate in question. Keynes referred to this as safety-first; to the Chairman of Provincial Insurance:

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 earning power are there…it I succeed in this, I shall simultaneously have achieved safety-first and capital profits. (p. 121)

Just as companies with competitive advantage are differentiated from inferior ones, an investor’s competitive advantage lies in acting when others hesitate:

Keynes himself exploited the tremendous uncertainty and fear created by the Great Depression to effect his greatest contrarian triumph. In late 1933, when shell-shocked American investors flinched at FDR’s robust anticorporate rhetoric, Keynes started buying preferred share of utility companies, reasoning that they were “now hopelessly out of fashion and heavily depressed below their real value.” Despite fears that Roosevelt would nationalize electricity utilities, Keynes acquired significant shareholdings in the belief that:

“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.”

In the following year alone, Keynes’ net worth would almost triple, largely on the back of his plunge on Wall Street. (p. 141)

The foundations of successful investing are basic principles. Probabilities, the power of compound interest and analysis of competitive advantage cover most of the tool kit. Time matters, too. Perhaps the most interesting thing about Keynes’ investing career is that it was the spectacular pratfall or two that were formative. So, as in life in general, experience truly is the best teacher.

Reference: Walsh, Justyn, Investing with Keynes, Pegasus, 2021.

John R. Gilbert

John is a Senior Research Consultant whose primary responsibilities include contributing differentiated macroeconomic perspectives as well as providing industry and company research.

In addition, he writes investment commentary, which is published on our website.

John has worked in the investment industry for over 45 years. He was formerly our Director of Research. Prior to joining BFS, he was the Chief Investment Officer at New England Asset Management, Inc.

John has achieved the designations of Chartered Financial Analyst® and Certified Public Accountant.


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