Keynes and Graham’s intelligent investor

Abstract

Keynes was a great investor in liquid markets. He operated in the currency, commodity and stock markets. The objective of this article is to describe Keynes’s profile as a stock market investor in the 1930s. He successfully beat the market during that decade. Benjamin Graham’s works are the primary references for stock market researchers and investors, particularly his book The Intelligent Investor. In it, Graham described the profile of an investor capable of beating the market. This article compared Keynes’ practices with those suggested by Graham in order for an investor to be intelligent. The conclusion is that Keynes was not fully Graham’s Intelligent Investor. Keynes was an idiosyncratic investor with unprecedented practices. He was a top-down, bottom-up, buy-and-hold and nondiversified investor.

Keywords:

• Keynes the investor
• stock market
• Benjamin Graham
• investments

JEL CLASSIFICATIONS:

• B31
• B26
• G11

Notes

Notes

1 Keynes in Walsh (2008, 150).

2 Ample literature exists that recognizes that Keynes beat the stock market using as evidence his investments for King’s College. It is extremely plausible that Keynes used the same investment strategy for King’s College and his personal investments. This correlation was explained by Chambers and Kabiri: “… over the period from 1930 to 1946, four out of every five U.S. stocks Keynes picked for himself were also held by the college endowment. It is also worth stressing that he appeared to take as much care with King’s money as he did with his own” (Chambers and Kabiri 2016, 302).

3 An example of these connections appears in the subsection Principle of stock buying based on a margin of safety. One can link a margin of safety to choosing stockholdings through the positive difference between the marginal efficiency of capital and the interest rate, which is an indicator for the acquisition of capital investments in Keynes (see chapter 11 of his General Theory). Another example appears in chapter 12 of his General Theory through which one can make a link between the difference in the intrinsic value of a stock and its market price with another type of cushion for choosing stockholdings. In chapter 11, one can find the yield margin concept and in chapter 12 the capital margin concept. Additional details are in the indicated subsection.

4 Value approach or value investing means that Keynes and Graham suggested and invested considering the true value of the investments, analysing the value of companies’ assets and their earnings potential. Neither believed in the efficient-market hypothesis, which claims that stock prices are good indicators of the true value of companies (see Woods 2013, 428–429).

5 As the bursar of King’s College, Keynes received permission to set aside part of the institution’s funds, which he managed according to his beliefs and decisions – this part was called a discretionary portfolio by Chambers, Dimson, and Foo (2015).

6 The concepts of intrinsic value and margin of safety will be thoroughly explored in the next two sections.

7 In a letter to Francis Scott, dated 7 June 1939, Keynes stated that the investments made should be subjected to two tests, which were considered definitive: they outperformed the market when compared to relevant indices and did not incorporate stumers (companies that had no intrinsic value or had lost it) (Keynes, 1983, 65–71).

8 A margin account is offered by a broker to an investor to allow him to operate. In fact, it is a form of credit. The investor can thus leverage his investments or take advantage of an opportunity that he considers advantageous without having to liquidate his own investments.

9 In short: the bottom-up method bases its analysis on the fundamentals of companies in order to relate them to the macroeconomic scenario, which remains in the background. The top-down method would do the opposite, beginning with an analysis of the macroeconomic context and selecting the companies that would supposedly be successful in the scenario analysed.

10 Marcuzzo and Sanfilippo showed that “His investment strategy changed in the 1930s, when, without losing his faith in commodities, he reduced the scale by 2/3 and almost abandoned the riskier component of his commodity investments (metals options), while at the same time increasing his investments in stock markets” (Marcuzzo and Sanfilippo 2019, 18).

11 This brief synopsis was presented by Marcuzzo and Sanfilippo: “…Keynes never lost sight of the complexity of factors behind the surface of price changes, but progressively and increasingly lost confidence in the ability to predict their course in the short run, and he turned increasingly to the fundamentals of the economy and behind individual assets…” (Marcuzzo and Sanfilippo 2019, 19)

12 Despite Graham’s scepticism about speculative activity, Jason Sweig made intriguing remarks in a note to The Intelligent Investor, saying: “Speculation is beneficial on two levels: First, without speculation, untested new companies (like Amazon.com or, in earlier times, the Edison Electric Light Co.) would never be able to raise the necessary capital for expansion. The alluring, long-shot chance of a huge gain is the grease that lubricates the machinery of innovation. Secondly, risk is exchanged (but never eliminated) every time a stock is bought or sold. The buyer purchases the primary risk that this stock may go down. Meanwhile, the seller still retains a residual risk—the chance that the stock he just sold may go up!” (Sweig in Graham, 2003, 21) The revised edition of The Intelligent Investor, originally published in 1973, is presented with comments by Jason Sweig in footnotes and longer texts at the end of each chapter.

13 Sweig (in Graham, 2003, 133) made the following comment about Keynes: “The great British economist John Maynard Keynes appears to have been the first to use the term “enterprise” as a synonym for analytical investment”.

14 In December 1932, South Africa abandoned the gold standard and joined the group of countries whose exchange rates were indexed to the pound sterling. The consequent devaluation of the South African pound resulted in a significant increase in the local currency revenues of gold mining companies. This led to a boom in the stocks of South African gold companies, or Kaffirs, in the London market. (Moggridge in Keynes 1982a, 225)

15 “… when Wall Street is active, at least a half of the purchases or sales of investments are entered upon with in an intention on the part of the speculator to reverse them at the same day”. (Keynes 1973, 160n, emphasis in the original)

16 “As far as the evolution of Keynes’s investment behaviour over time is concerned, there is further confirmation of the view – shared in the literature (…) – that a change occurred in Keynes’s speculative style (both in shares and in commodities) around the beginning of the 1930s, when he abandoned a short-term type investment behaviour in favour of a long-term investor perspective, but this is not confirmed in toto by all his dealings in commodities” (Marcuzzo and Sanfilippo 2019, 18).

17 The letter to Kahn (5 May 1938) and the letter to Scott (10 April 1940) are in Keynes (1983, 100 and 77, respectively).

18 Chambers, Dimson, and Foo (2015, 847) defined “… turnover as the average of purchases and sales in a given financial year, divided by the average U.K. equity portfolio value over that year”.

19 Keynes followed a similar practice when he traded in futures commodity markets: “Keynes relied heavily on information relative to each individual market and commodity, weighing up the quality and reliability of that information through calculation of the relevant data, the advice of experts and his own assessment of market conditions and of other participants’ opinions” (Marcuzzo and Sanfilippo 2019, 17).

20 Francis C. Scott was managing director of Provincial Insurance Company, where Keynes was a board member (see Moggridge in Keynes 1983, 1 and 19).

21 G. H. Recknell was an actuary and worked at the National Mutual Life Assurance Society, for which Keynes was the Chairman from 1921 to 1938. (Moggridge in Keynes 1983, 1 and 28).

22 Growth stocks are shares of companies that have a higher growth potential than the market index. The determining aspect is that the stock price rises higher than the market index and sometimes higher than most of the stocks available on the market. Furthermore, these stocks may not distribute dividends or do so in small percentages, as all or almost all of the earnings are reinvested in the company’s development. These days, the best examples are technology-dense companies.

23 Graham’s analysis is not about dividend-yield, i.e., how much the investor received in one year in dividends per share divided by the share price. First, dividend-yield denotes the past, and Graham is trying to decipher the company’s future; and second, as was mentioned, undistributed earnings that will be reinvested are very important in Graham’s analysis. The importance highlighted by Graham is precisely what Keynes had emphasized in his 1925 review of Lawrence Smith’s book, as observed in the previous section.

24 Keynes pointed out that what he called marginal efficiency of capital had already been defined by Irving Fisher in 1930 as “the rate of return over cost” (Keynes 1973, 140).

25 One can ponder that this comparison is valid because it has been made between fixed assets (a factory, for example) on the one side and “capital assets” that became liquid (stockholdings) on the other side. Keynes expressed this same idea when referring to stock markets: “investments which are ‘fixed’ for the community are (…) made ‘liquid’ for the individual” (Keynes 1973, 153). This comparison would not be valid if it was made between buying a machine on the one side and buying, for example, a derivative that is a financial security with a value derived from another underlying asset or group of assets on the other side.

26 Graham, unlike Keynes, seemed to have a positive assessment of stock market liquidity. In his words: “… this liquidity really means is, first, that the investor has the benefit of the stock market’s daily and changing appraisal of his holdings, for whatever that appraisal may be worth, and, second, that the investor is able to increase or decrease his investment at the market’s daily figure — if he chooses. Thus the existence of a quoted market gives the investor certain options that he does not have if his security is unquoted” (Graham 2003, 204 – emphasis in the original).

27 According to Graham (2003, 203), “… the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment” (emphasis in the original).

28 In a 1933 letter to Scott, Keynes gave as an example the “preferred stocks which are now hopelessly out of fashion with American investors and heavily depressed below their real value….[some of them] offer today one of those outstanding opportunities which occasionally occur of buying cheap into what is for the time being an irrationally unfashionable market” (Keynes in Cristiano, Marcuzzo, and Sanfilippo 2016, 8). And Keynes’ conclusion was that “The art of investing, if there is such an art, is that of taking advantage of the consequences of a mistaken opinion which is widespread” (Keynes in Holder and Kent, 2011, 4).

29 To describe the behaviour of his character and of an investor, Graham presented the following parable: “Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position” (Graham 2003, 204–205).

30 There are some examples that Keynes often used this term: in a 1940 letter to Scott (see Keynes 1983, 77), in a 1938 letter to Kahn (see Keynes 1983, 100) or even in the Memorandum for the Estates Committee, King’s College, in 1938 (see Keynes 1983, 107). Woods (2013, 433) would not have made a wholly correct statement: “Even though Keynes did not use the term intrinsic value, it is clear that his approach was identical to Graham’s”.

31 Keynes used different methods to evaluate the intrinsic value of a stock. For example, in October 1933, he compared the prices of the cars produced by Austin and General Motors and concluded that there was a 67% discount on the value of the former company compared to the latter (Chambers and Dimson 2013, 224).

32 Chambers and Kabiri (2016, appendix, 326–328) conducted research in different archives to reconstruct Keynes’ meeting schedule on his two trips to the United States in 1931 and 1934. Keynes met dozens of people, including academics, central bankers, industrialists, stock exchange specialists, politicians, and statesmen. But Graham was not among them.

33 In Keynes’ writings, only a single reference to Graham’s works was found: to the book Storage and Stability, published in 1937. Keynes cited the book in a discussion of the cost of storing commodities – the same reference appeared in 1938 and 1942 (see Keynes 1982a, 466n and Keynes 1980, 132n).

34 The only contact recorded occurred through the exchange of correspondence and public debates between Keynes and Graham in 1943 and 1944, but the subjects were relationships between currencies and exchange (see Keynes 1982b, 34–40).

35 Approximately 2,485 stocks were listed on Wall Street in 1937–1938. Of these, approximately 180 were those of public utility companies (source: Fourth Annual Report of the Securities and Exchange Commission, 1938).

36 Buffet’s admiration for Graham is so great that he named his eldest son Howard Graham Buffet.

37 Berkshire Hathaway is the Buffet holding company that controls all of his investments, including Coca-Cola, the Washington Post and American Express.

38 Markowitz defended his ideas by arguing that it is inefficient to hold a large position in just a few stocks and an investor should therefore diversify their portfolio across a large number of equity holdings (see Boyle et al. 2012, 253). It is important to remember, however, that Graham and Dodd’s book is from 1934, while Markowitz’s diversification proposal is from the 1950s (period when the Graham-Newman brokerage firm was closed). However, in a comment to Security Analysis, Howard Marks considered that Markowitz’s own idea of diversification would be a development of Graham and Dodd’s ideas (see Marks in Graham and Dodd, 2009, 123–1260).

Additional information

Notes on contributors

João Sicsú

João Sicsú, Institute of Economics, Federal University of Rio de Janeiro, Rio de Janeiro, Brazil