Keynes and the Market Part 5

Recognizing that, due to both uncertainty and the presence of qualitative factors, a range of possibilities was the best that could be expected when a.s.sessing the underlying worth of a stock, Keynes adopted a " safety . rst " policy that sought to identify those stocks trad-ing at a substantial discount to even low - range estimated intrinsic value. He realized that " the amount of the risk to any investor princi-pally depends, in fact, upon the degree of ignorance respecting the cir-c.u.mstances and prospects of the investment he is considering." In other words, as uncertainty surrounding expected future cash . ows increases, so too does the " fuzziness " of intrinsic value measures - consequently, a greater margin of safety is required.

Keynes observed that some stocks are more amenable to a tighter calculation of intrinsic value than others, and are therefore more com-patible with a safety . rst policy. In The General Theory he noted that: . . . there are many individual investments of which the prospective yield is legitimately dominated by the returns of the comparatively near future . . . In the case of . . . public utilities [for example], a sub-stantial proportion of the prospective yield is practically guaranteed by monopoly privileges coupled with the right to charge such rates as will provide a certain stipulated margin.

Warren Buffett repeated the point in a letter to Berkshire Hathaway stockholders, in which he commented that " the more uncertain the future of a business, the more possibility there is that the calculation will be wildly off - base."

A Bird in the Hand 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 to the Chief Of.cer of National Mutual, January 19, 1939 The tenets of value investing - which demand a wide margin of safety in respect of securities acquired - will naturally bias investors toward stocks with a relatively stable and sustainable earnings pro. le. Serial acquirers - corporate Pacmen with the capacity to hide earnings per-formance behind the latest acquisition - are of little interest to the value investor, nor are stocks offering the promise of " blue sky " returns at some inde.nite point in the future.Warren Buffett - a famous no - show at the Internet bender of the late 1990s - explained his preference, as an investor, for those stocks sometimes dismissively labeled as " boring " : With c.o.ke I can come up with a very rational .gure for the cash it will generate in the future. But with the top 10 Internet companies, how much cash will they produce over the next 25 years? If you say you don ' t know, then you don ' t know what it is worth and you are speculating, not investing. All I know is that I don ' t know, and if I don ' t know, I don ' t invest.

In an undergraduate essay on the British philosopher and statesman Edmund Burke, Keynes noted in pa.s.sing that: Our power of prediction is so slight, our knowledge of remote con-sequences so uncertain, that it is seldom wise to sacri.ce a present bene. t for a doubtful advantage in the future.

Keynes ' observation was a rather baroque restatement of the proverb " a bird in the hand is worth two in the bush." In the stock market arena, too, Keynes eventually adhered to this principle - " ultimate earning power," not the vague promise of riches in some unde. ned future period, was fundamental in determining the worth of a stock.

Warren Buffett similarly insists on " demonstrated consistent earn-ing power " before he commits capital to a particular security. He notes that: The key to investing is not a.s.sessing how much an industry is going to affect society, or how much it will grow, but rather determin-ing the compet.i.tive advantage of any given company and, above all, the durability of that advantage.

It is earnings - not market capitalization, revenue growth, or the nov-elty of an industry - that will ultimately determine the value of a com-pany, and therefore its stock price. A business that draws in $50 billion of revenue but, because of poor margins, ekes out the pro.t of a mar-ket stall is worth very little to the rational investor. Similarly, companies lacking defensible barriers to compet.i.tive entry may not have sustain-able long - term earnings, and therefore will be of little interest to the disciplined stock - picker.

Maintaining an Edge . . . I am generally trying to look a long way ahead and am prepared to ignore immediate .uctuations, if I am satis.ed that the a.s.sets and earning power are there . . . If I succeed in this, I shall simultaneously have achieved safety - .rst and capital pro.ts.

-Keynes to the Chairman of Provincial Insurance Company, February 6, 1942 Unlike many of his peers, Keynes did not harbor a secret desire to make economics as in.exible and austere as Euclidean geometry." Economics is essentially a moral science and not a natural science," he main-tained," that is to say, it employs introspection and judgments of value." Similarly, Keynes disclaimed the need for - or possibility of - precision in the stock market domain.The unavoidable presence of uncertainty - the fact that, in regard to the future, " we simply do not know " - combined with the existence of factors which impact on a stock ' s value but cannot be quanti.ed, means that the task of ascertaining the underlying value of a stock is a necessarily inexact art.

Accepting that intrinsic value can, at best, lie somewhere within a range of values, Keynes developed a safety .rst policy in respect of his stock acquisitions. Considering both quant.i.tative and non - numerical factors, he a.s.sessed a . rm' s " a.s.sets and ultimate earning power " and com-pared the implied value of the entire company against the market ' s ask-ing price for part - shares in that business. By " backing intrinsic values . . . enormously in excess of the market price," Keynes was con. dent that he would achieve his stated objectives of both " safety . rst " and, eventually, capital gains.

Warren Buffett ' s investment policy is very similar to that of Keynes. He accepts that " valuing a business is part art and part science " and therefore advocates a margin of safety - a .nancial shock absorber - to compensate for this lack of precision: You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close.That is what Ben Graham meant by having a mar-gin of safety.You don ' t try and buy businesses worth $83 million for $80 million.You leave yourself an enormous margin.When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it.And that same principle works in investing.

Exact.i.tude in the stock market arena is a . ction - because of uncer-tainty, no one can value a security precisely. The best response to this uncertainty, Keynes and Buffett argue, is to ensure a wide buffer exists between perceived value and quoted price. Eventually, as the stock mar-ket rea.s.serts its function as a weighing machine, this margin of safety should be converted into an investor ' s margin of gain.

Chapter 10

Leaning into the Wind

Apples for Peanuts Necessity never made a good bargain.

-Benjamin Franklin, POOR RICHARD'S ALMANACK In March 1918 the German army - its eastern forces loosed after a treaty with newly Bolshevik Russia - gambled on a ma.s.sive a.s.sault on the Western Front before the resources of that awakened giant,America, could be fully deployed. Ground which had been so expensively purchased in previous years - thousands of men killed for every few hundred yards of swampy, torn earth - now yielded itself freely to the Central Powers, and in just a few days Sturmtruppen were encamped on the outskirts of Paris. From these redoubts the Germans employed a fearsome new weapon, gigantic guns capable of hurling payloads high into the stratosphere and more than 80 miles distant - well within range of the center of Paris.

Unsurprisingly, the success of the German Spring Offensive and the destruction in.icted by the unseen " Big Berthas " generated enormous

panic in the French capital. Thousands of Parisians streamed west from the city, but battling against this current of people was Maynard Keynes. He had heard from his friend, the painter Duncan Grant, that the private collection of Edgar Degas was to be auctioned in Paris in late March. Grant and the Bloomsbury set urged Keynes to deploy his government connections to obtain funds to bid for these artworks. By proposing an ingenious scheme to offset any purchases against existing French debts to Britain, and arguing that " .ne specimens of Masters " would be a much better bet than .nancially distressed French Treasury bills, Keynes extracted more than half a million francs from the Exchequer. Keynes was so taken with the operation, in fact, that not only did he secure the means for the National Gallery to bid for the Degas collection, but he also decided to attend the auction in person.

As Big Bertha periodically belched forth another sh.e.l.l, Keynes and the Director of the National Gallery - who, in true cloak - and dagger style, had shaved off his moustache and donned spectacles to avoid detection by art dealers and the press - purchased twenty - seven paintings and drawings from the collection. Prices were so depressed by the fear and uncertainty caused by the encircling enemy that - despite the quant.i.ty and quality of the acquisitions, including works by Gauguin, Manet, and Delacroix - a quarter of the Treasury ' s grant remained unspent. Not only did this coup earn the grudging respect of the Bloomsberries - one offered the backhanded compliment that " your existence at the Treasury is at last justi. ed " - but it also proved a personal boon for Keynes. Failing to convince his covert traveling partner of the merits of Cezanne, Keynes bought the post - impressionist ' s celebrated still life, Apples, on his own account for the ridiculously small sum of 327.

It would take more than a decade before Keynes applied the lessons learned in the Paris showroom to the domain of stock market investing. Abandoning the bandwagon - jumping approach of " credit cycling " during the turmoil of the late 1920s and early 1930s, he turned instead to a diametrically opposed investment style - one that focused on acquiring a handful of stocks at prices offering a substantial discount to expected future earnings potential, regardless of the whims and fashions of the market. After many successes and reversals, Keynes had eventually discerned that the stock market could, on occasion, be myopic, excessively optimistic or pessimistic, .ighty, or propelled by informational cascades. It was at these times that the value investor ' s contrarian mantra that " one should be greedy when others are fearful, and fearful when others are greedy " came into its own.

Fashion Victim What is p.r.o.nounced strengthens itself.

What is not p.r.o.nounced tends to nonexistence.

-Czeslaw Milosz," Reading the j.a.panese Poet Issa "

Belying his impeccable Establishment credentials, Keynes was the scion of a long line of religious dissenters on both sides of his family. This ancestral trait of nonconformism, in Maynard ' s case, seemed to extend well beyond matters of the spirit - in everyday life he delighted in paradoxes, opposed accepted wisdom, and, as the social reformer Beatrice Webb observed, disliked " all the common - or - garden thoughts and emotions that bind men together in bundles." A policy of " leaning into the wind," as he sometimes called contrarian investing, was ideally suited to Keynes ' temperament - not only did it allow him to indulge the " perverse, Puckish " side of his nature, but his natural inclination to run counter to conventional thinking also offered the tangible satisfaction of . nancial gain.

Keynes rejected the more strident claims of ef.cient markets proponents, believing instead that, on occasions, a preponderance of " game players " over " serious - minded individuals " could produce a sustained divergence between quoted prices and underlying stock value. Like many other spheres of activity, stocks could be subject to the whims of fashion, caught up in the roiling currents of informational cascades where rising prices produce rising prices or falling prices engender further declines. Fred Schwed applied a characteristically cynical interpretation to this phenomenon: Those cla.s.ses 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 Eugenie hats or waxed mustaches.

The stock exchange is, at times, patently not the exemplar of ef. ciency that orthodox theorists claim it to be. Notwithstanding its proclaimed role as a machine to crystallize expected future cash .ows, the market on occasions succ.u.mbs to the fundamental fundamental - in an exuberant bull market, more willing buyers than sellers; in a despondent bear market, more willing sellers than buyers.

The ripples from these waves of optimism or pessimism affect even those stocks initially untouched by investor irrationality, as capital is channeled into " hot " stocks and away from others. As Ben Graham commented in The Intelligent Investor: The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.

This displacement effect was particularly evident, for example, in the dying days of the 1990s, when the rush to " new economy " shares created a two - speed market - on many exchanges the " TMT " trinity of telecommunications, media, and technology stocks broadly doubled in only a couple of years, while the derisively labeled " old economy " stocks languished out of the limelight.

The Perils of Popularity If .fty million people say a foolish thing, it is still a foolish thing.

-Anatole France (attributed) Even Berkshire Hathaway, that beacon of level headedness and contrarian values, appears itself to have been the periodic plaything of fashion.As Charlie Munger - who jokingly describes himself as " a.s.sistant cult leader " at the company - comments, " what we have created at Berkshire . . . is, to some extent, a cult . . . [and] I think it ' s had effects on the stock prices of . . . Berkshire." Some individuals have been known to acquire one or two Berkshire Hathaway shares merely for the right to attend the stockholders ' annual meeting and sit at the feet of Buffett and Munger. Conversely, in the last years of the 1990s - when Buffett was dismissed by many as a ponderous investment dinosaur doomed to extinction in the brave new world of dot - coms - Berkshire ' s stock became less modish and, in consequence, suffered a rare period of underperformance relative to the market.

Berkshire Hathaway' s experience is a case study in the life cycle of stocks - as - fashion accessories. A stock is .rst picked up by the cognoscenti because of some particular attribute - in Berkshire ' s case, the immoderate success of its value investing approach. As enthusiasm for the stock percolates through the wider market and investors jump on the br.i.m.m.i.n.g bandwagon, prices may overshoot any reasonable estimate of intrinsic value. And when the stock inevitably falls out of favor - as happened with Berkshire Hathaway in the late 1990s, when investors deserted old economy stocks for the blue sky of Internet plays - prices " overcorrect " on the downside.

A similar process - although far more exaggerated - was seen on Wall Street in the late 1920s and early 1930s. When Edgar Lawrence Smith published his seminal book in 1924, his key conclusion - that through the operation of retained earnings, stocks were effectively " compound interest machines " - launched the cult of the common stock. American equities - which had previously displayed no strong price trend, either up or down, over time - enjoyed annual growth rates of around 30 percent in the three calendar years following publication of Lawrence ' s study. Light - headed at these dizzying alt.i.tudes, the market subsequently overbalanced and fell into a chasm. As Warren Buffett remarked, " What the few bought for the right reason in 1925, the many bought for the wrong reason in 1929." Stocks are contrary creatures - when they are most despised they promise the greatest rewards, and when most loved they present the greatest potential hazard.

Backing the Right Horse A difference of opinion is what makes horse racing and missionaries.

-Will Rogers, THE AUTOBIOGRAPHY OF WILL ROGERS The model that perhaps most resembles that of the stock market is the humble racetrack. At the races, bettors compete against other bettors, the odds on horses constantly moving to re.ect the perceived favorites. Additionally, horses are handicapped with varying weights in an attempt to level the playing . eld - horses with a good win record will carry heavier weights than less successful nags. The stock market displays a very similar dynamic - investors compete with each other, buying and selling stocks based on their apparent prospects, and stocks perceived to have more potential are " handicapped " by higher price - to - earnings multiples than those securities deemed to be less promising.

In an ideal world - the world posited by ef.cient markets die hards - prices generated on the stock exchange by buyers and sellers will re.ect the relative merits, in terms of earnings potential, of a security, so that each share is as good a bet as the other. In an interview with Outstanding Investor Digest, Berkshire Hathaway ' s Charlie Munger expanded on this point: Everybody goes [to the racetrack] and bets and the odds change based on what ' s bet. That ' s what happens in the stock market. Any d.a.m.n fool can see that a horse carrying a light weight with a wonderful win rate and a good post position . . . is way more likely to win than a horse with a terrible record and extra weight and so on . . . But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it ' s not clear which is statistically the best bet . . . The prices have changed in such a way that it ' s very hard to beat the system.

In a broadly ef.cient stock market - as with a correctly priced horse race - it is indeed extremely dif.cult to beat the system. The key to success in both these arenas, therefore, is to identify the radically mispriced bet - the horse or stock that offers good odds and has a strong chance of performing.

Increasing the dif.culty of the investor ' s or bettor ' s task is the fact that " the house " - the stock exchange for the investor, the racing authority for the bettor - retains a percentage of each wager laid. Although the stock market ' s take is not nearly as large as that of the racetrack, and historically the stock market pie generally grows larger over time, the principle still holds - successful investors and bettors must not only out - bet the rest of the market, but also receive a margin large enough to compensate for the transaction costs incurred in laying the wager. Success on the stock market, as Charlie Munger reminds us, requires the individual " to understand the odds and have the discipline to bet only when the odds are in your favor."

Fear Factor Our distrust is very expensive.

-Ralph Waldo Emerson, NATURE Stock markets, although bedevilled by uncertainty, exist because of uncertainty.As John Kenneth Galbraith noted: Were it possible for anyone to know with precision and certainty what was going to happen to . . . the prices of stocks and bonds, the one so blessed would not give or sell his information to others; instead, he would use it himself, and in a world of uncertainty his monopoly of the certain would be supremely pro. table. Soon he would be in possession of all fungible a.s.sets, while all contending with such knowledge would succ.u.mb.

Simply stated, .nancial markets exist because certainty does not - markets are as much an exchange of opinions as an exchange of capital and securities.

Keynes realized that radically mispriced stock market bets are most abundant when there exists great uncertainty and, in consequence, widely divergent opinions about the value of a stock. As he explained to a colleague, " 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." In making this observation, Keynes echoed an insight of Frank Knight, a University of Chicago academic. Knight noted that there were two types of uncertainty - measurable probability, which he labeled " risk," and unquanti. able ambiguity, which was true uncertainty. " Risk " can be a.s.signed a probability value - such as the 50 percent chance of throwing heads in a coin toss or the one - in - six prospect of rolling a particular number on a die - whereas " uncertainty " is utterly unmeasurable. In the free enterprise system, Knight a.s.serted, only true uncertainty - " ignorance of the future," as he described it - can consistently create potentially pro.table situations, as quanti. able risk should, in theory, already be factored into the pricing of an a.s.set.

Those investors wishing to pro.t from the stock market, therefore, are those who embrace uncertainty.As 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." Uncertainty, in respect of stocks, may be attributable to ambiguity about the business prospects of a particular company, more generalized misgivings about the state of the stock market or the broader economy, or some combination of these factors.The value investor - forti.ed by a perceived margin of safety operating to his or her advantage - exploits uncertainty, rather than being cowed by it.

Groceries, Not Perfume People always clap for the wrong things.

-Holden Caul. eld, in J.D. Salinger ' s THE CATCHER IN THE RYE The stock market - the apotheosis of the free market system - frequently confounds a fundamental tenet of economics.When the price of a stock goes up, demand for that stock tends to increase, often merely because the price has risen. Similarly, when the price of a stock falls, demand for the stock often subsides. In so doing, the market betrays its true nature - it is under the in. uence of " game players," stock market partic.i.p.ants concerned primarily with short - term price movements rather than longer - term earnings pro.les.Warren Buffett provides a contrarian reality check on this behavior: . . . many [investors who expect to be net buyers of investments throughout their lifetimes] illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It ' s the seller of food who doesn ' t like declining prices.) If stocks are perceived as dividend - paying vehicles, then the investor is not afraid of corrections - indeed, a decline in exchange value should be viewed favorably, as it allows the investor to get more " quality for price " in terms of income as a proportion of initial outlay. Only speculators - those who perceive stocks as trading a.s.sets - will ordinarily view stock price declines negatively.The rules of price theory and utility maximization deem that the rational individual will be disposed to buy more of something the cheaper it becomes. With stocks, price and demand are often correlated because the " return " most people consider is capital gain, and as the market declines the prospect of trading pro. ts falls commensurately.

It was on this psychological quirk - the tendency for the market to be in.uenced by short - term price patterns - that Keynes based much of his investment philosophy. Discussing the disposition of the American stock market, he commented to a colleague that: 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 this psychological peculiarity that most money is made.

Value investors focus on long - term earnings, not short - term price cascades. As Ben Graham noted, intelligent investors buy their stocks as they buy their groceries, not as they buy their perfume - value is the key consideration, not the short - winded enthusiasms of the rabble.

Kissing Toads If you can keep your head when all about you are losing theirs . . .

then maybe they know something you don ' t.

-Market maxim Adhering to a policy of value investing - basing investment decisions on an a.n.a.lysis of intrinsic value rather than price momentum - means that value investors are often on the " other side " of the market.A contrarian policy is not, however, simply one of automatically opposing the mob, re.exively zigging when others zag.The practice of blind contrarianism is just as dangerous as bandwagon - jumping investing styles - like momentum investing, it dispenses with fundamental value a.n.a.lysis in favor of market timing and requires the speculator to divine something as .ckle as mob psychology. As always, the investment decision should be motivated by an a.s.sessment of the estimated intrinsic value of a particular stock relative to its quoted price, not by market sentiment one way or another.

One of Keynes ' .rst recorded contrarian forays, for example, foundered on the rocks of reality. In late July 1914, on the same day that the Austro - Hungarian Empire declared war on Serbia and markets recoiled at the prospect of a pan - European con.ict, Keynes bought a parcel of mining and transport shares. In effect, he wagered that hostilities would remain localized - " The odds appear to me slightly against Russia and Germany joining in," he wrote to his father on the day of purchase - and that stock prices would, in consequence, rebound. Keynes ' optimism proved to be woefully misplaced - two days later, Russia ordered the general mobilization of its army, and the Germans then formally declared war on Russia.The dominoes were toppling and the Great War would embroil a large proportion of the developed world. In the arrogant . ush of youth, Keynes had forgotten that markets, on many occasions, successfully execute their idealized role as an " intelligent mult.i.tude."

Ironically, the world ' s most successful investment inst.i.tution, Berkshire Hathaway, draws its name from a failed business investment - a " turnaround " that failed to turn. In the mid - 1960s, when Warren Buffett acquired the company, Berkshire Hathaway seemed to satisfy many of the rule - of - thumb measures used in identifying potentially underpriced opportunities - low price - to - book value, low price - to earnings ratio, and so on. But the market, in this case, had been correct in marking down the price of Berkshire stock, as Buffett recounts: [Berkshire Hathaway] made over half of the men ' s suit linings in the United States. If you wore a men ' s suit, chances were that it had a Hathaway lining.And we made them during World War II, when customers couldn ' t get their linings from other people. Sears Roebuck voted us " Supplier of the Year." They were wild about us. The thing was, they wouldn ' t give us another half a cent a yard because n.o.body had ever gone into a men ' s clothing store and asked for a pin striped suit with a Hathaway lining.

Berkshire lacked pricing power - its products were mere commodities and therefore subject to .erce compet.i.tive pressure.Two decades after his acquisition of the company, Buffett was forced to shut down the last of Berkshire Hathaway ' s textile operations.

Monopoly Money Better a diamond with a .aw than a pebble without.

-Confucius The early misadventures of Berkshire Hathaway ill.u.s.trate a broader lesson learned by both Keynes and Buffett - the importance of acquiring interests in businesses possessing a sustainable compet.i.tive advantage, or commercial " moats " as Buffett describes them. Berkshire Hathaway' s original business, textile manufacturing, was a commodity - type industry requiring high capital expenditure and delivering generally poor returns. Better long - term business investment prospects, Buffett discovered, lay in those companies possessing st.u.r.dy barriers to compet.i.tion, such as unique franchises, settled oligopolies, or well - known brand names.

Buffett emphasizes " the importance of being in businesses where tailwinds prevail rather than headwinds " - the ultimate investment opportunity presents itself, he advises," when a great company gets into temporary trouble." In this respect, Buffett departs from the practice of his mentor, Ben Graham. Graham believed in buying average businesses at cheap prices - he would build a widely diversi. ed portfolio of those stocks meeting his simple but rigorous quant.i.tative measures, in the expectation that a suf.cient number of these businesses would surmount their vicissitudes and eventually increase in price. Buffett ' s investment criteria, in contrast, focuses more on qualitative factors - he looks for " great companies with dominant positions, whose franchise is hard to duplicate and has tremendous staying power or some permanence to it."

In this emphasis on quality - buying companies with defensible moats at fair prices - Buffett re.ects the approach of Keynes. In an early magazine article, Keynes endorsed the virtues of " blue chips " : It is generally a good rule for an investor, having settled on the cla.s.s of security he prefers - . . . bank shares or oil shares, or investment trusts, or industrials, or debentures, preferred or ordinary, whatever it may be - to buy only the best within that category.

Most alleged " turnaround " plays offer a very .imsy margin of safety to the value investor - predictions of future income based on optimistic " blue sky " projections will always be highly speculative. For the long term investor, quality companies are a much better bet. As Charlie Munger explains: Over the long term, it ' s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for . . . 40 years, you ' re not going to make much different than a 6 percent return - even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you ' ll end up with a . ne result.

A long - term investor, harnessing the enormous c.u.mulative power of compounding, will reap a greater return from steadily increasing earnings than from a one - off bargain purchase.

Minority Report Many shall be restored that are now fallen and many shall fall that are now in honor.

-Horace, ARS POETICA Empirical evidence, generally speaking, tends to support a policy of contrarian investing. Numerous studies show that, over the longer term, " value " stocks outperform " growth " stocks - that is, securities with relatively low price - to - earnings multiples and price - to - book value ratios, and relatively high dividend yields, have provided better returns to the investor over time. Even Professor Eugene Fama, the University of Chicago academic known as " the father of ef.cient markets theory," has himself become something of a heretic among orthodox . nancial theorists with his .ndings that value stocks tend to produce higher returns than growth stocks in most of the world ' s major exchanges.

The phenomenon of " reversion to the mean " has also been observed on stock markets. The economist Robert Shiller, citing one study, notes that: . . . ten - year real returns on the Standard & Poor ' s index have been substantially negatively correlated with price - earnings ratios at the beginning of the period.

What this means in practice, Shiller explains, is that " when the market gets high, it has tended to come down." The behavioral economists Richard Thaler and Werner De Bondt, examining a broad sample of underperforming stocks, found that " a strategy of buying extreme losers over [the preceding two to .ve years] . . . earns signi. cant excess returns over later years," with prior " losers " outperforming prior " winners " by around 8 percent per year. Reversion to the mean - the tendency for stocks that have beaten the index in the short term to underperform the market in the longer term, and vice versa - can be viewed as a visible manifestation of the stock market rea.s.serting itself as a weighing machine rather than a voting machine by eventually reining in pricing overshoots.

A number of market pract.i.tioners have used these . ndings - the outperformance of value stocks, and the tendency for unusually volatile securities to swing back to the mean - to develop simple contrarian strategies. Perhaps the best - known approach is the " Dogs of the Dow " system, in which the ten highest yielding Dow Jones Industrial Average stocks are acquired at the beginning of each year.The rationale behind this strategy is that all stocks in the Dow Jones index are " blue chip " companies paying relatively stable dividends, and thus a high dividend yield may be an indication that the stock is relatively underpriced and trading at the bottom of its price cycle. Although statistical a.n.a.lysis of the Dogs of the Dow effect con.rms that over most periods the " Dow - 10 " has indeed produced excess returns, Keynes and Buffett would no doubt reject such a system on the basis that it dispenses with reasoned a.n.a.lysis in favor of a mechanical application of rules.

Buy on the Sound of Cannons Even outside the . eld of . nance,Americans are apt to be unduly inter ested in discovering what average opinion believes average opinion to be; and this national weakness .nds its nemesis in the stock market.

-Keynes, THE GENERAL THEORY One of Keynes ' colleagues at the Provincial Insurance Company recalled an occasion when a member of the Investment Committee suggested buying Indian government bonds. " By all means," Keynes responded," but timing is important.Wait ' til a Viceroy has been a.s.sa.s.sinated! " Maynard Keynes realized that it was periods of uncertainty that produced the conditions necessary for " stunners " to emerge. A rather extreme example of this tendency - and one that gives credence to the charge of economics as the dismal science - was the experience of Keynes ' prot e g e , the Italian economist Piero Sraffa. According to one story circulating within Cambridge, Sraffa - who was in possession of a substantial family inheritance - waited patiently for " the one perfect investment." Shortly after the bombing of Hiroshima and Nagasaki by the Allies, he invested heavily in j.a.panese government bonds - and subsequently reaped a fortune in j.a.pan ' s postwar " miracle years."

Keynes himself exploited the tremendous uncertainty and fear created during the Great Depression to effect his greatest contrarian triumph. In late 1933, when sh.e.l.l - shocked American investors . inched at FDR ' s robust anticorporate rhetoric, Keynes started buying preferred shares of utility companies, reasoning that they were " now hopelessly out of fashion with American investors and heavily depressed below their real value." Despite fears that Roosevelt would nationalize electricity utilities, Keynes acquired signi. cant 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.

Similarly, Warren Buffett achieved perhaps his most spectacular contrarian coup during another deep stock market slump. In 1974, when many pundits were proclaiming that " the Death of Equities " was imminent, Buffett acquired a large stake in The Washington Post. As Buffett explains, due to the overwhelming pessimism oppressing the market, the company was undervalued on any reasonable measure: In ' 74 you could have bought The Washington Post when the whole company was valued at $ 80 million. Now at that time the company was debt free, it owned The Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington, D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000 - ton - a - year mill up there, a third of the International Herald Tribune, and probably some other things I forgot. If you asked any one of thousands of investment a.n.a.lysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $ 400, $ 500, $ 600 million.

The radically mispriced bet - in this case, one evidenced by even a fairly basic sum - of - parts calculation of key a.s.sets - is most often thrown up amidst conditions of great uncertainty. As Buffett continually reminds his disciples, " Fear is the foe of the faddist, but the friend of the fundamentalist." Bolstered by a perceived margin of safety, the value investor exploits this uncertainty, rather than being intimidated by it.

Lonesome in the Crowd [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 .nd anyone 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.

-Keynes to a fellow stock investor, September 28, 1937 Keynes was a de.ant individualist and very dif.dent team player. He once joked that his chief hobby was " .uttering dovecotes, particularly in the City," and the man sometimes seemed const.i.tutionally incapable of .nding accord with the majority. In the closing stages of World War II, during loan negotiations with the United States, Keynes ' frustration with consensus - building excited some of his .nest invective. He called Leo Crowley, the American administrator of the Lend - Lease scheme, a " Tammany Polonius " whose " ear [was] so near the ground that he was out of range of persons speaking from an erect position," and observed for good measure that the unfortunately .orid Crowley had a face like " the b.u.t.tocks of a baboon." Of Marriner Eccles, chairman of the Federal Reserve and a key member of the American negotiating team, he commented:" No wonder that man is a Mormon. No single woman could stand him." James Meade, later a winner of the n.o.bel Prize in economics, unsurprisingly described the .ercely independent Keynes as " a menace in international negotiations."

Similarly, Keynes - the instinctive contrarian - was uncomfortable with an investment - by- committee approach. In a contrite letter to a fellow member on the Eton . nances committee, he explained: My central principle of investment is to go contrary to general opinion, on the ground that, if everyone 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 con.dence to give me a run, it is in the nature of the case that I must retire from unequal combat.

Keynes discerned that one is unlikely to be able to consistently outperform the crowd when one is part of it - as Ben Graham advised, sustained success on the stock market can only be achieved by following an investment policy that is " (1) inherently sound and promising, and (2) not popular on Wall Street ." Unlike some of his investment committee colleagues, Keynes realized that value investing is a matter of facts, not fashion - ascribing an intelligence to the ma.s.ses, as if knowledge could be weighed rather than evaluated, is a sure path to underperformance.

Value investors are almost by de. nition contrarians - an underpriced stock implies that the broader market has not recognised, or at least has underestimated, the earnings potential of that security.

Contrarian investing, however, demands more effort than a mere re. exive opposition to prevailing market sentiment - one needs to be a good swimmer to go against the .ow. Stock market " dogs " can bite, and the value investor must be satis.ed, after his or her own independent a.n.a.lysis, that the underlying company possesses a sustainable earnings .ow. Warren Buffett distinguishes " extraordinary business franchises with a localized excisable cancer " from turnarounds " in which the managers expect - and need - to pull off a corporate Pygmalion." Value investors - realizing that, all other things being equal, a fall in stock prices will allow them to acquire more earnings for a given outlay - are not upset by a decline in prices, provided that the earnings prospects of the underlying business remain substantially unchanged.The intelligent investor understands that lack of present popularity does not necessarily translate into lack of future pro. tability.

Chapter 11