Value Investing 01 (May 08 - Dec 08)

[winston]

The World's Most Successful Depression-Era Investor
By Chris Mayer, editor, Capital & Crisis

You probably know John Maynard Keynes as an economist, but may not know that he was also a great investor, maybe the most the successful of the Great Depression era. And for that reason, given all that our own markets are going through, it may be a good time to look at his investment career.

Keynes managed Cambridge's King's College Chest Fund. The Fund averaged 12% per year from 1927-1946, which was remarkable given that the period seemed to be all about gray skies and storm clouds – it included the Great Depression and World War II. The U.K. stock market fell 15% during this stretch. And to top it off, the Chest Fund's returns included only capital appreciation, as the college spent the income earned in the portfolio, which was considerable. I think it must be one of the most remarkable track records in the annals of finance.

Keynes also made himself a personal fortune as an investor. When he died, he left an estate worth some $30 million in present-day dollars, which surprised his contemporaries. How he did it is the subject of this essay. A new book by Justyn Walsh, Keynes and the Market, is our chief guide on the subject.

Keynes began as a run-of-mill speculator and trader, trying to anticipate trends and forecast cycles. The Great Crash of 1929 sent him back to the drawing board.

Keynes was, in fact, nearly wiped out in the Great Crash. His personal net worth fell by more than 80%. He then had a great conversion. Trading the market demanded "abnormal foresight" and "phenomenal skill" to work, he concluded. "I am clear," the new Keynes wrote in a memorandum, "that the idea of wholesale shifts [in and out of the market at different stages of the business cycle] is for various reasons impracticable and undesirable."

After the crash, he became an investor, rather than a speculator. His new ideas on investing began to presage those of value investing icons Ben Graham and Warren Buffett.

Keynes now focused less on forecasting the market. Instead, he cast his keen mind on individual securities, trying to figure out their "ultimate values," as he called them. He summed up his new philosophy in a note to a colleague: "My purpose is to buy securities where I am satisfied as to assets and ultimate earnings power and where the market price seems cheap in relation to these."

He also became more patient. Paraphrasing from his own analogy, Keynes described how it was easier and safer in the long run to buy a 75-cent dollar and wait, rather than buy a 75-cent dollar and sell it because it became a 50-cent dollar – and hope to buy it back as a 40-cent dollar. Keynes learned to trust more in his own research and opinions, and not let market prices put him off a good deal.

Keynes developed a fierce contrarian streak. One of his greatest personal coups came in 1933. The Great Depression was on. Franklin Delano Roosevelt's speeches gushed with anti-corporate rhetoric. The market sank. America's utilities were, Keynes noticed, extremely cheap in "what is for the time being an irrationally unfashionable market." He bought the depressed preferred stocks. In the next year, his personal net worth would nearly triple.

In a note, Keynes laid out his understanding of the quirky, contrarian nature of investing. It is "the one sphere of life and activity where victory, security and success is always to the minority, and never to the majority. When you find anyone agreeing with you, change your mind."

He also learned to hold on to his stocks "through thick and thin," he said, to let the magic of compounding do its thing. (In a tax-free fashion, too, by avoiding capital gains taxes.) "'Be quiet' is our best motto," he wrote, by which he meant to ignore the short-term noise and let the longer-term forces assert themselves. It also meant limiting his activities to buying only when he found intrinsic values far above stock prices.

Keynes came to the conclusion that you could own too many stocks. Better to own fewer stocks and more of your very best ideas than spread yourself too thin. At times during Keynes' career, half of his portfolio might be in only a handful of names, though he liked to mix up the risks he took. So though five names might make up half of his portfolio, they wouldn't be all gold stocks, for instance. "For his faith in portfolio concentration," Walsh writes, "Keynes was rewarded with an investment performance far superior – albeit more volatile – than that of the broader market."

In the depth of the Depression, Keynes lost a friend, Sidney Russell Cooke, who took his own life after suffering severe losses in the market. Keynes, perhaps reflecting on this experience, wrote that investors need to take losses with "as much equanimity and patience" as possible. Investors must accept that stock prices can swing wide of underlying values for extended stretches of time.

Keynes' investment performance improved markedly after adopting these ideas. Whereas in the 1920s, he generally trailed the market, he was a great performer after the crash. From 1931 to 1945, the Chest Fund rose 10-fold in value in 15 years, versus no return for the overall market. That is a truly awesome performance in an awfully tough environment.

[kennynah]

i cant help but pronounce my believe that "value" of a company is a notion than a fact. Not one person, whether professional or academic, can clearly provide a definitive amount that any public listed company is worth; ie its value, at any juncture. if so, it is very puzzling for the term "value investing" to have survived this long and adopted among so many people.

on the above, while it clearly demonstrated Keynes' ability and success in stock investment, in buying when everyone has sold, it says nothing of risk management, which is a critical aspect of any form of investing and/or trading. i'm very sceptical that every of Keynes' stock picks resulted in multibaggers in the post depression/wwII years. surely, some could not survive the depressed economy and if there were no risk management inbuilt into his investment strategy, these "bad" picks could have dented his capital somewhat.

it is very often that such inspirational articles about value investing that are responsible to the uninformed "value investors" causing them to become victims to stock investing; losing plenty and not knowing what hit them, or why their investment is now worth 10% of the value purchased....

to me, Value Investing, if it exists, is a concept that not many authors can articulate with sufficient clarity and logic... they are as narrow as paris hilton's outlook of life. perhaps, i am just dogmatic in my approach to any serious subject, such as investing/trading, that adopting any method requires utter convincing before i declare it useful to myself...

[winston]

Hi K,

The following are my comments:-

1) Yes, Risk Management must be used together with FA, TA, CANSLIM, etc.

2) Margin of Safety is also an important concept in Value Investing as well

Example: If you have a big Real Estate Company, say Capitaland with say, a recent RNAV of say $5 but is now trading at $1, then you have a bit of Margin of Safety. Applying a discount of 50% to that RNAV would give you $2.50. And applying another 50% discount to that $2.50 would give you $1.25, which is still 25% above the value of your stock.

The question then becomes:-
a) how low can your RNAV go to in a multi year slowdown ?
b) when would fundamentals improve for the company ?
c) are you missing anything else ?

I dont think Value Investing it's a Science. There are many Variables and the it's a matter of applying Probabilities to many different possible scenarios.

In addition, many so called "Value Investors" eg. Warren Buffett, Sir John Templeton, Peter Lynch or even Jim Rogers used other tools in addition to just pure FA. These tools could include eg. being a Contrarian, looking for great businesses, looking for long term trends etc.

In addition, their time frame could be in years/ decades unlike the traders who cares about now and in the next 5 mins...

Some comments on the above so called Gurus:-
1) Warren Buffett buys great businesses at an acceptable Margin of Safety. He has been right in Bull Markets..
2) Sir John Templeton looks at the whole world, is a Contrarian and buys when there's blood in the street and sell after 5 to 10 years
3) I recalled that Sir John Templeton also made alot of money shorting Tech stocks just before the expiry of their IPO locked up period
4) Peter Lynch likes Growth Stocks and hold on to them as long as their fundamentals are good
5) Jim Rogers looks for long term trends where he could be wrong on his timing but would still come out correct over the long term

I cant tell whether FA or TA really works as I have not really spent enough time on either subjects. And I think it takes about 10 years of rigorous study in a certain subject before one can really comment on that subject.

In the meantime, it is back to the grinding board for me to look for my next investment idea. It could be staring at me right in the eye this morning but I'm not seeing it

Take care,
Winston

[helios]

Hi K,

The following are my comments:-

1) Yes, Risk Management must be used together with FA, TA, CANSLIM, etc.

2) Margin of Safety is also an important concept in Value Investing as well

Example: If you have a big Real Estate Company, say Capitaland with say, a recent RNAV of say $5 but is now trading at $1, then you have a bit of Margin of Safety. Applying a discount of 50% to that RNAV would give you $2.50. And applying another 50% discount to that $2.50 would give you $1.25, which is still 25% above the value of your stock.

The question then becomes:-
a) how low can your RNAV go to in a multi year slowdown ?
b) when would fundamentals improve for the company ?
c) are you missing anything else ?

Will keep these notes in mind, thanks Win!

A combinatorial mix foresight and hindsight ...

[la papillion]

Managing the Schrodinger's cat

I think there's a fundamental shift in my research techniques. After immersing myself in investing and all the literature on investments, I came to the realisation that numbers and ratios are not everything. What is? Management!

Imagine out of your classmates in secondary school, you're supposed to pick one whom you think will have the greatest potential to be the most successful. Who do you pick? Do you pick the ones that perennially top the cohort? Do you select those who always play truant and disrupt the class? Do you pick the most talkative ones, or the most quiet ones? The ones with the most activities outside of school work?

I'll pick the ones with the character that I admire. Honesty, integrity, steadfastness, leadership, charisma are some of the characteristics one may look out for. They might not necessary be the smartest in exams nor the least playful. You literally have to bet for the ones that have the most qualities that you admire.

Now, how different is that from an investing point of view?

Investing is not just analysing the statements, the business and the economics. It's not just calculating the PE, liquidity ratios, free cash flow. It's not just forecasting and projecting the earnings forward. You're literally betting on the management to bring the company through in good times and bad times, to trust them to place your monies in worthy projects that gives adequate and safe returns, and to believe in them when they do not distribute dividends not out of their lack of a sense of security but because they can use the retained earnings to give you a better return. You're betting on the management to make decisions for you to run the company you've entrusted them in the best of their abilities, to be honest when they made mistakes and to have the foresight and leadership to propel the company forward. There's no numbers or ratios to determine that. There are no stock screens to determine that.

There's only the intangible human assets (or liabilities) that cannot be put in the balance sheet of the company. If you can't trust the management, you can't trust the statements, you can't trust the business.

It's not easy to see something that cannot be seen. It's both frustrating and futile to think that after analysing the companies quantitatively and it passes your criteria and viola! you have your company to invest in. In every investment, we are betting on the future, not in the past. How to determine the future? Project a straight line from the past records and extrapolate to the future (CAGR)? Using a linear model to predict a non-linear world is an exercise in futility. Rely on earnings model? We can't even predict tomorrow's weather accurately using the most sophisticated models, why talk about complex adaptive reflexive system in a particular company's earnings.

No...no.....the future lies in how the management handles the company in every road bumps that lie ahead. The future of any company is shaped by unknown decisions made by the management. They are the ones who come out with new products. They come up with plans to counteract competition and to consolidate their grounds. Management is everything.



In the face of such insurmountable and unknown uncertainties, what is an investor to do? We'll do a Pascal's wager on each company that we're going to do an investment in. We're going to focus on what we know and hope for the best. How about this as an action plan?

1. Value each company to the best of your abilities, in the most conservative manner and apply an adequate margin of safety in case your 'conservative' turns out to be not too conservative. How about a margin of safety for the margin of safety?

2. Think not of the growth, nor the earnings, but rather the downside. Think what happens if you're wrong. Think about what can make the company fail in the next 10 years, not what can make the company become the next triple-bagger in the next 10 weeks.

3. Can you trust the management to handle the company you're going to invest in? Are they shady? Do they have a sense of idea how to handle the company in crisis, and how to avoid joining the herd in bullish times? Do they blame others when they made a mistake? Do they think about the employees and cut them off like weeds when times are bad?

I cannot overemphasize this: Do your due diligence and hope for the best. In an uncertain world, we cannot hope to know everything. So the best plan is to make sure you're not overexposed to the downside. Being an investor would necessary mean that you have to handle uncertainty as naturally as breathing - to invest when you do not have all the information and to invest when times are uncertain.

Take care of the downside, the upside will take care of itself

[winston]

Hi la pap,

I think Warren Buffet has mentioned somewhere that you need to buy a business where an idiot would be able to run it because one day, an idiot would really be running it. From personal experience, I have seen this a few times in my career in the Corporate World..

Following on the above, I would look at the Business first. If it fulfills all the qualities of a good business, then I would probably be paying more attention to it rather than to first look at the Management and not the Business...

Maybe I'm very biased about Management as I think they are sometimes abit over rated. I have seen CEOS of Most Admired and Most Respected companies at work before. When they were hired to run mediocre companies, they are not able to turn those companies around. That tells me that these guys were never worth their salt in the first place.

The results were good because of the business and as long as they dont do stupid things like asking for 40% growth in a sunset industry, the business would be able to survive. Because when they do stupid things like asking for 40% growth in a sunset industry, the only way to get those numbers is to acquire companies. And they tend to acquire lousy businesses. Always ask why are the Sellers selling ...

Take care,
Winston

[la papillion]

Hi W,

Thks for your thoughts on my post. I agree with you. Management is hard to figure out. I'm blogging out the thoughts because I think I've been overly concerned with the numbers and not the non-numbers aspects of analysing. Used to think about ratios and such, but realised that is the result of something intangible, not the end by itself.

Oh, so much to learn

[Musicwhiz]

Value investing is qualitative + quantitative + also a healthy dose of common sense.

I am still working on the common sense part.....

[Poles]

if all decisions can be based on numbers & ratios, then can put in s/w.....no need to keng so much...hahha.....but we are dealing with humans ,whom most of the time are irrational.

[helios]

WOW!

this thread is so shiok!!

How about being part of the Management?

Have a dip in the decision makings. Plan the menu, see what you have on your plate, and steer the company around?

Management = Operators (People) = Value