A lesson from the other ‘sage’ of investing

In his famous letter to Berkshire Hathaway shareholders in 1988, Warren Buffett declared: “When we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever.” Compare this statement, apparently from a kindred spirit: “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.”

Earlier, in 1984, Buffett had explained his view on diversification by approvingly quoting the theatre impresario Billy Rose: “If you have a harem of 40 women, you never get to know any of them very well.” Here’s that kindred spirit again:

“It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.”

In each case the second statement is from a man who is as quotable as the Sage of Omaha himself: John Maynard Keynes, writing to a colleague in 1934. The affinity between Buffett and Keynes isn’t a new discovery but a newly published study of Keynes’s investments for King’s College, Cambridge allows us to see whether Keynes took his own advice, and whether the results paid off.

Keynes had dabbled in currency speculation after the first world war, trading on margin and realising both large losses and large gains. But after assuming responsibility for the college’s investments in 1921, Keynes had to take a different approach. He persuaded the college to liberate part of its endowment from its traditional, highly conservative strictures, and it is this “Discretionary Portfolio” which has been tracked by David Chambers and Elroy Dimson of Cambridge’s Judge Business School.

At first, Keynes – who arguably invented the very idea of macroeconomics – relied on his gifts as an economist to time the business cycle, moving in and out of investments as economic trends dictated. It speaks volumes about macroeconomics that even for Keynes, this approach was not a success. By August 1929, the Discretionary Portfolio lagged behind the UK equity market by a cumulative 17.2 per cent. Worse, the stock market collapsed in September and Keynes had failed to see it coming.

Chambers and Dimson then document a change in Keynes’s approach. Instead of trying to anticipate macroeconomic trends, Keynes searched for undervalued stocks, bought substantial holdings and tended to hold on to them. He favoured companies that paid generous dividends and distressed companies that held out the possibility of recovery. This approach paid off handsomely, dragging Keynes’s lifetime track record with the Discretionary Portfolio up to a 16 per cent annual return, well above the 10.4 per cent of the market as a whole.

But Keynes was not just a successful value investor, he was an investment innovator. He appears to have developed the basic principles of value investing independently of Benjamin Graham, the man most closely associated with the approach. And he advanced the idea that equities were a fit investment for the likes of King’s College, at a time when any respectable investor would have stuck to property and bonds.

One note of caution, however: Keynes was very well connected, particularly in the mining sector, where he invested heavily and successfully. Insider trading was also legal in Keynes’s day.

Chambers and Dimson don’t think that the latter is the chief explanation of Keynes’s success. That said, he was so well connected that in 1925 he even received advance notice that the Bank of England’s interest rate was to change. Value investing is a fine idea – but perhaps a little easier to pull off if you are John Maynard Keynes.

Tim Harford’s ‘The Undercover Economist Strikes Back’ is published this week by Little, Brown