Agora Financial’s Rude Awakening

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Laguna Beach, California

·      Markets off to a snappy start for the year, but for how long?
·      Lessons from one great investor on how to profit during depressions,
·      One part guess, one part reason: have you say on the year ahead and more…

Eric Fry, reporting from Laguna Beach, California…

So far, the New Year on Wall Street is nothing like the old year. After the first two trading days of 2009, the S&P has already gained nearly 3%. By contrast, the first two trading days of 2008 produced a LOSS of nearly 4%. And we all know what happened next…the S&P 500 continued losing, day after day and month after month, until it had swooned 37% by the end of the year.

A series or crises, panics, bankruptcies and near-bankruptcies chased investors out of stocks and every other asset that was not a Treasury bond. As investors flocked into the safety of AAA-rated Treasurys, yields tumbled to 50-year lows. At one point, the flight to safety became so crazed that 3-month Treasury bills offered no yield whatsoever. But 2009 is nothing like 2008. Bond prices have plummeted, pushing the yield on the 30-year Treasury bond back up to 3.0% from 2.55% just three days ago. Meanwhile, investors have returned to the stock market.

The upbeat start to 2009 does not guarantee that the worst of the credit crisis is over, or that a new bull market in stocks has begun. But the upbeat start does, at least, produce a cease fire that allows investors to conduct triage on their portfolios and care for the wounded.

Some of the “wounded” are beyond hope, and should be shot right where they lie. Others will recover, given enough time. Still others are perfectly healthy, but just wearing the soot and ashes of the harrowing campaign of 2008. Sure they may be suffering a little post-traumatic stress, but they’ll be good to go once the smoke clears.

This latter category of stocks is the group that deserves our attention. These are the stocks that merely appear disabled, but are actually as healthy as a teetotaler’s liver. And these are the stocks that forward-looking investors should be buying whenever panic selling sweeps through the financial markets. This classic contrarian philosophy has produced a number of very large fortunes, including that of John Maynard Keynes, the famed British economist.

Although Keynes famously acknowledged that “markets can remain irrational longer than you can remain solvent,” he did not lament this tendency. He merely incorporated it into his investment philosophy. Keynes invested very selectively and very patiently. “My purpose is to buy securities where I am satisfied as to assets and ultimate earnings power,” said Keynes, “and where the market price seems cheap in relation to these.”

In today’s edition of the Rude Awakening, “Anti-Depression Remedies, Part II,” Chris Mayer takes a deeper look into the investment wisdom of John Maynard Keynes. [If you happened to have missed the first edition of Chris' "Anti-Depression Remedies," click here: http://www.agorafinancial.com/afrude/2008/12/18/anti-depression-remedies ].

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Anti-Depression Remedies, Part II
By Chris Mayer

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.

As Walsh points out, Keynes spent his last six years as an unpaid Treasury adviser. He outlived his parents, who left him no inheritance. And Keynes was a great patron of the arts, financing many ventures out of his own pocket. To finish with such a grand sum sent London society abuzz. “Some surprise has been expressed about the large fortune left by Lord Keynes,” reflected the Financial Times. “Yet Lord Keynes was one of the few economists with the practical ability to make money.”

It wasn’t easy for Keynes, as these things seldom are for anyone. 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. Interestingly, the crash hurt Graham too and motivated him also to think deeply about the process of investing. The two great money minds came to nearly the same place in their thinking.

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. When the market fell, Keynes remarked: “I do not draw from this conclusion that a responsible investing body should every week cast panic glances over its list of securities to find one more victim to fling to the bears.”

Keynes also 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.

Keynes was an adviser to an insurance company, as well as manager of the Chest Fund. 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. 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.”

He also learned to hold onto 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 also 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. Committees and others repeatedly criticized Keynes for making big bets on a smaller number of companies. In a typically witty reply, Keynes defended his views. In this case, his critics accused him of making too large a bet on Elder Dempster: “Sorry to have gone too large on Elder Dempster. I was suffering from my chronic delusion that one good share is safer than 10 bad ones.”

He rejected the idea, as Buffett and other great investors have, that you dilute your best bets by holding a long list of stocks. 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. Walsh dates Keynes’ adoption of what we’d think of as a Warren Buffett sort of approach as beginning in 1931. From that time 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.

As investors wonder whether we face a 1930s-style market or not, I found a review of Keynes’ investing career useful and inspirational. The more I study investing, the more this same handful of ideas and principles seems to recur…among successful investors, that is.

[Joel's Note: If the only criterion e for publishing essays on investing in these humble Rude pages was that the author had to be one of the “good guys,” we’d run Chris’ work every chance we could get. But being a nice guy is only ONE of the necessary elements; your investment strategies also have to work! So, with this additional prerequisite, we choose not only to publish Chris’ essays every change we get…but also to occasionally republish them.

If you’re thinking of taking advantage of the many discount opportunities that await the career value investor in 2009, we highly suggest taking a gander at Chris’ flagship service, Mayer’s Special Situations. Not only does Chris share lessons from history’s greatest investors, he also applies his growing body of knowledge to his own security analysis. For instance, he’s recently discovered a royalty program that allows you to earn money on prized resource stocks, without all the usual risk.  Read on here if you’d like to get started.

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[Rude Endnote: “Real inflation to hit 30+% this year,” one reader wrote in response to our request for predictions for the year ahead. “Watch gold and silver soar!”

Perhaps you disagree? Perhaps you believe that “deficits don’t matter,” that the future of the greenback is sound and solid, that emerging markets will continue imploding as a result of a slowdown in the west?

Will gold go for peanuts by next New Year’s Eve celebrations? Or will those who hold physical bullion be the only revelers toasting the occasion? Or do you think, as one other reader morbidly put it, “we’ll all be dead by then anyway, so why bother?”

Feel free to opine ’till your heart is content with your fine-tuned predictions, well-reasoned forecasts and outlandish guesses for the year ahead. Emails go to the address below.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com