Buffett, Keynes & Graham

Unusually for a billionaire, the American investor Warren Buffett (with an estimated net worth of $80 billion), is not customarily considered an exploiter of the masses, or a symbol of the failure of capitalism. Having made his fortune by investing an initial stake made from the proceeds of his paper round and some friends-and-family funds, The Sage Of Omaha lives a famously frugal life, spending his days reading company reports with no large staff or extravagant personal indulgences. His lifestyle and folksy manner may help explain this positive reputation, as may his devoted acolytes who invested in Berkshire Hathaway (his investment fund) along the way; more likely though, is the specific philosophy and method that underpin Buffett’s extraordinary investment track record. 

Buffett is well known for his long term investments in apple-pie-Americana symbols like Coca-Cola and Sears Candy, and for his historical eschewing of what is fashionable on Wall Street. Certainly, this, not being based on Wall Street and clearly not being a part of the financial establishment has been a further boon for Buffett’s reputation. But his and long-time investor partner Charlie Munger’s strategy itself contains in it a kernel of a wider life-lesson; a form of wisdom indicative of a mind that understands far more than the operation of vulgar money-making. The very fact that Buffett openly calls for himself and his billionaire peers to be taxed more, and that having spent a lifetime creating his fortune he is subsequently giving it all away to charity, suggests the importance of his depth of thought. 

The basis of Buffett’s strategy stems from the school of thought of value investing, pioneered by Benjamin Graham (who was both a tutor and partner with Buffett early in his career). In short, purchasing stocks and other assets on the basis of their underlying subjective value, regardless of the fads and fashions of the stock market. This relies on dispassionately investing for the long term, waiting for ‘true’ value to reveal itself, and avoiding both the panic and the irrational over-optimism of the general public. Buffett once said that if you understand chapters 8 and 20 of The Intelligent Investor (Benjamin Graham, 1949) and chapter 12 of the General Theory (John Maynard Keynes, 1936) 'you don't need to read anything else and you can turn off your TV.' Here we will examine those chapters and their relation to investing. 

The General Theory Of Employment, Interest & Money, is John Maynard Keynes’ magnum opus, published in response to The Great Depression and it’s failed policy response. Whilst Keynes wrote in reasonably technical terms on macroeconomics, chapter 12 sits somewhat outside of the general schema, as Keynes himself acknowledges, dealing as it does with the uncertainty involved in any future investment decisions in an economy. In addition to being the world’s preeminent economist and a public policy advisor, Keynes was an active investor on the stock market. Investing his own wealth as well as managing the funds of King’s College, Cambridge University and several insurance companies, he took King’s College’s assets from £30,000 to £380,000 at the time of his death, a compound growth rate of 12%. This is all the more remarkable when one notes that all dividends were spent on the college rather than being reinvested, and that (due mainly to the Wall Street Crash and World War II), the British stock market fell 15% in the same period.

Benjamin Graham was an economist and investor, and author of two seminal books on investing, Security Analysis and The Intelligent Investor, and is best known for his pioneering Value Investor strategy described above. Whilst Graham is not in the same league as Keynes as an intellectual figure, his influence on Buffett was far more profound, with Buffett describing The Intelligent Investor as “the best book about investing ever written”, and describing Graham as the second most influential person in his life after his father. 

Keynes’ General Theory stipulates that aggregate demand consists of consumption and investment, and that if investment is below a certain level, an economy can be in equilibrium below full employment. Investment is determined by the relation between the rate of interest and the marginal efficiency of capital. The marginal efficiency of capital depends on the supply price of an asset relative to its prospective yield. Simply put, we judge whether to make an investment if the return on our initial stake exceeds the rate of interest we will receive without risk. That decision is of course uncertain, since we don’t actually know what our annual return might be if we invest £10,000 in our friend’s new bakery. 

The uncertainty involved is redoubled when we are speaking about investing in the stock market, and Keynes gives several reasons that this is the case. If I buy shares in Amazon, the total price of all the shares in existence should reflect the true total value of the company. But if there is a higher proportion of investors with no real knowledge of the workings of the company, the price will be a less accurate reflection of true value. Day to day fluctuations of share prices often reflect trivial or ephemeral changes in profit for a company, such as an ice company trading at a higher share price in the summer - this is not rational. Further, mass psychology of the market sentiment will wildly swing the stock price regardless of the effect on the company’s profit of the cause of that psychological shift. A breakthrough in Brexit talks will spike all shares on the FTSE100, including companies who will be unaffected. 

All these follies can be mitigated by professionals on a stock exchange. If Wall Street bankers spent all day identifying mistakes of mass psychology and amateur investing, and profiting from those mistakes, they would be eliminated by arbitrage. This however, is not the pastime of the average broker, according to Keynes. Professional investors are concerned not with dividends paid out by profitable companies, but the share price itself, often over short periods of time. The determinant of this price is as often general market sentiment or mass psychology rather than a dispassionate valuation of the company based on its fundamental financial and market attributes, and so the job of the trader is not to judge the company but to anticipate the trader’s view on the company. Or to anticipate the trader’s view on the trader’s view of the company. An investor might rightly ask, ‘who cares if Amazon’s share price represents double it’s true value as judged by its balance sheet, if the price is expected to continue to rise?’. This Keynes describes as a game of musical chairs, in which the only object is not to be the last person to sit down when the music stops (as it did in 1929, 1987 and 2008). “Professional investment may be likened to one of those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick not those faces which he himself finds prettiest, but those which he thinks are likeliest to catch the fancy of other competitors, all of whom are looking at the problem from the same point of view.” The above quote explains why mass panic in the market is not necessarily irrational - one may need to sell because of the sentiment itself even if one is in possession of the truth that the panic is unfounded. 

From Keynes’ perceptive description of the workings of the market, follow Graham’s instruction as to how an intelligent investor must respond. Chapter 8 in The Intelligent Investor cautions that whilst it is natural to monitor prices of one’s portfolio, one must avoid becoming a speculator. Graham makes the distinction between making a profit from pricing and timing. Pricing is buying shares below their true value, whilst timing is buying and holding when a share’s trajectory is up, and selling or abstaining when it is down. Timing is the road to speculation. One can link this statement directly to Keynes’ chapter 12, since timing is entirely dependent on the sentiment of other participants in the market, whilst pricing depends on an assessment of the company. Thus by avoiding timing, one is not entering the ‘newspaper competition’ Keynes describes. Looking at the cyclical nature of markets, one could of course plan to buy only during a bear market, and sell only during a bull market. This is the logical and obvious course of action. But how could anyone ever know what is the top or bottom of any market, when fundamental values are discarded? A more nuanced version of the previously stated strategy might be to slowly sell small portions of a portfolio as stocks rise, thus locking in gains as time goes on. Whilst this sounds conservative and sensible, Graham points out that the same problem persists. If one were to follow this strategy in the 1950s, by 1954 the entire stock portfolio would have been sold, such was the growth of the market in that year. An investor who had followed such a strategy would then have sat on the sidelines awaiting a slump for a further 5 years, as stocks doubled in value. Any systematic strategy given by professional forecasters or found in historical data will, according to Graham, either fail to work due to fundamental uncertainty in the world, or (even if they were ‘true’ patterns), become widely adopted and therefore self-defeating. 

Graham encourages investors to see that in owning shares, they have a dual position. Firstly, the shareholder is a part owner in a company, able to value the shareholding based on its balance sheet and profit & loss account. Secondly, they are a holder of a highly liquid share certificate which can be sold at any moment for a quoted price. Often highly popular ‘superstar’ companies have shares quoted way above the book value. This makes an investor a hostage to fortune in the sense that one’s investment is subject to the sentiment of other investors holding. Again this relates to Keynes’ description of the market. Graham states that companies with great prospects can be found on the tier below that are not over priced in this way, and that the intelligent investor ought to buy them instead. 

It is important to realise that whilst systematic and grounded in logical analysis, Graham’s advice to investors is also a psychological one. Both he and Keynes argue that it would often be advantageous to not be quoted a price at all times for one’s investment - Keynes because it would make overall investment in an economy more rational, Graham because it would avoid the temptation to acquiesce to feelings of greed or fear. It is in the latter part of chapter 8 that Graham introduces the now famous metaphor of Mr Market. Imagine he says, if you had a friend, the obliging Mr Market, who every day offers to buy from you your shares. Some days Mr Market is extremely optimistic, and will pay far in excess of the true value of your shares; other days the schizophrenic Mr Market will be extremely pessimistic and offers you a pittance. 

This states Graham, is the situation in which anyone owning shares does find themselves, and of course, his central point is that on no particular day is the intelligent investor obliged to take him up on his offer. Selling because the market is going down is the greatest folly of all.

Having established clear arguments in favour of attempting to profit from pricing rather than timing, we move to chapter 20 of The Intelligent Investor, entitled Margin Of Safety. How can one avoid, having purchased shares in a company for all the right reasons, falling prey to the panic that often engulfs stock markets? To quote Warren Buffett, “in order to succeed, you must first survive.” This can mean firstly and most directly, factoring in the fundamental uncertainty in the world, by following an investment strategy that leaves a margin of error. The margin for safety as defined by Graham is the difference between the percentage rate of return on your investment and the return on risk free bonds. This needs to be high (he says ideally 5X) in order to factor in that one cannot know in advance the actual rate of return with any accuracy. When one looks at an investment in these terms he argues, diversification is a natural companion of the margin of safety. For only if the odds are significantly in your favour on each investment will diversification have any effect at mitigating the inevitable bumps in the road. 

More broadly speaking, the margin for safety concept immediately gives one a better chance at distinguishing between investment and speculation. The boom in ‘junk bonds’ in the 1980s stemmed from the realisation that bonds issued by financially suspect companies (junk bonds) were paying a yield that far exceeded the actual risk of default. By holding enough of these the investment was a prudent one. Graham gives a similar example of housing bonds that crashed in 1929; assets that seem ‘speculative’ at face value are in fact good investments based solely on the criteria of margin for safety. Price versus true value is the only test to which an investor must subject herself. 

The essential message of Graham’s chapter 20, is that consequences must dominate probabilities in investing. Long Term Capital Management (LTCM) almost brought down the financial system because they failed to heed this message. Nobel Prize winning economists and mathematical ‘geniuses’ developed models that reliably identified tiny errors in pricing, and used massive leverage to exploit these gaps. After a few years of extraordinary profits, LTCM bankrupted itself, realising only later that the small size of the error is of far less importance than the consequences of the leverage. Similarly, if one is confident that the business in which they have bought shares is worth far more than Mr Market is offering, they must be in a financial position to turn him down. Money managers who must show the highest possible percentage return on the funds at their disposal must necessarily use all funds to hit their target return. Often they might leverage $100 into $1000 in order to reach returns that will impress their employer. This sort of leverage is exactly why, when a panic occurs they are forced to sell simply to meet obligations, and why panics cascade into crashes. Both Buffett and Munger advocate keeping at least a third of the portfolio in cash, so that such occasions can be exploited, as bargains will abound for the few left able to buy. Nassim Taleb’s ‘Barbell Strategy’ follows a similar logic; since we cannot truly know if something is ‘medium risk’, he advocates 80% of a portfolio be held in ultra safe cash or equivalent, and 20% invested in ultra-speculative, ultra-high-risk-and-return investments. This was one simply cannot go bust.

It is important to note that the above exposition of three important chapters mentioned by Buffett do not accurately reflect his investment strategy as such. Keynes’ chapter is merely an excellent representation of the behaviour of stock market investment before such descriptions were commonplace. Graham’s chapters represent the central tenet of Value Investing, which was Buffett’s doctrine early in his career but later rejected. This is not to say that Graham’s principles were later considered wrong by Buffett (lest this would be a pointless examination of those principles), more that Buffett adapted and improved them. Having made millions as a value investor, Buffett came to value intangibles such as brand power more highly than the cautious Graham. Furthermore, he came to realise that a wonderful business, which was set up to be successful for years or decades, was worth paying for, even when the price was well in excess of book value. By holding all shares under a company (Berkshire Hathaway was originally a textile firm), all profits could be reinvested before being taxed, allowing Buffett’s portfolio to grow ever bigger. Similarly, Buffett bought insurance companies, giving himself a reservoir of cash with which to invest. Nonetheless, all these things stem from his disdain for naked speculation, for the virtue of margin of safety, and for rendering oneself immune to the whims of Mr Market.

It is interesting that Hyman Minsky’s critique of New Keynesianism was it’s failure to anticipate the macroeconomic problems caused by finance; it’s failure to factor in the uncertainty of which Keynes was so keenly aware. Serenity in the markets causes overconfidence, which causes ever greater speculation, which causes volatility. Such volatility would cease to exist if all investors based their valuations on sober, realistic company valuations in the way that Benjamin Graham did. Buffett advocates such an investment strategy publicly and often, yet were all investors to heed his advice, his profits would vanish. Just as he asks for higher taxes for billionaires, and works into his eighties to make money in order to give it away, the paradox of Warren Buffett is that his investment strategy transcends his investments. The virtues of patience, of the avoidance of panic and greed, and of long term thinking transcend the world of finance as much as Buffett himself.