John Maynard Keynes (1883-1946) was one of the most influential economists of the 20th century. After his magnum opus, The General Theory of Employment, Interest and Money, came out in 1936, it revolutionized economic thought and the macroeconomic policies of governments around the world.
Keynes was also an active investor who outperformed the market by a wide margin. Let’s take a look at how this was done.
In addition to his work as an economist, he was involved in managing the portfolios of several institutional investors. Of note was his direction from 1921 to 1946 of the endowment fund at King’s College (one of the colleges at the University of Cambridge).
Keynes generated an average annual return of 16 per cent on the fund’s discretionary stock portfolio, exceeding the market’s annual return of 10.4 per cent by 5.6 percentage points. This is what Elroy Dimson and other academics found from an examination of the fund’s archival data, as published in their 2015 study, Keynes the Stock Market Investor: A Quantitative Analysis.
Keynes’s personal portfolio mostly mirrored the endowment fund, so he likely earned a similar return in his own account. It’s possible he may have done even better, assuming his dividends were reinvested (the endowment fund’s dividends were not reinvested but spent by King’s College).
During the 1920s, Keynes plied a top-down approach. He used his expertise in economics to shift money in and out of the stock market according to the swings in business and credit cycles. Returns were positive because the stock market boomed during the Roaring Twenties. Nonetheless, the endowment fund still underperformed by a cumulative 12.5 percentage points up to 1930.
After failing to foresee the stock-market crash of 1929, Keynes lamented: “We have not proved able to take much advantage of a general systematic movement out of and into ordinary shares as a whole at different phases of the trade cycle.”
He abandoned the top-down macro approach in the early 1930s to focus solely on a bottom-up approach of long-term investing in undervalued companies with solid balance sheets and good commercial prospects. This called for a careful analysis of the fundamentals of individual companies – then sticking with one’s picks through thick and thin, unless an error was discovered in the analysis.
Keynes also preferred a portfolio that took large positions in a few “enterprises which one thinks one knows something about.” He thought it was “a mistake to think that one limits risk by spreading too much between enterprises about which one knows little.” But even with a concentrated portfolio, one should hold some stocks with “risks that were opposed.”
This was the approach that outperformed for him. It more than made up for the underperformance of the 1920s, enabling the endowment fund to surpass the market index over the quarter century to 1946 by a substantial 5.6 percentage points a year. This approach was similar in many respects to the one followed by Benjamin Graham at the time and later by Warren Buffett. But Keynes adopted it independently of both men.
Buying common and preferred stocks in the 1930s took a lot of courage when markets were down by as much as three-quarters from their 1929 peaks. One thing that fortified Keynes was Edgar Lawrence Smith’s 1924 book, Common Stocks as Long Term Investments. In a review of the book, Keynes wrote: “Mr. Smith finds in almost every case, not only when prices are rising but also when they were falling, that common stocks have turned out best in the long run.”
Keynes’s endowment portfolio was overweight in public utilities, investment trusts and industrials during the 1930s and 1940s. As for public utilities, Keynes foresaw substantial capital gains on their preferred shares as dividend payments were reinstated after the Depression. The investment trusts had leveraged baskets of stocks that could track a market recovery, somewhat like long-dated call options. In industrials, gold producer Homestake Mining was a substantial holding that was expected to benefit from the U.S. government’s upward revaluation of gold to US$35 per troy ounce in 1934.
Keynes was well-connected but did not rely on inside information or tips. Indeed, “the dealers on Wall Street could make huge fortunes if only they had no inside information,” he once declared.
In the early 1920s, Keynes also tried leveraged speculation in currencies and commodities, using a top-down strategy in his own account. It brought him to the precipice of financial ruin twice. But the bottom-up method he later applied in his stock portfolio eventually helped win the investment battle. At the time of his death in 1946, Keynes’s net worth was close to US$30-million (in current U.S. dollars).