The Hindu Business Line : Keynes’ thoughts on investing

John Maynard Keynes – the name rings a bell for several reasons, an economist who proposed government spending to fight slowdowns and the one who predicted the rise of Germany under the Third Reich, due to the harsh reparation terms for the First World War.

While Keynes may be widely cited for his works of economics, he was also a savvy investor and had several insights to offer about how equity markets function and how assets are priced. We capture some of his thoughts here.

A chapter innocuously titled The State of Long-Term Expectations in his 1936 magnum opus, Theory of Employment, Interest and Money, has deconstructed how equity markets operate. Unsurprisingly, most of the insight still hold true.

Keynes says the basis for valuation is the estimation of what an asset will yield over its lifetime.

Mind you, he makes a clear distinction between the price you pay for an asset and the return or payout you get from it, the latter being a virtue of its efficiency and output. Keynes makes the point that the distinction between the two has been lost with the increasing emphasis on capital appreciation.

The idea behind equity markets was to to spread the ownership base for business and make frequent payouts from the profits in the form of dividends that allowed investors to recoup capital. Therefore, greater the payouts relative to the prevailing interest rates, the greater the incentive to invest in a certain asset.

What contributes to the disconnect between price and intrinsic worth is when investors stop valuing the payout and emphasise the price.

Problems with estimates

According to Keynes, managers and entrepreneurs are better placed to gauge the likely yield from an investment, as they are backed by experience. By virtue of this experience, some arguably factor in the risk associated with the uncertainty of their expectations more effectively than others.

Long-term expectations for investors can go wrong because our conviction is often based on current knowledge, which may not be an accurate indicator of the future.

As Keynes put it “the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations...” This phenomena comes a full circle when the confidence we place in our conviction dictates the way we invest in assets.

Keynes also notes that “liquidity” often drives asset prices away from their actual worth. The market, under the guise of providing liquidity, revalues an investment several times every day.

This as “is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week.”

While the markets operate to enable transfer of ownership of investments, the price fluctuations wind up affecting the current rate of investment. This constant revaluation is very capable of distorting the potential yield of an asset.

This explains why someone like Warren Buffett would prefer to hold his companies privately. It possibly saves Buffett the pain of obsessing over market pricing and focus on business results.

When there is “liquidity”, there is a real risk that the rate of investment will be governed by the average opinion of market participants rather than the “genuine expectations” of an entrepreneur.

The problems with this are manifold. As the number of participants grows, it is likely the quality of knowledge backing the long-term expectations diminishes. “Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market,” writes Keynes.

Long-term expectations without strong roots are likely to deteriorate into mere opinions, which may end up having no bearing on the actual long term payoff from the investment.

Liquidity while providing an individual an exit option, there is as Keynes says “no such thing as liquidity of investment for the community as a whole.”

There are several hurdles for any investor who looks to dig deep, dissect a business and look to hang in there for the long haul.

To borrow Keynes words: “The professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced.”

Says he, “The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future.”

When investing becomes about “devoting our intelligences to anticipating what average opinion expects the average opinion to be”, rest assured there will be no quality opinions left standing.

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