John Maynard Keynes was one of the most influential economists of the twentieth century and a highly successful investor. However, he came close to being wiped out by the stock market crash of 1929. Yet, through disciplined application of his contrarian approach, Keynes soon recouped his position and went on to build a substantial private fortune. From this experience Keynes has given us insights into some of the key principles that stand behind successful investing. First amongst these is the principle that investment success does not stem from following the market or by herding with other investors. Crowds might be right for a short time. But it is a mathematical impossibility for the crowd to beat the market over time. Rather, investment success stems from standing apart from the crowd. As Keynes noted, investing is a “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.”

Keynes’ principle gives us a useful perspective in the current equity market environment. Since the middle of last year, financial markets have been washed over by waves of anxiety relating to the global economic slowdown, substantial increases in commodity prices (especially oil), rising consumer price inflation, increasingly beleaguered consumers, stressed credit markets and, related to all of this, an increased incidence of distress or failure amongst banks and financial firms, including the recent government-led rescue of Freddie Mac and Fannie Mae in the United States (US). Consequently, it is hardly surprising that 35 of the 49 markets that make up the MSCI World Index have experienced declines greater than 20 percent year to date (measured in US dollar terms), with the much vaunted emerging markets of Brazil, Russia, India and China (the so-called BRIC countries) having experienced declines of between 28 percent (Brazil) and 43 percent (Russia). The extent of depression about world equity markets is further evidenced by the fact that only two of the 49 markets making up the MSCI World Index have produced gains year to date, namely Morocco (9 percent) and Jordan (6 percent). Collectively, these two markets account for less than one-tenth of one percent of the World MSCI Index. In US dollar terms the South African equity market, measured by the FTSE-JSE All Share Index, is off more than 20 percent year to date.

This gloomy backdrop, however, quickly restores Keynes to the picture. By stepping away from the crowd sentiment that has driven market participants to single-mindedly sell into the gloom, investors will start to notice opportunity. For instance, in the case of South Africa’s JSE, the market’s price-earnings ratio has fallen from a local peak of 17.6 times trailing earnings at the start of 2007 to the current 11.2 times. Interestingly, and as shown in the figure, taking the past fifty years of market history as a guide, when the JSE trades on a price-earnings ratio of 17.6 times, the following five-year return equates to 10.1 percent per annum. By contrast, a price-earnings ratio of 11.2 times equates to an average annual return of 19.6 percent. Despite this material improvement in prospective returns, investors were far more excited about the market when it was priced on the much higher ratio in early 2007 than they are today. By taking advantage of this type of perverse investor behavior, those who are willing to “buy on the cannons”, or buy when others are fearful, will do far better than those who buy with the herd or sell when others are selling. 

Source: Adapted from Cannon Asset Managers

Of course, being a true contrarian, Keynes’ inquiry did not stop with establishing whether a market was expensive or cheap, but extended to discovering attractively priced investments in attractively priced markets. If we bring the principles of value investing into this contrarian stance, this amounts to finding sectors that house companies which, amongst other things, trade on a low price-earnings ratio, a low price-to-book ratio or a high dividend yield.

In the case of the South African market, a handful of sectors stand out as offering deep value if measured by comparing the sector median of these multiples to the market median, namely banks, life companies, financial asset managers, furniture and motor retailers, transportation and packaging (see the table below).

keynes table

It is hardly surprising that these sectors are amongst the least loved by investors in South Africa at the moment given the particular concerns surrounding the financial sector (asset managers, banks, life companies) and the health of the economy, especially the consumer-led parts of the domestic economy (furniture and motor retailers, in particular). The extent to which investors have fallen out of love with these sectors is evidenced by the fact that, on average, prices in these six sectors have fallen by more than twice the market. With such price declines it takes high conviction and a willingness to go against the crowd to buy stocks in these sectors. In short, however, and in obeying Keynes’ principle, the best opportunities are available in the least loved parts of the market, with investment success being fashioned from the disciplined application of a contrarian view. Of course, being contrarian is difficult, which is why success will continue to go to the few.