Trading the Way the Teacher of Warren Buffett’s Teacher Pioneered
Warren Buffett is a folk hero to many individual investors. From his perch in Omaha, Buffett has proven himself to be a master of Wall Street. His investment philosophy is widely studied, and individual investors are inspired by Buffett.
But, as the economist John Maynard Keynes explained, Wall Street is, at least in some ways, not the problem that it appears to be.
The Famous Keynesian Beauty Contest
To understand the problem of Wall Street, Keynes, who was also a successful investor, once explained that investors should think of the stock market trading in the way readers should play a newspaper’s beauty contest.
In the newspaper’s contest, readers are asked to choose the six most attractive faces from a hundred photographs. The results of all entries are used to determine the six most attractive faces. The biggest vote getter is the most popular, the second biggest vote getter is the second most popular, and so on.
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Readers with the highest number of correct guesses are then entered into a drawing for a prize.
Some readers will pick the six faces they find most attractive. These readers, Keynes explained, aren’t really playing the game. To maximize the chance of winning the prize, readers need to identify the six faces they believe the most readers will find attractive.
Now, some readers will go a step further, or as Keynes wrote in his 1936 classic book, General Theory of Employment, Interest and Money:
“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
In 2011, National Public Radio’s Planet Money put this idea to the test. They asked listeners to pick what they considered to be the cutest of three cute animal videos.
Listeners were divided into two groups. One selected the animal they thought was cutest, and the other selected the one they thought most participants would think was the cutest.
Half of the first group (50%) selected a video with a kitten. They thought that was the cutest video. In the second group, the ones predicting which video most people would find to be the cutest, 76% picked the kitten video.
NPR concluded these results were consistent with Keynes’ beauty contest theory. Individuals in the second group were generally able to disregard their own preferences and accurately make a decision based on the expected preferences of others.
The Third Degree of a Wall Street Legend
Buffett has never explained exactly how he makes investment decisions. His silence has led to a search for those who influenced his thinking. Buffett has explained that Ben Graham was a significant influence in the development of his philosophy.
Many investors now read Graham’s books for insights into Buffett’s thinking. On the cover of Graham’s The Intelligent Investor, Buffett wrote, “By far the best book on investing ever written.”
Keynes might explain that Graham is the second order of thinking about what Buffett might do but there are some investors operating at higher orders. Those investor’s might be studying books like John Burr Williams’s The Theory of Investment Value.
The Importance of Dividends
Williams is recognized as the first to recognize the value of dividend investing. He wrote his book in 1938, about the same time Graham’s work with David Dodd, Security Analysis, appeared. While Graham and Dodd focused on earnings, Williams focused on dividends.
Williams believed that the intrinsic value of a company was equal to the present value of its future dividends, not earnings. “Earnings are only a means to an end,” Williams argued, “and the means should not be mistaken for the end. Therefore, we must say that a stock derives its value from its dividends, not its earnings.”
Like Graham, Williams was a writer of many talents and he included a poem to explain his belief in the importance of dividends:
A cow for her milk
A hen for her eggs,
And a stock, by heck,
For her dividends.
An orchard for fruit,
Bees for their honey,
And stocks, besides,
For their dividends.
The poem may not be a literary classic but is almost certainly one of the most important poems in the annals of finance.
Graham published a review of the book in The Journal of Political Economy, and noted the value of dividends for safety, “The emphasis on the primacy of dividends and the insistence that the value of reinvested earnings is to be found only in increased dividends sound a much-needed warning to Wall Streeters.”
Some companies don’t pay dividends and Williams suggested valuing them assuming they pay dividends later, “If earnings not paid out in dividends are all successfully reinvested, then these earnings should produce dividends later; if not, then they are money lost. In short, a stock is worth only what you can get out of it.”
Putting These Ideas to Use With Options
It is simple enough to screen for high dividends and to add filters to identify dividends that are likely to be safe. This can be done with the free stock screening tool available at FinViz.com. An example of the criteria for that screen are shown below.
This screen is simply looking at very large companies (megacap) stocks, headquartered in the United States. These factors will help ensure safety. Large companies are reluctant to cut dividends and rarely do so. Companies in the US tend to pay regular dividends while dividends in other countries can vary with earnings.
The payout ratio measures how much of the company’s earnings are dedicated to dividends. The lower the payout ratio, the safer the dividend. This screen restricted buy candidates to those with payout ratios that are below 50%. The list of stocks is tend sorted from highest to lowest dividend yields.
According to Williams, these are the stocks that are likely to be among the best performers in the long run. However, dividends will only account for part of the stock’s total returns. These stocks are likely to increase in value and deliver capital gains for share holders.
Buying call options allows investors to participate in capital gains in the stocks with limited risk.
Among the potential buys are:
- The Procter & Gamble Company (NYSE: PG) January 2019 $90 calls for about $5
- Wells Fargo & Company (NYSE: WFC) January 2019 $60 calls for about $5
- Intel Corporation (Nasdaq: INTC) January 2019 $45 calls for about $3.50
This is a relatively low cost, long term portfolio of stocks that could be among the biggest winners of the next year. It’s interesting to note that Buffett owns large stakes in two of these companies, PG and WFC.
This long term strategy is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide exposure to stocks for the long term at just 7% of the cost of owning the individual stocks.
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