Greg Beckett, the founder of the Richmond Club, recently interviewed Ed Kelly on how he got started with Conscious Investor and some of the results from his research into it as an investment tool. Also see the comments by Professor John Price on Ed Kelly's research. [click here]

Greg Beckett: Who are you and what is your background?

Ed Kelly: My name is Edward Kelly, I am 44, married with 4 small children and I live in Dublin, Ireland. I have a BA and an MBA. I am currently completing a Masters degree (MLit) in finance at Trinity College and plan to do a PhD on Warren Buffet and Conscious Investor. My business background can be divided into two streams, successful ones and non-successful ones. The successful ones are two periods of time where I set up and ran my own business, one for profit, the other a non-profit (i.e. 10 of the last 17 years) and the non-successful ones (4 of the last 17 years) where I worked for other people. The remaining time was spent studying. It seems I seem to do better on my own. In the business sense, I could be described as an entrepreneur in the medium to strong form.

GB: How did you get started with Conscious Investor?

EK: I came to Conscious Investor through reading about Warren Buffet. Back in 1993, I had a plan to raise $100,000 and start an investment fund following the Buffet approach to investing. However, I could not create the investment macros in Excel which were necessary to analyze the numbers, i.e. returns on equity, growth in earnings etc. Anyway, I got diverted into a new business, made quite a bit more than $100,000 and then blew most of it in non-Buffet-like investments in the late 1990’s.

Then one day in 2002, licking my wounds, I came across Conscious Investor on the Sydney Morning Herald website. Wow! Here was the product I needed and wished I had back in 1993! Now someone with real credibility had developed the software that would do all the number crunching for me, leaving me to make the decisions on what I wanted to invest in. An opportunity seemed to be emerging. I thought, this is great; I can now set up a fund and start investing like Warren Buffet. As it happened, I was coming to the end of a 7 year cycle with my business and I was bored and needed a change? Maybe this could be achieved with Conscious Investor?

GB: What do you like about it?

EK: I can’t praise the product highly enough. To be honest, I have not compared it with other products in the market; I don’t need to, as it has all I need. Even if I did, I imagine it would score very highly, assuming there is something else like it out there. It is incredibly powerful. If you think about it, using a long-term conservative approach to stock selection, you can analyze 6,000 US stocks and eliminate 99.9% of them in minutes. This leaves a small number of ‘great performing’ stocks that can then be analyzed in detail. The kind of investing we are talking about, i.e. using ‘excess capital’, i.e. those funds that you have left over as savings needs to be invested wisely and for the long term. The other thing I like about Conscious Investor, and this is more to do with the overall Conscious Investor approach, is the emphasis on linking both sides of your brain while making an investment decision. I.e. the analytical side and the emotional side. I am sure that this is where the real skill lies with Buffet and his partner Charlie Munger. I don’t think Conscious Investor answers all the questions here, but it does go someway to raise the importance of knowing what kind of investor you are. Controlling the voices in your head must lead to greater clarity of thought!

GB: Why did you decide to undertake a research study?

EK: It was confluence of events. Firstly, I came across Conscious Investor at the right time as I was coming to end of a cycle in my business. Secondly, for almost ten years I have been reading about Warren Buffet and wanted to learn to invest like him. Thirdly, I thought at the back of my mind that there might be an opportunity to be involved with the development of Conscious Investor in Europe. However, I wasn’t prepared to get involved in selling something, even if such an opportunity arose, as important as an ‘investment methodology’ until I fully understood it myself and more importantly, fully believed in the credibility of the product. So, I thought I will take some time off, head for the nearest University (ten minutes walk from my house) and start back testing the Conscious Investor approach on the US stock market.

GB: What are some of initial findings?

EK: I have conducted three studies so far, the most important and advanced one of which is the S&P 100 study (1993-2003). This might take a bit of time, but please bear with me, as the results are interesting. I should say that doing a ‘retrospective study’ is peculiarly difficult. For instance, if I picked Wal-Mart back in 1993 because I thought it had strong earnings growth potential, I could be accused of bias aforethought, i.e. I knew it would do well. So to avoid accusations of bias, I ended up simply applying a set of Conscious Investor default settings to the S&P 100 in 1993 and buying all those stocks that passed the defaults, and at the price quoted on the market at that time, i.e., no margin of safety. Also, getting accurate and consistent data over 20 years proved difficult, hence the ‘paired down’ Conscious Investor default settings/financial hurdles used.

These results are impressive. They show an inefficient market which is not what is expected from standard finance theory. What I can say for sure is that if you were to invest in the S&P 100 in 1993 and if you were to invest in a portfolio using the Conscious Investor default settings as applied in this study you would have outperformed the S&P 100 over ten years by 99%.^# And further, if you increased the financial hurdles in selecting your stocks in 1993, you would have outperformed the S&P 100 over ten years by 200%.

An amount of $1m invested in a portfolio using the increased financial hurdles in Conscious Investor in 1993 would have grown to over $4m in 10 years. In contrast, $1m invested in the S&P100 over the same period of time would have grown to around $2.4m.

Overall the Conscious Investor portfolio had an average annual return of 17.13 percent compared to 10.22 percent for the S&P 100.

GB: How have people reacted to your results?

EK: I have to say that I had little knowledge of what I was letting myself in for. The minute I showed these results to the academic community in the College and told them of my desire to study Warren Buffet, they were taken aback. Did I not know that the market was efficient? Did I not know that you can’t predict future price movements and that the only sensible way to manage a portfolio was through diversification? I was accused of all sorts of heresies and that my work was really of an undergraduate standard! At one stage, one fellow PhD student (on a grant) told me “my work lacked academic credibility”. I said what! He said, “your works lacks any academic framework”. I replied, “Here’s a framework. You are down to your last $1,000 and you have Warren Buffet and Professor Efficient Markets in the room, who do you give your $1,000 too?” Stunned silence. “Well,” I said, “the rational answer is Warren Buffet because over the last 37 years, he has generated an annual return of 22% and Mr Efficient Markets has done no better than 10%.

However, to be fair to the PhD student he did me a favor. If Conscious Investor, and more to the point, my research, is going to stand up in the academic community and to a lesser extent in the broader market, it can only benefit from being framed within the context of modern finance and investment theory. At least we will know who the competition is!

GB: How would you like to extend the study?

EK: Once I have managed to fend off the Efficient Markets police, assuming I can do that which is really up to the data, I mean it works or it doesn’t, I would like to extend the study to different time periods and different data sets. After that I want to find a way to test the non-financial aspects of the Conscious Investor approach, i.e. economic moat, management and so on. This is what might be called the ‘Charlie Munger’ (Buffet’s partner) side of the house. This is a much more challenging area to model, particularly retrospectively. My thoughts are to somehow come up with a Human Capital Index which rates companies for the quality of the management and their execution of their strategy. This would include areas such as:

• Is the business simple and easy to understand?
• Does the business have a competitive advantage or economic moat?
• Does management have a clear unambiguous strategy and are their decisions in line with the strategy?

Charlie Munger is getting increasing attention for his contribution to the success of Berkshire Hathaway. He seems particularly interested in the human capital side of the business and says one of the things that he and Warren like to do is marvel at the misjudgments of people. Charlie Munger has spoken of the “24 Standard Causes of Human Misjudgment” which I would like to look at in more detail, particularly as they apply to investment decisions. However, by its very nature, the non-financial side of business analysis is much more subjective and thus more difficult to model so I am not sure how this will turn out. However, to learn you must go from the known to the unknown!

Appendix: Research Results

This is part of the technical study in which a set of Conscious Investor financial hurdles (see Table 1) were applied to the Standard & Poor’s 100 index (S&P 100) in 1993. Of the 100 S&P stocks, 18 stocks passed the financial hurdles. These 18 stocks were then grouped into a portfolio called The Conscious Investor Portfolio (CI Portfolio). The performance of the CI Portfolio was then compared with the S&P 100 from 1993-2003 (ten years).

No attempt was made to understand the businesses, nor was any attempt made to buy these stocks building in a margin of safety. All 18 stocks were bought in June 1993 and sold again in June 2003. The key financial hurdles were as follows:

Ten years financial data was deemed necessary to provide a clear picture of the historical performance of each stock. The required ROE level was set at 10%. The HGROWTH¹ in EPS hurdle, i.e. the historical growth of the earnings per share over the previous ten years, was also set at 10% and the stability of the EPS, i.e. STAEGR² was set at a minimum of 70%.

While 10% was the minimum ROE requirement, the average ROE for the 18 stocks selected was 21.5%. Also, while the minimum HGROWTH in EPS was also 10% whereas the average HGROWTH in EPS for the 18 stocks was 18.8%. Similarly, the minimum STAEGR in EPS was 70-80% while the average for the 18 stocks was 87.9%. Of the original 100 stocks, only 76 had ten years financial data. Of those 76, 57 met the ROE requirements, 30 met the historical HGROWTH in EPS requirement and 33 met the stability or STAEGR in EPS requirements. However, only 18 companies met all four requirements together. (See Table 2).

Many of the 18 stocks in the CI Portfolio are household names which is not surprising as the S&P 100 is made up of some of the largest and best know companies in the US and worldwide. After ten years, $1m invested in the CI portfolio was worth over $3m, a return of over 200%. A corresponding amount invested in the S&P 100 was worth just over $2m, a return of 100%.

During the first six years (i.e. from 1993-1999) the performance of the CI Portfolio was slightly better than the S&P 100. But when the market came off its ‘irrational exuberance’³ of the late 1990’s that the CI Portfolio substantially outperformed the S&P 100.

Overall the Conscious Investor portfolio had an average annual return of 13.40 percent compared to 10.22 percent for the S&P 100.

Figure 1 - Conscious Investor Performance

The performance of the CI Portfolio, at least in academic terms, needs to be considered in the context of the dominant paradigms of modern finance, i.e. the Random Walk Theory (RWT), the Efficient Markets Hypothesis (EMH) and Modern Portfolio Theory (MPT).

The RWT asserts that the past performance of a stock price has no bearing on future stock performance, i.e. stock prices have no memory.

The EMH says that all information on a stock is contained in the current stock price which is the best estimate of the stock’s fair value.

MPT says that you can’t outperform the market without taking greater than market levels of risk (as defined by volatility, size and value) and that risk, at least the risk of any one stock in relation to the market, can be reduced or eliminated by diversification.

It is fair to say, that these theories form the intellectual basis, through index fund investing, for at least 40% of the investments in the market today. A considerable amount of time in this study is devoted to framing the results of the study within the above paradigms.

During the final stage of the study, the Conscious Investor financial hurdles were increased. The objective was to see what impact, if any, would occur if the financial hurdles in Conscious Investor were increased and applied to both the existing CI Portfolio and the original list of 100 S&P 100 stocks. A total of 17 different portfolios were considered using a range of Conscious Investor financial hurdles. 16 portfolios outperformed the S&P 100 of which nine portfolios out-performed the S&P 100 without selecting Medtronic (the star performer in the original CI Portfolio) and nine portfolios out-performed the original CI Portfolio. Only one portfolio failed to outperform the S&P 100. The increased financial hurdles were as follows:

The ROE was increased from a minimum 10% to 20% and the HGROWTH in EPS from a minimum of 10% to 15%. The STAEGR in EPS level stayed the same at 70%. Instead of selecting 18 stocks, the IFH 4 portfolio selected seven stocks. Theses seven stocks outperformed the S&P 100 by over 200% and the original CI Portfolio by more than 200%.⁴

So in this case, it was possible to double the performance. The actual average annual returns are shown in the next figure.

Figure 2 - Performance of Second Conscious Investor Portfolio

These results are impressive. They are showing an inefficient market which is not what is expected. I now have to run statistical tests on the results to show whether or not we could have got such results from chance

My own sense is that it is too early to say with any certainty whether the results are of any real value. But what I can say for sure is that if you were to buy a set of stocks from the S&P100 in 1993 using the Conscious Investor default settings as applied in this study you would have outperformed the S&P 100 over ten years by 99%. And further, if you increased the financial hurdles in selecting your stocks in 1993, you would have outperformed the S&P 100 over ten years by more than 200%.⁴

The second point is that the Conscious Investor portfolio was selected back in 1993 and then held for 10 years. No further stocks were added or removed over that time.

We don't recommend this. It is only common sense to monitor your portfolio, even if only minimally. But even if you do use Conscious Investor to buy a portfolio of stocks and then just forget about them, this study shows that the Conscious Investor portfolio still outperformed the market by a considerable amount.

Footnotes

1) "HGROWTH is a proprietary function in Conscious Investor that calculates the average annualized growth rate of a sequence of data. The function is based on the calculation of an exponential curve that is best fit to the given data. Special adjustments are made for negative data, for extreme outliers and for earnings near zero. The rate returned by HGROWTH is the annualized growth curve of this curve”. Prof John Price Conscious Investor Manual 2000.

2) "STAEGR is the function that measures the stability or smoothness of the growth in earnings and sales and is a partner to HGROWTH. HGROWTH measures how fast the earnings or sales are growing while STAEGR measures how smoothly this growth is taking place. The function STAEGR measures the stability of the growth of historical data from year to year as a percentage. This data can be any sequence of numbers. Its purpose in Conscious Investor is to measure the stability of earnings and sales per share. The maximum figure of 100% represents data that goes up or down by the same percentage each year. The calculations are based on fitting an exponential curve to the historical data with more emphasis placed on the stability of the growth of recent earnings. Special adjustments are made for negative earnings, extreme outliers and for earnings near zero”. The calculations also require at least three years of earnings. Prof John Price Conscious Investor Manual 2000

3) US Federal Reserve Chairman, late 1990’s referring to the stock market. See also Robert Shiller’s book “Irrational Exuberance ”.

4) A return of 10.22% per year (the S&P100) means a total return of 164.60% over 10 years and a return of 17.13% (the Conscious Investor portfolio) per year means a return of 386.05% over the same eriod of time. Hence the Conscious Investor portfolio out performed the S&P by 221.45%.

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