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:
|
Table
1- Conscious Investor Financial Hurdles |
|
Number |
Parameter |
Minimum Level |
1 |
Financial history |
10 Years |
2 |
Return on Equity (ROE) |
10% |
3 |
Earnings per Share HGROWTH |
10% |
4 |
Earnings per Share STAEGR |
70% |
|
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).
|
Table
2 - Conscious Investor Portfolio |
|
Number |
Company |
10 Years |
ROE |
EPS HGROWTH |
EPS STAEGR |
1 |
Altria GP |
Yes |
31% |
21%
|
85% |
2 |
Amer Intl GP |
Yes |
13% |
19% |
77% |
3 |
Anheuser-Busch |
Yes |
14% |
11% |
82% |
4 |
Bank One |
Yes |
16% |
12% |
97% |
5 |
Boeing |
Yes |
14% |
16% |
75% |
6 |
Coca Cola |
Yes |
48% |
18% |
96% |
7 |
General Electric |
Yes |
17% |
11% |
88% |
8 |
Heinz |
Yes |
23% |
13% |
93% |
9 |
Home Depot |
Yes |
16% |
43% |
90% |
10 |
Johnson & Johnson |
Yes |
32% |
18% |
80% |
11 |
Limited Brands |
Yes |
20% |
23% |
83% |
12 |
McDonalds |
Yes |
18% |
13% |
97% |
13 |
Medtronic |
Yes |
25% |
17% |
92% |
14 |
Merck |
Yes |
22% |
23% |
87% |
15 |
Pepsico |
Yes |
25% |
22% |
82% |
16 |
Raytheon |
Yes |
16% |
11% |
94% |
17 |
Toys R Us |
Yes |
15% |
19% |
90% |
18 |
Wal-Mart |
Yes |
23% |
30% |
93% |
|
Average |
Yes |
21.5% |
18.8% |
87.9% |
|
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:
|
Table
3 - Increased Conscious Investor Financial Hurdles |
|
Number |
Parameter |
Minimum Level |
1 |
Financial history |
10 Years |
2 |
Return on Equity (ROE) |
20% |
3 |
EPS HGROWTH |
15% |
4 |
EPS STAEGR |
70% |
|
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
|
Table
4 - Conscious Investor Portfolio
with Increased Hurdles |
|
Number |
Company |
10 Years |
ROE |
EPS HGROWTH |
EPS STAEGR |
1 |
Altria GP |
Yes |
31% |
21%
|
85% |
2 |
Coca Cola |
Yes |
48% |
18% |
96% |
3 |
Johnson & Johnson |
Yes |
32% |
18% |
80% |
4 |
Limited Brands |
Yes |
20% |
23% |
83% |
5 |
Medtronic |
Yes |
25% |
17% |
92% |
6 |
Merck |
Yes |
22% |
23% |
87% |
7 |
Wal-Mart |
Yes |
23% |
30% |
93% |
|
Average |
Yes |
29% |
21% |
85% |
|
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
Comments
by Professor John Price: It is exciting
to see more and more independent validation of what we have
been working on at Conscious Investor for many years. I would
like to add two points. The first is that Ed Kelly's results
were obtained using only a part of the total Conscious Investor
approach. The full approach also considers the companies involved
in terms of such things as their products and services and
their economic moat. In other words, what makes them special
in regard to consumers and their competition. 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%.
Disclaimer:
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is not necessarily indicative of future results. Information
and advice provided here is not an offer to buy or sell
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