John Maynard Keynes is one of the most influential economists of all time. Keynes was among the intellectual elite of England and studied at Cambridge University. In 1936 he wrote a book called The General Theory of Employment, Interest and Money.

I won’t get into the details of the book, but it revolutionized the way we look at Economics and government policy. Keynes was a bold thinker; he asserted that “in the long run we are all dead” and all policy and investments must be done for the short term.

In his book, Keynes also talks about an important characteristic of the stock market. Many have forgotten Keynes’ theory about the stock market, but you will be surprised to know it still holds true. Let me explain…

Keynes likened stock markets to the beauty contests of his day. During the early 1900s, the London newspaper would print 100 photos of beautiful women. You had to write in with the six women you liked the most. Everyone that picked the most popular woman could win a prize.

Here is the twist: If you simply picked the women YOU thought was pretty, you wouldn’t win, because your entries have to match the popular vote. So you didn’t pick the women you liked; you didn’t even pick the women you thought a panel of judges might think were beautiful. You had to pick those women whom you thought that everyone else thought that everyone else liked!

Get it? You’d have to vote based on what you’d think average opinion thinks average opinion is. Keynes’ beauty contest explanation always reminds me of a conversation I often have with my husband. Strangely, it only occurs when we’re deciding where to go for dinner.

“Honey, where do you want to eat tonight?”

“I think that you think I want to go for Mexican. But I know that you know that I want to go where you want to go.”

(On days like these we end up cooking at home.)

But when it comes to the stock market, this sort of thinking works. Here is the beauty contest in Keynes’ own words: “It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which 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.”

So how can you profit from Keynes beauty contest theory? Quite simply, anticipation of what average opinion expects average opinion to be is reflected in a stock’s PE ratio. If all investors expect all investors to buy into a stock, its PE ratio will be higher than normal.

You see, the return on a stock doesn’t just depend on its earnings growth. Return on a stock is also heavily dependant on whether earnings growth exceeded what investors expected.

This is where investors play the beauty contest game. If an investor believes that all other investors believe that a company will exceed expected growth, they will buy the stock. Take Blue Nile Inc. (NILE:NASDAQ) for example. In late March, I recommended this online diamond jewelry retailer for my subscribers.

The stock went up nearly 12% in one day when the company announced earnings. This is because investors were practicing the second degree — “I think that everyone else thinks this stock will go up, so I’ll buy it today too.”

But the key to winning in the stock market is to get in before the frenzy starts — like we did with Blue Nile. And you can do that only through due diligence and buying those stocks that YOU think are sound investments. That is, according to Keynes, investing in the first degree.

The lesson from a forgotten beauty contest theory is this: You need to get in before the “I think that they think” guys start buying.

Regards,

Sala Kannan
May 05, 2006

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