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The Value of Cash

This article was originally published on MastersInvest.com.

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The typical equities investment mandate and most mutual funds are required to be fully invested in stocks. The mindset being that the asset allocation decision is a separate function from stock selection. So for instance in the case of a balanced fund, the asset allocator determines the percentage of total assets allocated to each asset class – cash, fixed income, bonds, alternatives etc. The equity manager gets the equities allocation and must remain fully invested in equities regardless of whether or not he or she can find quality assets at attractive prices.

In such an approach, the individual tasked with the stock picking is prohibited from holding cash even at times when they perceive valuations as unattractive or macro risks as elevated. It’s not whether an investment makes or loses money that is important (ie absolute returns), their concern is the investment’s performance relative to the stock market.

Most top-down asset allocation models place the greatest weight on an investors risk profile when determining appropriate asset exposures. Commonly, this is on the basis of age, ie young age = more risk tolerance = more equities exposure, less bonds. So there is little or no consideration to the relative attractiveness of each asset class at the time of it being set. While it sounds good in theory, the downside was blatantly obvious in the global financial crisis. In broad market sell-offs, it can be impossible for an equities manager to deliver attractive returns when they have to remain fully invested.

“For most people, the most dangerous self-delusion is that even a falling market will not affect their stocks, which they bought out of a canny understanding of value” Leon Levy

“Unfortunately, an emotionally inspired selling wave snowballs and carries with it the prices of all issues, even those that should be going up rather than down.” J Paul Getty

“I used to hold Berkshire stock as a proxy for cash and that was a mistake.  During times of distress, everything will go down, including Berkshire” Mohnish Pabrai

“When the market falls sharply, it doesn’t distinguish between the good girls and the bad girls”  Peter Cundill

“You’re deluding yourself if you believe your stocks, however cheap they are, won’t temporarily go down when Mr Market decides to correct ” Charles de Vaulx

The individual picking the stocks doesn’t get to decide if stocks are attractive.  And, the asset allocator is rarely held accountable for a sub-optimal outcome and tends to hide behind the notion of historical asset class returns. If the balanced fund loses money in equities, the equity manager says “don’t blame me I had to be fully invested” and the asset allocator responds “don’t blame me, the ultimate fund investor is 20 years old and that means 45% [blah blah blah] was the right percentage to have in equities”. Pass the buck! Conversely, the Investment Masters recognize that the optimal allocation to equities at a particular point in time is a function of relative price levels at that time, and relative pricing is constantly changing.

Contrary to this approach, the Investment Masters maintain a flexible approach to investing where they can hold cash if attractive opportunities aren’t available. They don’t compromise on their pricing criteria because they insist on operating flexible mandates that do not require them to be fully invested. In addition the Investment Masters recognize the benefits of having financial firepower to buy assets when opportunities arise.

Despite Warren Buffett advocating index funds to Joe Public his largest current holding is cash. In a recent CNBC interview Buffett stated ..

“Now unfortunately right now the largest ‘business’ we own– we’ve got about $95 billion in and it’s selling at a 100 times earnings. And the earnings can’t go up, which sounds like a pretty dumb investment and it is. But that’s what we get on treasury bills basically and– we literally have– it’s not all in bills. But we have $95b in cash including mostly bills and we are paying a 100 times earnings for something like I say whose earnings can’t go up. You get 1% and that does not make me happy. And I like to buy businesses. We will buy businesses. But it makes it much tougher– when there’s 1% money around and the people who– many of the people who buy businesses use as much borrowed money as they can. And when they get that– at rates that are based off that very low rate of 1%– they can pay a lot more money than we can – using what– pretty much all equity money ’cause that’s the way we look at money. So– we have not—made significant acquisition now for 15 months or thereabouts”

While Buffett says he doesn’t consider the macro environment or the level of the stock market per se when making investments he will only invest when he can identify attractively priced opportunities. It makes sense that there are less attractively priced opportunities when markets are elevated than weak.

“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.” Charlie Munger

The lesson from the Investment Masters is not to be afraid to of holding cash. Cash is an asset which allows you to take advantage of opportunities when asset prices are subdued.

“Cash combined with courage in a time of crisis is priceless.” Warren Buffett

“In many different ways, cash gives you options.  It offers wonderful downside protection and upside optionality”  Mohnish Pabrai

“Because we are focussed on absolute returns, we will hold cash in the absence of values and a margin of safety. We view cash as an opportunity fund” Arnold Van Den Berg

The ability to hold cash provides investors with the flexibility to avoid buying unattractive assets. It is better to receive little or no returns from cash than exposing the fund to the risk of permanent loss of capital. 

“Holding cash is uncomfortable, but not as uncomfortable as doing something stupid” Warren Buffett

“Thinking outside the box about the optionality of cash gives quiet but resolute credence to the contention that this seemingly benign asset is in reality a double edged sword, defending against loss on one hand and arming for gain on the other.” Frank Martin