- Stewart Salisbury
Over the past year the amount of cash I’ve held in individual client accounts has risen to roughly 25-30% of total AUM. That’s significantly higher than the average percentage over my career as an investment manager. It’s not easy holding so much cash. My partners pay me to invest - and that doesn’t mean sitting around thumb sucking refusing to swing at a pitch. I’ve written previously about my strategy of holding cash – ranging from its use as an anchor in crashing markets to holding it in reserve when prices are such I can find no opportunities in the market. As this bull market gets a little long in the tooth, it’s important to look at the amount and role of cash in your portfolio.
Over time, I’ve found that holding a significant amount of cash has been helpful in three specific cases. History never repeats itself exactly, but as Mark Twain said, it can certainly rhyme.
Inverted Yield Curve
When short term bond yields exceed those of longer-term bonds, markets generally perceive this as a warning of impending recession. In a normal yield curve, the short-term bills yield less than the long-term bonds. Investors expect a lower return when their money is tied up for a shorter period. They require a higher yield to give them more return on a long-term investment. This is the simple concept of time-value of money at play. Yield curves invert when investors begin to lose confidence in the economy of the near future. They ask for a higher yield for today’s market than the future. Because the perception is the economy will be better in the future than the present, investors prefer locking in their capital for a longer period of time at a lesser rate. During these times, it makes sense to hold more cash as short-term debt instruments yield more than similar longer-term investments. Additionally, stocks – in general – perform poorly as the yield curve inverts.
Hedging versus Excess Price
Another reason to hold significant amount of cash is simply because there are no investment opportunities. For instance, here at the end of 2018 after a nearly decade long bull market, I simply can’t get excited about many valuations of companies I’d love to own. This inability to allocate capital is a perfectly valid reason to let cash build. That said, investors generally don’t pay their investment managers to hold cash. Getting a statement that shows 25% of their hard-earned savings earning very little in a cash sweep account rarely makes my investment partners jump for joy. Here, individuals have a huge leg up on institutional investors. Like Warren Buffett said, individual investors are at bat in a game where no one calls strikes. Take advantage of that when you can.
Taking Advantage of Mispricing
I generally run a very focused portfolio of 20-25 stocks that I hold for (sometimes) decades. My watch list is quite small consisting of roughly 25-50 additional companies. I usually keep 2-3 slots open in my portfolios for companies on the watch list I would love to own but just can’t get the discount to fair value I require. Having a significant amount of cash allows to pounce on those rare opportunities when they arise. For instance, I’ve had a stock that remained on my watch list for 6 years until I was able to make a significant purchase in 2016 when the markets misread (or I thought they did) management’s outlook. I could not have taken advantage of that situation should I have had less than 10% in cash at the time.
Why This Matters
What’s important to draw from these three justifications is that none of them are driven by how the general markets are performing (the first is driven by bond markets not equity markets). Cash position is – and as a value investor should be – agnostic to general market valuation. Is there a correlation between finding individual investment opportunities versus market levels? Sometimes and sometimes not. Warren Buffett wrote in his 1961 Partnership semi-annual report
“Our holdings, which I always believe to be on the conservative side compared to general portfolios, tend to grow more conservative as the general market level rises. At all times, I attempt to have a portion of our portfolio in securities as least partially insulated from the behavior of the market, and this portion should increase as the market rises. However appetizing results for even the amateur cook (and perhaps particularly the amateur), we find that more of our portfolio is not on the stove.”
Buffett has mentioned how he hates to hold cash, but given the choice of overpaying for an asset or holding cash, he will pick the latter every time. Not only do his securities look conservative compared to the general markets, his cash position grows significantly as well. His stove top has only so much room.
I also want to point out the decision to hold cash is as active a decision in capital allocation as purchasing a new investment holding. Taking no action is just as powerful as taking action through the purchase of some new asset. Some of my investment partners have said they don’t pay me to hold cash. But when you look at non-action as a choice in capital allocation – or taking that capital off the stove top as Buffett would say – then the decision to build up cash is as powerful a strategy as being fully vested.
As I write this, the markets are just coming off a week where they lost roughly 4% of their value. Nearly a trillion dollars’ worth of value has evaporated over the past 30 days. Even after all of that, I’m finding few opportunities that shout out as great investment opportunities. Unfortunately, I found myself stuck in the first two buckets I discussed (inverted/inverting yield curve and excess prices) and eagerly awaiting the third (taking advantage of mispricing). Until the latter becomes a reality, I will be holding a significant amount of my AUM in cash. For now, the old adage holds true – cash is king. Long live the king.
 Warren Buffett, 1960 Buffett Partnership Ltd Semi-Annual Report, page 1.