Editor’s note. I asked Roger this question about holding cash.
“I heard you on Mark Todd’s programme last week say your funds are now 30% in cash.
If I have an investment with an Australian equity fund manager, it is part of my overall portfolio. I have decided in my asset allocation I want x% in Australian equities, and I allocate money to other asset classes including cash. If my Australian equity manager then puts the money into cash, my asset allocation is upset. I want exposure to the specified asset class. At its extreme, for example, if an equity manager went to 100% cash, and the market rallied, I would feel it was more than a poor call, but that it went against my allocation wishes.
When I ran the geared share funds at CFS (which at one stage held $10 billion), we explicitly stated that we would gear the funds to their maximum. Everyone knew that’s what they were buying, and I did not have the skills to second-guess the market. It was a supercharged portfolio in both directions, and we told investors and advisers to look elsewhere if they did not want the associated risk and volatility.
I know many top quality managers see a need to protect capital, and as you said on TV, you have hurdle rates which companies must meet. But I go to equity managers like you for Australian equity exposure.”
Cash. For such a simple investment, it can cause an awful lot of grief.
Has there ever been a time in history when investors had so much to worry about? Not a day passes here at Montgomery that a client or blog subscriber doesn’t express some concern about Brexit, the perils of asset prices inflated by unprecedented central bank intervention, the coming collapse of China or the Japanese-led deflationary spiral. Charlie Munger and Warren Buffett once observed, “Market forecasters will fill your ear but will never fill your wallet.”
But in reality, there has always been a time with an equally-worrying frequency of concerns. Consider the investor in the 1920’s, the 30’s, the 40’s, the 60’s, the 70’s, the late 80’s, the early 2000’s, the late 2000’s and so on. With monotonous regularity, fears concentrate and abate. It is safe to assume that stocks must be an incredibly risky asset class to invest in. In fact, cash is riskier.
Cash seems safe but erodes purchasing power
In the age of retiring baby boomers demanding income, cash might seem like the safest option but cash returns currently guarantee your purchasing power will be eroded the longer you remain invested in it. It is as certain as the sun rising in the east tomorrow.
Check out the Top 200 Rich List. How many decades did many of those entrants take to achieve their wealthy status? And how many black swan events hit the market and the economy in that time? And how many of them listed ‘cash’ under the heading, Source of Wealth?
Of course most investors in the stock market don’t think of their portfolio as a selection of stakes in operating businesses. They instead think of their portfolio as a group of ‘stocks’ that rise and fall with every latest fad and fear. To them, risk is the volatility in the share prices. But if the temporary movement in the prices of stocks is compared to the permanent erosion of purchasing power from holding cash, should not we be endeavoring to hold as little cash as possible?
The answer is yes. Our aim should be to fully invest in the assets that produce the highest long-run returns. And that’s pieces of the types of wonderful businesses we have defined here at Cuffelinks previously.
What if equities are expensive?
The problem and subsequently-required decision however emerges when the preferred assets are not available at an attractive price. Share prices should be so attractive that even a mediocre performance from the underlying business produces an attractive return.
And while the current rate of cash is likely to produce sub-inflation returns, so too will the overpayment for equities and property.
The decision must then turn to the more immediate probability or risk of capital destruction. On that score, equities possibly have higher downside risk. Stan Druckenmiller recently highlighted 1981 as a beautiful time to be invested in equities. Interest rates were at 15% and the real rate was 5%. Those high rates ensured companies were careful with their capital allocation and interest rates were about to commence a long decline. Productivity received a boost from the advent of the internet and debt was so low that a long-run credit-fuelled expansion was possible. The S&P500 Price to Earnings ratio was just 7X. Between 1981 and 2000, the S&P500 produced a return of almost 15% per annum, creating a 16-fold increase of your wealth.
Today, we have almost the mirror opposite image. Debt is double that of 1981 and appears to have reached its limit. Full employment and declining productivity suggests corporate profit margins are about to decline and interest rates cannot fall much further, and may begin to rise. Since 2011, earnings per share in aggregate have not grown but US company payout ratios have increased from 55% to more than 75%. Combined with elevated levels of debt, it suggests little earnings growth will be experienced in the near future. And investors are paying 18x earnings. So how can the polar opposite of 1981, be an equally attractive time to invest? It cannot.
The current market justifies a cash holding
In that scenario, holding some cash seems prudent, and cash is particularly valuable when no one else has it. On cash being to a business as oxygen is to a body, Warren Buffett said: “Never thought about it when it is present, the only thing in mind when it is absent.”
The only people who can benefit from a correction and take advantage of cheaper prices are those who hold cash. As India’s Warren Buffett, Prem Watsa, recently noted;
“Cash gives you options, gives you the ability to take advantage of opportunity but you have to be long-term. The cash gives us a huge advantage in terms of taking advantage of opportunity as and when they come. At the moment, we don’t think they’re many, so we are building cash.”
Remember Warren Buffett’s observation that fund managers are playing a baseball game where the investors in the bleachers are always yelling out “don’t just sit there, swing at something!” Private investors aren’t playing a game where they have to listen: they can sit there and wait for the perfect pitch.
Cash provides that opportunity, even though it is a terrible long term investment. It should be thought of as a call option over future cheap shares with no strike price and no expiration. Cash is guaranteed to avoid one risk – the risk of permanent capital loss – but it is also guaranteed to adopt another risk – the loss of purchasing power. Having all your assets in cash all the time makes no sense.
In the long run, share prices will always follow the performance of the underlying business. In the short run, the share price will bear no resemblance to business performance. That is why Ben Graham observed that in the short run the market is a ‘voting machine’ but in the long run it is a ‘weighing machine’.
It follows then that owning equities for a week or a month or even a quarter is risky. The corollary is that owning cash for a short period must be safe. When investing for a multi-decade period, daily share prices are meaningless and being fully invested should be the goal. Building a diversified equity portfolio over time is the process
And there’s your answer. You are buying ‘over time’. In the meantime, hold some cash. It’s an option over future lower prices. Don’t hold all your assets in cash, that’s not sensible. But don’t eschew the wealth-protecting and wealth-building power of cash either.
Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific circumstances of any individual.