Despite calling cash the ‘worst investment you can have’, Berkshire Hathaway’s Warren Buffett has sat on billions of dollars worth of non-interest bearing bank deposits. Meanwhile, Baupost’s Seth Klarman recently called cash ‘the ultimate contrarian investment’.
These cash hoarders are joined by many a man on the street. The average cash weighting in Australia’s self managed super funds is 28 per cent.
Some think sharemarkets are expensive. Others think all asset classes have been pumped up by low interest rates and unprecedented monetary stimulus. But can we really enhance our returns by going to cash when the market is expensive and buying back in only when it is fair value or cheap?
That’s a question Tobias Carlisle, US investor and author of the blog Greenbackd, put to the test in a statistical study of the past 88 years of US market returns. Carlisle used the Shiller PE as a proxy for the relative valuation of the market and tested what it would do to your returns were you to sell and hold cash when it flashed expensive.
His conclusion? You would have been better remaining fully invested the whole way through:
“The Shiller PE is not a particularly useful timing mechanism. This is because valuation is not good at timing the market (Nothing works. Timing the market is a fool’s or genius’s game).”
Obviously, had you sold your whole portfolio on October 2008 and bought it back on the lows of March 2009, at 55 per cent cheaper, you’d be rich (and probably famous) today.
But Carlisle’s analysis ties in with my own anecdotal experience. There are always a few people who are going to look like geniuses in hindsight but most do themselves a disservice holding large amounts of cash.
Those that sell out at the top inevitably get back in too early or fail to reinvest at all. Most of those who happened to get fully invested at market lows in 2009 shifted to cash way too early and missed out on the substantial gains of the past few years.
On average, you are better off riding out the unpredictable waves fully invested than trying to time the market.
So we should be fully invested all of the time, then? No. In our Australian Fund the average cash balance has been 15 per cent since we started almost five years ago. And it has ranged from close to zero to more than 20 per cent. But that has nothing to do with trying to time the market.
It has everything to do with trying to emulate Buffett and Klarman.
Firstly, individual bargains occur more frequently than market-wide bargains, so our lazy cash comes on and off the bench much more frequently than Carlisle’s piece might suggest.
Over the past 12 years, I’ve seen three times where the opportunities where broad (2003, 2009 and 2011). Over that same time, though, I’ve found dozens of individual bargains to buy, many of them outside those three periods. As Klarman puts it: “One doesn’t need the entire market to become inexpensive to put significant money to work, just a limited number of securities.”
The current market is a perfect example. Despite the index trading at five-year highs, there are pockets of the market offering extreme value. Cash is the enabler that allows us to move quickly when these opportunities arise.
Secondly, and most importantly, holding cash gives us optionality. Alice Schroeder, author of the definitive Buffett biography, The Snowball, says this is one of the most important things she learned: “the optionality of cash”.
“[Buffett] thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”
Extreme bargains don’t usually arise because of varying opinions on the value of a share. They arise when the market is fearful and when someone must sell, irrespective of price.
At the depths of the financial crisis, Buffett’s Berkshire invested tens of billions of dollars in General Electric, Bank of America and Goldman Sachs on incredibly favourable terms.
The companies issued him preference shares, paying interest of 10 per cent or more, and attached warrants that allowed him to participate in share price appreciation.
These companies needed money, and Buffett was the only one who could provide it because he spent years sitting patiently on cash waiting to use it.
And this is the true value of cash. I don’t hold cash because I think it’s going to give me a return. I don’t hold cash because I think the market is expensive and is going to crash. I hold cash because it gives me an option. The option to be the one who can act when everyone around me is panicking.
By Steve Johnson – Chief investment officer of Forager Funds Management
30 July 2014 AFR
Original article here