Is it worth paying your fund manager to hold cash?

holding cashWarren Buffet has called cash “the worst investment you can have.” Cash is an unproductive asset. At best interest earned on cash might enable an investor to slightly outpace inflation and maintain spending power. At worst this power could be eroded over time (if inflation runs higher than the interest rate on a bank deposit), leaving an investor unable to buy tomorrow what could have been bought yesterday. So why would you want to pay an investment manager for holding cash?

There are two valuable reasons for holding cash as part of a prudently managed investment portfolio, as described below:

  • Margin of safety

“How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value…By replacing current holdings as better bargains come along. By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available” (Klarman, Margin of Safety 1991)

The key to sustained superior investment performance is to build in a margin of safety by investing in securities that trade at prices below their fair value – bargains! This “buffer” protects against a permanent loss of capital and enables above average returns to be generated. However, when prices and valuations rise the buffer narrows, risk increases, compelling new bargains become scarcer and existing holdings become less attractive. Under these circumstances a prudent manager will shift to higher levels of cash, rather than chasing returns with little room for error.

Over the last few years global equity markets have continued to appreciate – in the past 3 years the US stock market is up 54 per cent and the Australian stock market has risen 25 per cent. A key contributor to this robust performance has been a circa 30 per cent increase in the price/earnings multiple that the market is willing to afford stocks (that is, their “valuations” have risen) both in Australia and the US. This is not to say that bargains aren’t available in certain pockets, but overall the search mission has become more challenging and the case for holding higher levels of cash has strengthened.

  • Take advantage of attractive opportunities

“If you hold cash, you are able to take advantage of such opportunities. If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels. This creates an opportunity cost, the necessity to forego future opportunities that arise” (Klarman, Margin of Safety 1991)

Holding a cash balance provides the manager with the optionality to buy securities when they become cheap. In the parlance of derivatives, cash represents a “call option” over securities, without a strike price or an expiration date!

Warren Buffett has been willing to hold significant cash balances for long periods throughout his career in order to invest in the most attractive opportunities when they became available and when there was little competition from other investors, who had typically been hampered by losses in their own portfolios. After closing his private partnership in 1969, Buffett was able to deploy cash into high quality businesses when the market sold off by circa 40 per cent in the early 1970s. In the mid-1980s Buffett again increased his cash holdings, before investing in Coca-Cola in 1988. More recently Buffett was able to deploy vast amounts of cash in the depths of the financial crisis at very high returns in companies like Bank of America, GE and Goldman Sachs.

Although cash could very well be the “worst” investment, holding cash enables a manager to generate superior returns, reduce risk of loss and take advantage of the best opportunities as they come along. Why wouldn’t you expect an investment manager to hold cash on your behalf?

P.S. Seth Klarman is one of today’s most successful value investors. Klarman founded Baupost Group, a Boston-based hedge fund, in 1982 and has achieved compound returns in the high teens while maintaining an average cash balance of circa 30 per cent, which frequently climbs to circa 50 per cent. In 1991 Klarman penned “Margin of Safety” (you can pick up a second hand copy for a few thousand dollars on Amazon) which served as a new testament to Graham & Dodd’s value-investing bible “Security Analysis” which was first published in 1934.

By Chris Demasi – Senior Analyst
Montgomery Investment Management.

Note:  Roxburgh Securities has a number of Absolute Return funds that can provide a more stable investing experience, as well as “Capital Protected” investments

 

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