CASH: A NECESSARY EVIL?

(2011 Q2)

Ugly!

We have been receiving many questions regarding the amount  of cash in client accounts. And for good reasons:

• All of us are painfully aware that cash balances, such as money market funds and certificates of deposit, pay miniscule interest, if any.
• Worse, our government’s policy is to create 2.0% inflation. At the end of a one-year cash investment, therefore, investors could be left with $0.98 on the dollar.
• Subtract another 1% for a typical investment management fee, and a cash position looks down right stupid. Clearly, the negative aspects of holding cash are revolting.

Mitigating Factors

Despite these self-evident negatives, a cash position may not be as bad as it seems on the surface.

•  As far as inflation is concerned, it affects all investment the same. Whether one’s investment return is 0% or 10%, it is necessary to subtract 2% (if that is the inflation rate) to derive the real return. So it is unfair to ding the money market by the inflation rate. Comparing cash returns nominally with alternative choices is an apples-to-apples process.
• Cash is not the whole portfolio. Interpreting one, small negative cash flow as investment failure diverts attention from the current yield that may be generated from all of the investments held. For instance, a fully invested portfolio yielding 3.0% on a current basis, if put into a 10% cash position, would experience a decline in yield to 2.7%. Similarly, the same portfolio with a 20% cash position would yield 2.4%, and the yield would only decline to 2.1% with a 30% cash position.
• Another factor that is often overlooked when focusing on the negatives of cash is the amount of time investors hold cash, or at least high cash balances. Ideally, cash is a temporary holding between investment opportunities. A 25% cash balance resulting from some profit taking that is redeployed in a few weeks or months has a different ring to it than “OMG, my account is 25% in cash with no yield and I’m paying for this?!”

Thus, to a certain degree at least, when looking at the negative features of cash, it is easy to overstate the obvious.

Where’s The Value?

Cash may not be as bad as it seems, but what is the value of holding any? Think of it in terms of risk. In today’s low interest rate environment, it’s easy to equate small numbers (ie-2.0% or 3.0%) with low risk. But that 3.0% return in today’s Treasury market requires a 10-year lockup before the principal comes back. That may not seem too risky, but is a 10% cash reserve too costly if it only means a reduction from 3.0% to 2.7% on the overall portfolio? It might come in handy to buy more bonds if interest rates go up in the meantime. (1)

And so far we’ve only considered Treasury bonds, which are risk free on a nominal basis.

Investments in corporate bonds and equities contain more risk. The small, overall yield sacrifice of a cash reserve could pay for itself many times over if it puts investors in a position to take advantage of opportunities delivered by a volatile market.

With only rare exceptions, it paid to be fully invested during the decades of the 1980’s and 1990’s, But during the 2000’s, a buy and hold strategy was disappointing for many investors and even disastrous for some. Cash would have been a friend during this latter period.

What Kind of Decade Are We In Now?

The market crash of 2008-2009 laid to waste Wall Street’s traditional mutual fund model of being fully invested in a particular investment style. An astounding number of legacy mutual  unds experienced losses exceeding 40%. And many superstar funds have yet to get back to even, so horrendous were their losses.

Of course we can’t know the future, but we think it’s important to recognize the possibility of further market-disrupting events. The obvious possibilities are numerous: structural unemployment in the sluggish U.S. economy, European debt, declining world energy supplies, instability in the Middle East—including the U.S. conflicts in Afghanistan and Iraq—and our involvement in NATO’s no-fly zone over Libya. Makes us wonder what else is out there.

Dynamic Versus Static

We believe recognizing these uncertainties means being willing to make adjustments. For the past three years, we have sought out and invested in mutual funds that change their allocations between stocks and bonds depending on management’s assessment of these macro risks. Of course, they don’t always come to the same conclusion, and they are not always correct, but at least they invest looking over their shoulder for exogenous risks.

The willingness to be opportunistic and adjust positions does not mean investors have to become traders. And the strategy is not new. In The Intelligent Investor, Ben Graham (Warren Buffett’s mentor) recommended an asset allocation system calling for a minimum 25% exposure to bonds and the same for stocks. The remaining 50% can be adjusted depending on economic conditions.

As we have written before, in today’s investment landscape it is naïve to put on the blinders and remain fully invested in one style unaware of opportunities, values and risks in other markets. (See ANNUAL REPORTS 2008, 2009, 2010). This may require higher cash balances from time to time as capital is warehoused for redeployment.

Hedging (2)

View cash reserves as a hedge. Most investors embrace the logic of owning gold, silver and basic commodities to hedge their investments against inflation. And judging from the market action in currencies and derivative bond exchange-traded funds, these too are finding their way into investor portfolios.

We sometimes joke that when we get all the risks hedged, we won’t have any money for investments; we’ll just own a portfolio of hedges. But like investments, hedges also contain risk. Gold could drop $500 an ounce and still be selling at double its cost of production. As for currencies, it may be well to remember that John Maynard Keynes, the famous economist and astute investor, went broke trading them.

Investors need to recognize that if they don’t need the hedge because their investments turn out OK, there is a high probability of loss in the hedging mechanism. It is possible, therefore, that cash is a superior hedge. Its costs are transparent, as described above (2.7% current yield versus 3.0%?), and there are no market losses in the end.

What About The Holding Tank?

Yes, the Holding Tank is designed to hold excess cash to maintain a defined exposure to stocks and bonds. Depending on our market outlook, the HT can represent a conservative, moderate or aggressive posture. As discussed in our Q1, 2011 Report to Clients, however, success of the HT is relative: investors can still lose money even if the HT outperforms on a relative basis in a down market. (And, of course, there is no guarantee of this: it is possible the HT could under perform.) Thus, as stated, the HT is only a partial solution for high cash balances.

Stock Market Risk

It’s interesting that disdain for cash seems so high at this time (beginning of May). In the process of “buying low and selling high,” one might expect equity exposure to decline as valuations rise and profit taking ensues following a two-year, 100% increase in stock prices. Yet this is not the case, according to Investors Intelligence as reported in the Investor’s Business Daily. This contrarian indicator peaked in May with almost three times as many bulls as bears, a two-standard-deviation reading.

Again, we claim no clairvoyance when it comes to the market. But in assessing the ebullience evident in these numbers, we think it might behoove us to remember another statement from Ben Graham’s Intelligent Investor. To paraphrase, Graham said that the greatest risk of loss in stocks comes from buying the stocks of mediocre companies during ebullient times.

If our research on equities is successful, it will help us identify the high quality companies. Then, if we’re patient, we may be able to buy their stocks at prices that reward us in the future. Cash reserves are an integral part of this process.

Conclusion

We hope this discussion of cash balances dispels some of the concern investors may have about holding cash.

• As stated, we recognize that it is a problem, but not as onerous of one as it appears on the surface.
• Plus, to the extent that balances may spike from time to time, remember that profit taking and otherwise selling positions to reduce risk generates cash. Such balances should recede with redeployment of the proceeds, so they need to be regarded as temporary and not permanent.
• Finally, having cash available to capitalize on an opportunity could turn out to be an attribute instead of a problem.

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(1)     Reinvestment of dividends and interest is an important part of the overall return investors will experience on the investment. Counterintuitive as it may seem, falling bond prices and rising yields can actually improve investment results. For a more in-depth discussion of this phenomenon, we would be happy to send you a reprint of our article in NAPFA’  investment Advisor: “Investment Risk 101: Some Straight Talk on Bonds.”

(2)     Of course we may be wrong, and we don’t agree with many of our constituents, but—based on the studies we have seen—we don’t think gold is an effective hedge against inflation. We do believe, however, that it could become the world’s default currency on a temporary basis as the destabilizing effect of currency devaluations spreads around the globe. Many of our clients own small—hedging—positions for this reason.

By: Sam Dreher