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Some thoughts on holding cash and the current market level

November 13, 2012 | About:
whopper investments

whopper investments

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It’s interesting to me how many investors seem to be frustrated by the current market levels. Almost every value investor I respect, from Buffett to Einhorn, have expressed concerns with the fed’s policy and how high the stock market is in the face of on going economic weakness, the fiscal cliff, and the European crisis. Some of them have explicitly expressed their concerns, while other have implicitly expressed their concerns by raising large levels of cash. Personally, I’m a bit cautious on the market, as it’s getting harder and harder to find interesting net-nets or situations that I consider really undervalued. However, I don’t think the market is tremendously overvalued by any stech of the imagination- the ratio I consider most relevant for overall stock market valuation, market cap to GDP, points to a modestly overvalued stock market, and given how low interest rates are, how easy monetary policy is, and how strong most corporate balance sheets seem to be, I think that’s a pretty fair level.

But my thoughts on the markets aren’t what I want to discuss in this post. As I’ve said many times, I’m by no means a macro-investor, and I don’t think my thoughts on macro are either interesting or of value to my readers.

Instead, I want to talk about what I think investors who are having trouble finding drastically undervalued stocks should be doing. And the answer is not going massively into cash.

Instead, I think investors who are having trouble finding their “normal” undervalued stocks need to start looking for special situations, merger arb, etc. In other words, look for non-market corralated opportunities to park your cash while you wait for markets to pull back or to discover more interesting opportunities.

I’m obviously not the first person to think of this. And it is true these situations are both hard to find and require a bit of digging. But I think the efforts worth it, and I think it’s a hunt that’s necessary for small investors looking to outperform today’s markets.

I’ve felt this way for a while, but what inspired me to write this post is this (excellent) review of Buffett’s shareholder letters over at valueprax. When he was running money for his limited fund, he would lighten up on “generally” undervalued situations when he felt the market was high and he couldn’t find the normal undervalued stocks he was looking for. And would he just sit on all that cash? No, he put that cash into workouts and arbitrage situations.

Now, many will point out that Buffett returned all of his outside money in the late 60s/early 70s when he couldn’t find any undervalued stocks. And they’ll also point out that Buffett is holding tons of cash now, not investing in merger arbitrage and workout situations.

But I think there’s a pretty simple reason for that: both at the end of his fund and today, Buffett simply employs too much capital to invest in most workouts and arbitrage.

In other words, this is an advantage that we as small time investors have over Buffett and the big guys- we can invest in almost literally any stock / bond, and thus every workout situation is available to us.

So where would I recommend looking?

I’m personally looking at bankrupt equities, though I don’t have any good ones I’m currently in. I think turn around plays like Gramercy (GKK) and Premier Exhibits (PRXI) make for excellent investments which iwll ultimately have little correlation to the market. Things with fixed, hard catalysts like GYRO offer interesting plays with no correlation to the market. And of course, merger arb remains an interesting place, though I (again) don’t have any current opps there.

As I’ve said many times, I think that an interesting place to invest if you’re just looking to park a bit of cash and get some alpha to the markets is closed end funds trading at a discount that are likely to liquidate (per Special Opportunities Funds strategy). While I wouldn’t want to put all of my cash in those strategies, it’s a nice place to reduce some of your cash balance if you’re truly devoid of ideas.

Another fun idea is investing in pink sheet / over the counter stocks that are about to uplist to an exchange. While I wouldn’t want that to be the only part of an investment thesis in a stock, an uplisting can often serve as a catalyst to drive an undervalued over the counter stock closer to fair value, and it presents a nice firm timeline.

And, of course, there are still plenty of net nets / deep value stocks out there if you look hard enough!

Obviously, there are other places to look. And if you can’t find anything that falls in your personal circle that you feel comfy investing in with a nice margin of safety, than it’s way better to just sit in cash and speculate.

But I’m writing this article to say this: don’t get discouraged. You may have noticed that I took a pretty long dry spell the past two months in terms of writing articles. It’s because I was discouraged- it seemed every stock I looked at had enjoyed a 50% run before I got to it, and I was having trouble finding anything new and fun to talk about.

But if you keep turning over rocks, you will find things to invest in, and you will find interesting work out opportunities. Keep at it, and you’ll be able to keep (relative) pace with the market while it’s rising, and you’ll have plenty of cash coming your way if and when the market ever falls.

Disclosure- long GKK, PRXI, SPE


Rating: 2.5/5 (6 votes)

Comments

tonyg34
Tonyg34 - 1 year ago
http://www.sinletter.com/merger-arbitrage/

by no means a complete list by an easy searchable place to start looking at m&a deals
batbeer2
Batbeer2 premium member - 1 year ago
>> Instead, I think investors who are having trouble finding their “normal” undervalued stocks need to start looking for special situations, merger arb, etc. In other words, look for non-market corralated opportunities to park your cash while you wait for markets to pull back or to discover more interesting opportunities.

This is a great solution. Having said that I believe there is a way to avoid the problem. The problem of finding new undervalued companies arises from the fact that the ones you bought before were mediocre to begin with. For the sake of this discussion I define mediocre as "unable to compound intrinsic at a satisfactory rate."

If you can sell a mediocre company at a good price..... you should sell. Lexmark, GM, Solitron and Steinway come to mind. As far as I know, these companies are not going to grow intrinsic value at a rate I consider satisfactory.

If on the other hand the price of a great company becomes a tad expensive.... you have options.

Leucadia comes to mind. Buying that company at 0.5x book is probably a good idea. Selling at 2x book is a choice. You could do it and rotate into a portfolio of workouts or... you could go fishing; ignoring the elevated price of the stock.

If you don't like LUK, think of MMM, KO, BRK, DJCO or for that matter MTD.

In short:

Pick your poison:

- Sitting on cash in a bull market is mentally tough.

- Managing a portfolio of work-outs is a lot of work.

- Buying growth stocks on the cheap requires some skill and a lot of patience.

I choose #3. Heaven forbid we find ourselves in an extended bull market. I do not want to spend a decade or more turning over rocks in search of increasingly elusive workouts and/or net-nets.

Just random thoughts.
BEL-AIR
BEL-AIR - 1 year ago
Actually all those things simply do not work anymore like merger arbitrage and workout situations, the market is far to efficient nowadays.

As soon as someone announces to buy a company called abc that is currently priced at $23 for $30. so another words the company was $23 before the buyout announcement, after hours it shoots up to $30 and opens close to $30 the next morning.

So no chance to make money that way, just to much information available and to many guys with brokerage accounts who put in market orders the day before, so unfortunately trying to make money with these does not work any more..

Back in the day not many knew what buffett knew, he spent weeks researching a company in the library before he bought, nowadays it happens in minutes, no time to research, to many guys putting market orders in..

I tried looking and did researching on these types of plays, and even by looking in the rear view mirror still could not really find such plays, markets always go up after hours soon as it is announced.

Lets face it with zero interest rates around the world today, and trillions on the sidelines such under valuations are not gonna happen in this internet screening age.

Best to have cash and wait for even a small sell off that happens once every year or two, besides that it is tough.

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