Triggers and Cash Positions

When I first started in the investing world, a mentor of mine who I have quoted before once said, “Don’t lose much money in the downturns and your total returns will take care of themselves.” Not having lived through the 1973-1974 bear market (In the 694 days between Jan. 11, 1973 and Dec. 6, 1974, the Dow Jones Industrial Average lost over 45% of its value, making it the seventh-worst bear market in the history of the index [1]), I couldn’t quite get my head around such an insight. After the 2000-2002 bear market and the 2008-2009 Great Recession, I finally have an all too clear idea of his maxim.

Over time I have taken this key learning to heart. In 2002, at the Nintai Charitable Trust (a trust I personally manage), I began to add trigger mechanisms to our risk mitigation strategy that over time have proven their worth. While I can’t go into specifics for proprietary reasons, I thought I’d share one group of numbers and what steps we take after each is triggered.

Nintai Charitable Trust’s (NCT’s) risk mechanisms are centered on two very broad buckets of data – aggregate market and total portfolio. While I am less concerned about what happens in the market, I do acknowledge some conditions can tell us about the current and future risk of both. Each time one of these mechanisms is triggered, I expect a correlative increase in NCT’s cash position within the portfolio. In other words, the more expensive both the markets and our portfolio get, the more cash NCT should be holding.

As an example, one trigger is based on the general market P/E ratio. NCT utilizes Morningstar’s valuation criteria and market tools to calculate this. The first trigger is set to engage when the P/E ratio exceeds a certain number such as 15. At this point, I would expect to add roughly 2% to 3% cash to the portfolio. In general, this is achieved by taking profits from our companies with the highest price/valuation ratio. Each additional one (1) point gain in the market P/E requires an additional increase in our cash position. The following triggers are utilized in a similar fashion.

1. Portfolio P/FC
2. Portfolio PEG
3. Portfolio Fair Value Average

I feel these triggers – along with NCT’s stock selection criteria – are the two key components that led to our outperformance in 2001, 2002, 2008, and 2011. I should make clear, though, that while allowing me to pat myself on the back in the downside years, they forced NCT to underperform in many of the up years like 2013 and 2014. But much like our mentor John Stanos said, taking care of the down years can mostly (but not always!) create adequate returns in the long term.

The Cruelest Month

These triggers provided us with clear guidance in the market run up through this summer. By July 1, cash represented the largest position (roughly 30%) in the Nintai Charitable Trust portfolio. Every one of its triggers was somewhere between three (3) and five (5) grades (or “ticks” as we call them) above the initial warning levels. While painful to hold so much cash as the markets continued their unprecedented run during 2013 and 2014, all bills came due when we suffered a significant downturn in August. As seen below, the NCT portfolio was up for the month while both its bogey and the general markets fell substantially.

Controlling What You Can

Nobody can predict when markets will crash or by how much. Trying to calculate this will likely drive most normal human beings crazy. A Greek philosopher once said “Control what you can, prepare for what you must.” I can only control two items during a down market – NCT’s holdings and whether I buy, sell, or hold during the crash.

This philosophy drives two key criteria I utilize in our portfolio management. First, NCT seeks companies that will face absolutely no credit worries if or when the markets crash. These are companies with high returns, generous free cash flow, little to no debt, deep competitive moats, and management who are great allocators of capital. Second, I can control the timing and duration of our ownership. A move to cash when markets and stocks seem overpriced gives me the freedom to either ignore downward swings or participate by acquiring shares at a discounted price. Triggers during bull markets give NCT the best chance to meet these goals.

I should emphasize (as mentioned previously) triggers on valuation upside can lead to significant underperformance – particularly in the last stages of a bull market. For instance, the NCT portfolio has underperformed the S&P 500 over the past three (3) years with a 9.8% return versus a 13.2% return for the index. At five years, we are nearly even and only at 10 years do we show a real advantage (15.9% annual return versus a 6.9% annual return for the S&P500). If you are planning on using upside triggers be prepared to face extraordinary pressure from your investors and your own inner convictions.

Conclusions

NCT sees cash as any other asset class when it comes to investment returns. Any decision when it comes to allocation should answer a simple question: Will this asset provide investors with the greatest possible upside and/or does it provide the greatest downside protection? The ability to have triggers that create increasing cash positions provides an answer to the latter part of that question. It’s not easy to carry out, but I think you can be handsomely rewarded for your efforts.

As always, I look forward to your thoughts and comments.

[1] Don’t feel bad. The London Stock Exchange's FT 30 lost an incredible 73% of its value during the same time period.