If there’s one thing Warren Buffett (Trades, Portfolio) likes, it is cash. Cash generation has always been a priority at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), and over the years Buffett has successfully deployed cash reserves into select investment opportunities, all of which have combined to make Berkshire what it is today.
Berkshire Hathaway is now generating tens of billions of dollars in cash every year, and Buffett likes to deploy this cash using what he calls an "elephant gun." Put simply, the cash elephant gun is simply a slug of cash used to buy the biggest and most attractive investment opportunities at the right moment. And when it comes down to it, waiting until it is the right moment to pounce is what Buffett is best known for – without his elephant gun it's unlikely he would have been so successful over the years.
Learning from Buffett's cash gun
Investors can learn a lot from Buffett’s approach to cash. The conglomerate closed the third quarter with a record $84.4 billion in cash, a gain of $13 billion year on year. Buffett likes to keep around $20 billion of cash on hand in case of unexpected losses at Berkshire’s insurance subsidiaries. Excluding this cushion, Berkshire held $64.4 billion in cash ready for spending at the end of the third quarter.
Buffett will only spend this money when he finds an asset worth paying for at a price worth paying. Characteristically, Berkshire usually runs down its cash balance during bear markets when the best deals are to be had.
Keeping a cash balance on hand is perhaps one of the most valuable lessons you can learn from Buffett. Indeed, most readers are probably familiar with Buffett’s famous phrase “be greedy when others are fearful,” but it is only possible to apply this methodology if you have cash ready to spend when the eventual crash comes. Of course, the big problem is that it is not possible to know when the crash will come, and most investors will feel that they are missing out on the market’s gains while they have cash on the sidelines, a feeling that will push them to make investments.
Change your perception
To be able to use the elephant gun strategy successfully, investors need to change their perceptions of cash. By holding cash, you’re not missing out on gains but holding a cheap hedge. As Frank Martin of Hummingbird Partners describes:
“Consistent with everything else written above, we think of cash as a trump card that can be played any time. Holding a card in your hand that ranks above all others is a secret weapon in the competitive game for the best ideas at the best price, allowing us to gain an advantage.”
What’s more, consider these figures. According to Dalbar’s annual Quantitative Analysis of Investor Behavior study, over the past three decades the average equity mutual fund investor has achieved an average annual return of 3.66% while the Standard & Poor's 500 returned 10.35% per annum and inflation averaged 2.6% per annum.
If you had cash on hand ready to buy at the beginning of the financial crisis, say at the beginning of 2009 (three months before the market bottomed in March), between January 2009 and January 2010 you would have achieved a return of 27% just by investing in the S&P 500. If you held the position for two years, the performance would have been even greater at 44.1%. If a virtual investor had held a 15% cash balance before the 2008 crash and invested 10% of this cash in an index fund at the beginning of January, by the end of the year – assuming the rest of the portfolio achieves an average 3.7% – the portfolio would be up by 5.8%, a 2.1% improvement on the average investor. Over the two-year period, assuming the average investor returns a basic 7.4%, the cash-to-S&P 500 investor could see a return of 11.1%, an improvement of 3.7%.
These are just back-of-the-envelope figures, but they make an interesting point.
The bottom line
All in all, every investor can learn something from Buffett’s cash elephant gun approach. Cash gives investors optionality to invest when markets are skewed in their favor. Without this optionality, you stand to miss the best investment opportunities – and no investor wants to be in that position.
Disclosure: The author does not own any share mentioned within this article.
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