The S&P 500 continued climbing in the first half of 2017, with a total return of 9.3% (according to Morningstar). Over the past five years, the compounded return for the index has been nearly 15% per annum (enough to double your money). It’s been a wonderful time to be long U.S. equities.
As a corollary, it’s been a tough time if you’re holding dry powder. Instead of double-digit annualized returns, cash and equivalents have earned a pittance. As I’ve communicated previously, I’m holding a significant amount of cash and short-term bonds (just to clarify, I don’t own any long-term bonds). The combination of rising stock prices (which brought certain positions closer to fair value), a lack of enough new ideas at valuations that justified large initial purchases and continued contributions to my investment accounts has pushed the balance even higher. In the short term, the opportunity cost of holding a large – and growing – pile of cash has been sizable.
Despite this, I still maintain that holding cash is a reasonable position. I’ll use the remainder of the article to try and explain the role cash plays in my investment portfolio.
What’s your goal?
In order to determine the “right” path, we first need to decide where we’re trying to go. What is your investment objective? Personally, my goal is attractive long-term rates of return.
Let’s unpack that. The “long term” part is pretty obvious. It alludes to the fact that I have no idea what the market (or any individual stock) will do tomorrow, next week or next month. While I’m happy when my investments outperform the market, I try to focus on short-term performance as little as possible. Importantly – and I think this is often overlooked – the noise from short-term price swings can distort my thoughts on the long-term fundamentals. For this reason, I try to check stock prices infrequently. I also try and avoid the constant horse race against Mr. Market.
The second part of my goal – “attractive rates of return” – is a bit messier. The first hurdle to clear for “attractive” returns is a relative measure: what could I achieve if I invested in a low-cost index fund? I personally view the S&P 500 as a reasonable benchmark. Historically, the return for the index has been around 9% to 10% annualized. The second hurdle is an absolute measure – albeit a somewhat arbitrary one. My definition of “attractive” is a few hundred basis points more than I could achieve by investing in the broader market (I see no reason to assume that equity returns over the next 50-plus years will differ greatly from the returns over the last century).
Admittedly, the distinction between the two is somewhat flimsy. For example, I’ve reduced my absolute return requirement over the past few years to account for the current interest rate environment as well as to account for less attractive forward rates of return in the ensuing five to 10 years than have historically been achieved in equity markets. Said differently, I’ve tried to maintain the size of the gap between my hurdle rate and reasonable short-term (five to 10 years) market expectations. You could argue I’m giving in to the fact that Mr. Market is offering less attractive opportunities. Another way to frame it is I’m being realistic about the current environment. I’ll leave it to you to decide whether this is a pragmatic compromise or a breakdown in process.
Anyway, here’s the point: My bogey is somewhere between a relative and absolute metric. What I’d argue is that the relative hurdle – the index return – moves closer to an absolute hurdle as you expand your time horizon. While I’m willing to be somewhat flexible in the short term, there are limits. Buying – or continuing to own – securities that offer expected returns that are well below my hurdle rate is something I’m not willing to do. That alone guides my investment approach. When I find opportunities that exceed my return requirement, I’ll invest. When I can’t, I’ll wait.
Howard Marks (Trades, Portfolio) believes that “patient opportunism – waiting for bargains – is often your best strategy.” This approach resonates with me. Instead of forcing my hand, I'll be patient. My default assets in that scenario are cash and high-quality, short-term bonds.
Here are your other options if you’re not going to hold cash: (1) have your default position be to an equity index like the S&P 500 or (2) increase the weightings of your current holdings.
Here’s my issue with the first approach: if I go out and analyze every company in the S&P 500 and none appear particularly attractive (the return potential is not sufficient relative to the assumed risk), where’s the logic in deciding to own all 500 of them? It simply doesn’t make sense to me.
While I find the second approach more appealing, it comes with its own issues. Is the answer to a generally expensive market (as indicated by our bottom-up research) to go all-in on whatever’s least expensive? Is today's relative valuation all that matters? Unsurprisingly, even the attractive securities in the current environment (or at least the one’s I’ve found) are not clear bargains. Most of them only clear the return requirements I discussed above by a thin margin. While I can see why some people go this route, I still get the sense it’s not something I’m personally comfortable with.
Conclusion
I don’t think the current opportunity set appears particularly attractive, broadly speaking, for stocks and bonds alike. It is what it is. As Peter Bernstein once said, “The market is not a very accommodating machine; it won’t provide high returns just because you need them.”
As I see it, here are our two options from there: commit to owning securities priced for subpar returns, or move to the sidelines and wait for better opportunities. I prefer to do the latter.
On the other hand, there are “professionals” in the industry that have (and will) stay invested. There’s career risk associated with missing the late stages of a bull market. If you live in a world of short-term, relative performance, Mr. Market largely dictates how you act – not the other way around.
Of course, this all comes with my usual disclaimer: That’s not to say stocks will fall anytime soon. This quote from Marks is spot on:
“Most of the time, assets are overpriced and appreciating further or underpriced and still cheapening.”
If you are influenced by the price action of the overall market – either by your own “choosing” or an external investment mandate - holding cash may not be a viable option. If you’re focused on the short-term performance of your portfolio relative to the market, holding cash is likely to be a source of pain for much of your career. If you’re in this position, it’s probably not worth it.
But if you're cognizant of these considerations, the current “cost” of holding dry powder really isn’t that taxing. I’d argue the cost is falling as market values climb at a faster rate than intrinsic value. While painful in the short-term, I think it's likely to work out in the long-run.
I’ll close with something Seth Klarman (Trades, Portfolio) wrote to investors in his year-end 2004 letter:
"Some argue that holding significant cash is gambling, that being less than fully invested is akin to market timing. But isn’t a yes or no decision the crucial one in investing? Where does it say that investing means always buying something, even the best of a bad lot? An investor who can’t or won’t say no forgoes perhaps the most valuable tool available to investors.
"Charlie Munger (Trades, Portfolio), Warren Buffett (Trades, Portfolio)’s long-time partner, has counseled investors, 'Look for more value in terms of discounted future cash flow than you’re paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor.'
"Investors expect corporate managements to make carefully reasoned decisions, such as whether or not to commit their capital to build new factories, hire additional staff or acquire a competitor. A corporate management that invested capital at low expected returns just because they had the funds at their disposal and nothing immediately better to do would inevitably arouse investor ire.
"Why, then, should any investor (hedge fund, mutual fund or individual) always deploy 100% of their capital into marketable securities, applying none of the analytical rigor or intellectual honesty they would demand of the underlying corporate managements? As we said last year, why should the immediate opportunity set be the only one considered, when tomorrow’s may well be considerably more fertile than today’s?"
