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Rupert Hargreaves
Rupert Hargreaves
Articles (1003)  | Author's Website |

The Benefits of Holding Cash

Seth Klarman discusses the benefits of holding cash

December 11, 2017

Seth Klarman (Trades, Portfolio) is one of the best value investors in history. Since its founding in 1982, Baupost Group has achieved high-teens returns for investors every year.

What is more impressive is Klarman has been able to chalk up this performance while keeping a significant portion of his portfolio in cash. Famously, the cash portion of Klarman’s portfolio has averaged around 20% since inception and has, at times, risen above 40%.

Klarman’s love of cash is not unique, but his ability to be able to chalk up such impressive returns, while at the same time holding so much cash, is remarkable.

So what’s the logic behind this? Why is Klarman happy to have so much cash and still achieve market-beating returns? He offered some insight into his process in an interview with editors of the TIFF Education Foundation newsletter in 2009.

When asked about his love of cash, Klarman replied:

“I think there’s a tendency in the modern world of people wanting their money to be working hard, and I joke that our money is like a couch potato by comparison. In my opinion, the market tells you when to buy things.”

He goes on to say the market should dictate your asset allocation. If stocks are cheap, you should be overweight equities. If stocks are expensive, then it may pay to be overweight cash, something institutional models fail to take into account:

“And when things are really cheap, on a Graham and Dodd valuation basis, you should like them more. And when they’re really expensive, you should like them less. One of the hard things about institutional asset allocation models is that they don’t necessarily vary all that much based on price.”

This seems to be the whole driving force behind Klarman’s asset allocation. Rather than setting out to have a certain portfolio percentage in cash and another set amount in equities, Klarman is building his portfolio in the way of the market. Compared to other funds (Bridgewater), this is a relatively simple process as it only requires a simple mental model:

“We have a mental hurdle rate that says we ought to get paid for the risk of that investment, and if it’s low-risk we ought to get a good return, and if it’s medium-risk we should get a really good return, and if it’s high-risk we should get a great return. Even if those move around a little bit based on where the world is, our discipline is to not invest when we don’t see pretty good bargains and pretty good potential returns.”

As the head of one of the world’s largest and most successful hedge funds, Klarman is in a unique position. He is fed ideas on a daily basis, which allows him to judge the market and only pick the best ideas. Other investors just do not have the same information flow and degree of flexibility:

“So I wouldn’t want the crowd here to think, 'Well, we need to start going to 50% cash sometimes.' I don’t know what everybody should do. I just know that because I sit at a really interesting desk where a lot of really interesting bottom-up ideas cross my plate, I can tell very quickly, do we have no opportunities? Do we have a few sparse opportunities? Do we have a flood of opportunities?”

But as it turns out, having a flood of opportunities might not be the best situation to be in, as without enough cash, taking advantage of cheap stocks is impossible. Maintaining a healthy cash balance is required to keep the ideas funnel open:

“There’s also something about the engine of creating opportunities that needs some cash to function. You’d hate to tell a great real estate partner or a great broker, 'You know, that’s a really interesting opportunity; I’m glad you have this billion dollars of assets for sale at a ridiculously low price, but I’m sorry, we’re tapped out today.' That’s not a good answer. When you’ve worked really hard to cultivate relationships, you’d like to feed them, so you in some sense always want to have some buying power.”

So not only is cash a tool to buy securities for Klarman, but it is also a tool to help gauge the level of the market and help maintain the “engine of creating opportunities.”

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website

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