Cash might not be the most exciting asset out there, but it is vital in the asset allocation process.
I believe cash is one of the most overlooked assets when it comes to investing, from both an asset allocation perspective and business perspective.
In fact, I could argue that cash is the most important thing to consider for any investor when making any investment decision.
Cash optionality
Cash is so important because it gives you options. Having a large cash allocation in your portfolio might not seem attractive, especially with interest rates where they are today in comparison to dividend yields, but there's more to this asset than its income. By holding cash, you have options -- options to invest when and where you want at the click of a button, to take advantage of market opportunities when they arise without having to sell other holdings and possibly crystalise a loss when there was no need to in the first place.
Granted, cash alone won't make you rich, but it is what you're able to do with the funds that really matters.
Holding cash for three years and then pouncing on an opporuntiy that returns 100% in 12 months gives an compound annual growth rate of 18.9% -- what Warren Buffett (Trades, Portfolio) calls waiting for the right pitch.
"Ted Williams described in his book, ‘The Science of Hitting,’ that the most important thing – for a hitter – is to wait for the right pitch. And that’s exactly the philosophy I have about investing – wait for the right pitch, and wait for the right deal. And it will come… It’s the key to investing."
But there's more to cash than the flexibility it gives you to swing at the best pitches.
Insurance policy
Cash can also protect you from making stupid investment mistakes.
You should only invest what you can afford to lose, and you should never put yourself in a position where you may have to sell investments to meet and unforeseen expense. Being forced to sell will lock in losses and may push out of a long-term winner too early.
The problem with this approach is that unforeseen expenses are just that: unforeseen. You don't know how big they will be and when they will strike. This is why it will certainly pay to have a layer of cash in your portfolio, to act as an insurance policy against the unknown and unforeseen. Once again, in this scenario, the flexibility offered by cash is its best trait.
Cash is a vital tool from an asset allocation perspective and it is also an extremely telling marker of business quality.
Quality control
There are many different ways to evaluate companies. However, I have found cash is by far the best.
There are two key reasons why I believe this to be the case. First of all, companies with a cash-rich balance sheet are less likely to run into financial problems. Survival of companies with a large level of debt on the balance sheet is dependent on the kindness of strangers -- something you can never rely on. In times of stress, creditors will most likely disappear, and this will be bad news for the firm. Businesses with plenty of cash have flexibility, and they're not likely to go out of business at the first sign of trouble.
Second, cash flows tell you more about a business and its prospects than any other metric. If you study frauds, the most common indicator in all scenarios is cash. Profits can be manipulated, but cash flows are more difficult to adjust favorably without giving the game away. If a company is converting the majority of its profits into cash, there's a high chance it's not a fraud.
Put simply, I believe cash is one of the most underrated assets around. Not only does it fill a critical asset allocation role, but it is also a key marker of business quality. Humble cash is the investor's best tool.
Disclosure: The author owns no stock mentioned.
