Seth Klarman (Trades, Portfolio) is one of the best value investors of all time. Over the last few decades his hedge fund, the Boston-based Baupost Group, has produced an annualized return of around 20% for investors.
What's impressive about this return is that he has been able to achieve it while keeping a large percentage of assets in cash.
Klarman likes cash because it offers optionality. He has said in the past that it is his favorite investment hedge because unlike other hedging instruments, it does not cost money to hold cash and there is no chance of unforeseen losses if the market turns against you.
For most investors (and I'm referring to institutional as well as retail), however, the opportunity cost of holding cash rather than being in the market is just too much. But for Klarman, it is all about reducing the risk of permanent capital impairment -- the overriding goal of his investment strategy.
Why Klarman loves cash
In his 2004 year-end letter to Baupost partners, Klarman outlined his "painful decision to hold cash." What's fascinating about this text is that it is still highly relevant today, nearly 15 years on from when it was first written.
Klarman's letter started with a broad overview of why he favors cash over securities, even though there is an opportunity cost associated with the switch:
"It wouldn’t be overstating the case to say that investors face a crisis of low returns: less than they want or expect, and less than many of them need. Investors must choose between two alternatives. One is to hold stocks and bonds at the historically high prices that prevail in today’s markets, locking in what would traditionally have been sub-par returns. If prices never drop, causing returns to revert to more normal levels, this will have been the right decision. However, if prices decline, raising prospective returns on securities, investors will experience potentially substantial mark to market losses, thereby faring considerably worse than if they had been more patient."
So much KlarmanÂ strategy is designed to reduce risk, and this part is no different. He laid out the primary risk investors face by choosing to invest in stocks at high prices rather than sitting on their hands and holding cash.
The primary risk is a permanent capital impairment or substantial mark-to-market losses. Any investor who has been putting money to work for some time will know that losses can come hard and fast, erasing years of returns. Avoiding these at all costs is, in my opinion at least, worth sacrificing a few percentage points of returns for.
In some respects, we face a similar environment today, especially in the frothy tech sector, where investors are chasing stocks ever higher in the belief that we are in a new normal environment and valuations will never revert to the mean. On this topic, Klarman also had something to say:
"Betting that the markets never revert to historical norms, that we are in a new era of higher securities prices and lower returns, involves the risk of significant capital impairment. Betting that prices will fall at some point involves opportunity cost of uncertain amount. By holding expensive securities with low prospective returns, people choose to risk actual loss."
Supporters of passive investing and efficient market theory might argue that this strategy has many similarities to market timing, which multiple studies have shown to be a fool's errand. Klarman believes this is incorrect, and choosing when to enter the market is a crucial component of investing:
"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.”
Disclosure: The author owns no share mentioned.