One of the most frequent questions that potential and existing investors ask us is about our high cash position in the portfolio. Currently, the cash allocation is ~19% of the portfolio value. This is clearly a high level. Most other funds do not have even 5% of their assets in cash.
Our high cash holding is not intentional due to our desire or belief in ability to time the markets. The cash holding is entirely an outcome of our investment process and capital allocation process – (1) finding an investment idea that meets our return objectives and (2) deciding the stock idea’s allocation in the portfolio. (1) and (2) are not disconnected. Very attractive ideas will invariably have a higher portfolio allocation.
A high cash holding essentially means that finding very attractive investment ideas is harder than ever before. Based on our discussions with several fund managers, we are not alone in this respect. In such a scenario, fund managers have two options (1) be patient and work harder to find investment ideas that have an adequate margin of safety or (2) deploy capital irrespective of underlying valuations.
For a fund manager, the choice between the two options is not easy. We have chosen Option 1 and strongly believe it is the better option for long-term investors.
Staying in cash when valuations are rich is the most rational thing to do. Having no aversion to a large cash position ensures that we do not fall in the trap of investing on the basis of relative valuations (“Look X is trading at 40 P/E multiple so Y is cheap at 30 P/E multiple- Invest”) and focus entirely on absolute fundamentals (“Y’s 30 P/E multiple is not justified by its fundamentals – Avoid”). Warren Buffett considers cash as a call option on all stocks with no exercise price and no expiry date. Cash allows investors to exercise the call option by buying those stocks which are “in the money” in the future. No wonder that Berkshire Hathway even at this scale has over $70 billion in cash.
Behavioral factors also support staying in cash. The Disposition Effect is a well-documented anomaly in behavioral finance. It is the tendency among investors to “sell winners and hold onto losers”. It is also related to Daniel Kahneman and Amos Tversky’s Prospect Theory – “losses have more emotional impact than an equivalent amount of gains”. In a market fall, it proves to be difficult for someone who is fully invested to sell a losing position to buy some other stock (which may have better return prospects). Quoting Thomas Moore verbatim – “When you have sufficient cash in reserve, you get to dictate how and when you’ll make your next investment. If, on the other hand, you are mostly (or worse, fully) invested, your ability to take advantage of new, good investing opportunities is restricted.”
While we prefer Option 1, majority of the fund managers choose Option 2 i.e. staying fully invested. This is the case even when the fund mandate allows a higher cash allocation. Most of the fund managers who follow a 100% or near 100% deployment do so due to institutional constraints. However, few behavioral biases also justify staying fully invested.
Institutions managing large pools of capital have a significant problem of being measured on a monthly basis by their investors and distributors. Even a small period of underperformance due to a large cash position in a rising market results in shift in capital from underperforming funds to outperforming funds. This can be a life-and-death issue for institutions which don’t have a sticky investor base and have high dependence on distributors for investor relations. Being 100% invested ensures no significant underperformanceand higher client retention in rising markets.
Few behavioral factors also support staying fully invested. After a period of underperformance in rising markets, even experienced investors can end up deploying their cash position at much higher valuations. This is primarily due to the Fear Of Missing Out (FOMO), peer pressure and the media cacophony which will find zillion reasons for markets to rise further. Staying level-headed in such an atmosphere is easier said than done. Even if fund managers are sitting on cash in the portfolio, they may be unable to benefit from market downturns as they are also swayed by the fear of further decline in prices (“will buy after it falls more”). Therefore, it is better for them to be 100% invested at all times.
So, the preferred option for a fund manager largely depends on his constraints and/or the dominant behavioral factors of his personality. While we prefer Option 1, this doesn’t mean we will perpetually have a high cash position. If we find good ideas at attractive valuations, we will invest more capital irrespective of market levels. However, in the absence of a margin of safety, we will prefer to be in cash than to relax our investment criteria.
While these are still early days, this approach has worked quite well for us. Our cash position allowed us to buy several quality businesses at bargain prices during events such as the demonetization scare of Nov-Dec 2016 and the surgical strikes of Sep 2016. We believe there will be many such opportunities over the next few years as the equity markets go through their normal cycles of greed and fear. However, it remains to be seen how successfully we manage periods of underperformance in rising markets and if we can stay level-headed in euphoric times.