I have agonized over the role of cash in stock portfolios for long. Often I felt that I should have some cash at all situations because market throws some very attractive opportunities from time to time. Other times I felt that by not remaining fully invested in the stock market I am trying to time the market which is impossible. Generally I have jumped around from one school of thought to another. Before I go into my latest thoughts on cash let me share what two popular investors practice.
First is Warren Buffett who is holding a gigantic amount of cash in Berkshire Hathaway. Buffett has over time mentioned that he prefers to hold some cash at all times because he never wants to get into a desperate situation and cash acts as an insurance for him. It also helps Berkshire achieve other strategic goals by being a strategic buyer in crisis situations. Over the years however Berkshire’s cash has grown larger than what Buffett might have wanted it to be. The reason for this is the elevated stock market valuations and challenge of allocating such a large amount of cash. It’s not easy!
The other gentleman who has strong views on this topic is Seth Klarman. Klarman is the founder of The Baupost Group which is a Hedge Fund with some spectacular performance. He also authored “Margin of Safety” one of the most popular books on investing ever written. Klarman has often gone into large cash positions when he felt the market to be overvalued. He believes that only funds managers trying to perform on a relative basis remain fully invested. That means the manager might have beaten the index when the market is down 25% but probably was down 10% in his own fund (and hence lost money for his investors). Investors who are looking for absolute returns will at times have cash positions.
Based on these thoughts I have tried to formulate my strategy on cash.
1. If I find enough undervalued stocks I will remain fully invested. This is regardless of whether I think market is undervalued or overvalued. If the overvaluation is blatantly obvious then I might have a small cash position but not too much as long as I have enough shares to invest in.
2. If market starts getting overvalued and I am unable to find clearly undervalued stocks then I have a decision to make. Do I allocate more to stocks that are undervalued and get out of the overvalued ones or get into cash? I generally have a policy of the maximum allocation I will put in a single share. That determines if I am reallocating or increasing cash position.
It became very easy for me to understand the role of cash when I constructed a simple model of the stock market. Assume there are two stocks in the market, A & B. Outside of these two stocks we can only keep cash. When A & B are both undervalued I can own both. However when A becomes overvalued I can switch over to B. But when both become overvalued I SHOULD go into full cash. Mathematically what is happening is
Cash today > Present value of future cash flows of either A or B (the last part is how we value companies)
The cash I have today is more valuable than the present value of the cash I get from my investments. At this point we should indeed be holding as much cash as possible.