Beyond The Headlines
The Ultimate Argument for Holding Cash
With the stock market at an all-time high, patient and disciplined investors have gone right out of fashion, but that’s how we at Sicart still proudly identify ourselves. We don’t just attempt to hold the best- quality businesses we can identify, which we seek to buy at the lowest possible prices. We also remain historically underinvested, holding substantial (and seemingly idle) cash.
In moments like this one (which I might experience many more times in my investing career), I’m reminded of the words of Jean-Marie Eveillard, the famous value investor and long-time manager of the First Eagle Fund: “I would rather lose half of my clients than half my clients’ money.” The majority of our own money is invested alongside that of our clients. It is our intention to keep all of our clients, add many more, and preserve and grow their capital along with ours.
The last eighteen months (with the exception of a recent Fed-funded mini-rally) has been a period of flat, sideways markets. However, it’s been an increasingly exciting time for us, stock pickers, who intend to build a portfolio for the next five, ten, possibly even fifteen years. The pick-up in volatility and the market’s mild corrections have been short-lived, though. In the last 12 months we have managed to buy more stocks, and invested a larger portion of the capital, than in the previous three years. Yet we still hold ample cash reserves. There would be no trouble with that choice if it didn’t create an obvious drag on short-term performance. On one hand, we add new positions that have yet to perform. On the other, the fact the we are underinvested gives a meaningful and growing headwind versus the market for the near term.
This creates an opportunity to raise the age-old question – why hold cash at all? Why not stay 100% invested through thick and thin? Of course, the ideal scenario would be to stay 100% invested all the way to the top, and 100% in cash all the way to the bottom of the market. The trouble is that no one has ever perfectly called the top and the bottom. If you look at the cases of investors who have supposedly performed this feat, you’ll find that in reality, what they did was to allow their cash balance to grow as the market rose beyond reason, and reinvest it all when the market dropped and investors panicked. The biggest concern with this approach is fear of missing the peak of an ever-rising market as we maintain our investment discipline. Regrettably, it’s a fear that has often cost investors more than they could afford to lose.
Since numbers don’t lie, let’s do a little experiment. Let’s assume that we have two portfolios, A and B. B is always 100% invested, but A chooses to go to 65% invested in the late years of a bull market. For simplicity’s sake, let’s assume that the managers’ picks for both portfolios are the same, equal to the overall market performance. (We give the managers no credit for stock-picking ability!) Let’s also assume that the manager of Portfolio A is exceptionally early with his decision to raise cash level, and it takes another whole five years from today for the market to correct and become more reasonably priced.
Finally, we’ll imagine that the stock holdings return 12% compound rate over those next five years – close to the (exceptionally high) last five-year return of the S&P 500 Index. Portfolio B (100% invested) will have grown each hypothetical $10,000 investment to about $17,600, while Portfolio A (steady 65% stock exposure) will have reached around $14,600, a whole $3,100 less.
Before you decide which strategy, you prefer, let’s entertain a scenario where stocks do drop by 50% after those five years. That’s in line with the historic market corrections. I might be a year shy of forty, but I have already seen two similar corrections in my adult life, and my senior partners have weathered half a dozen — if not more!
After that drop, our hypothetical Portfolio B is valued at around $8,800 and Portfolio A at around $9,800. That’s an immediate lead of $1,000 for the patient Portfolio A. But consider this: Portfolio A now holds over 50% in cash, ready to invest! In this scenario, if stocks were to compound again at a historically high 12%, it would take Portfolio B (100% invested) a whole six years to reclaim the previous peak value — or over a decade if the market returns 7% (close to the actual ten-year total annual return for the S&P 500). That’s assuming Portfolio B managers do the impossible — keep their cool, and stay fully invested all the way to the bottom and back up!
Portfolio A’s lead will grow from the market lows, and if you assume that Portfolio A’s stock picks do a little better on the way down, and a little better on the way up than the fully-invested Portfolio B, that $1,000 lead will grow even faster in the next 5-10 or 15 years.
It’s difficult to ignore that a mere 33% market correction would erase the entire hypothetical five-year lead of Portfolio B over A, and 33% doesn’t even get us to the pre-2016 Presidential election market levels. For example, a 65% drop in stock prices would have derailed Portfolio B for almost a decade, assuming historically high 12% S&P 500 returns. That lag would increase to over fifteen years given a 7% return, which is close to a ten-year actual annual return for the S&P 500. That’s how long it would take Portfolio B to reclaim its past highs. With a 33%, 50% or 65% drop, Portfolio B (100% invested) would lag Portfolio A (65% invested at the peak) by a growing margin for decades to come.
With those numbers in mind, next time we wonder if we are missing the boat, and possibly never catch up with the market, we remind ourselves how even a minor market correction would not only put us ahead of a 100% invested portfolio, but also set us on a very promising path of outperformance for decades to come. Most of all, it’s important to note that even if it takes five years, Portfolio A ends up on top.
The United States is in the eleventh year of the longest-lasting, most heavily-subsidized, politicized, propped up, helped, and cheered on bull market ever. We are eager to be 100% invested eventually, we don’t believe this is the time though. We at Sicart consciously choose to sacrifice some of the near-term upside in the name of protecting capital from the near-term risk, while staying well-positioned to capture an even bigger long-term upside. It might prove to be the hardest investment decision of our careers, but we remain convinced it’s the right one given what we know. The underinvested portfolio remains the wise choice, especially for anyone who intends to stick around in the investment world for many decades to come. We do! Do you?
And as a bonus, here you will find a short explanation why Warren Buffett and Charlie Munger hold “idle” cash: 2019 Berkshire Hathaway Meeting.
Published: December 5th, 2019
This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.