Since I didn’t have time to check on the markets last Friday, I turned to financial television for a quick update. I watched three networks and all were discussing the same topic – record high stock prices and the FANG stocks.
Technically the FANG stocks include Netflix. No offense Netflix, but your market cap of “only” $71 billion is a small cap relative to other FANG members ($480 to $810 billion market caps). I consider Apple, Microsoft, Amazon, Facebook, and Google the official FANG gang. Together they make up approximately 40% of the Nasdaq 100 and $3 trillion in market capitalization (similar to the size of Germany’s economy). When market caps get this big, I like to value stocks relative to the cost of a modern aircraft carrier. Move over Shiller P/E, meet the AC (aircraft carrier) ratio. Currently, the FANGs are trading near 230x aircraft carriers — a record high and clearly a world superpower.
For many portfolio managers, the decision to own the FANGs is not an investment decision, but a risk management decision – as in, the risk to relative performance and risk to assets under management.
To illustrate, let’s assume the FANGs are significantly overvalued and are selling at 2x their intrinsic value. With this assumption in mind, would a portfolio manager be better off buying the FANGs or holding cash? Holding cash would seem to be the obvious choice, but not so fast. From the perspective of a manager focused on relative returns, holding cash instead of a rapidly inflating asset may be too risky. In effect, does the relative return manager assume the investment risk of owning the overvalued FANGs or assume the career risk associated with holding cash? I think we know the answer. As Jeremy Grantham wrote, “Career risk is likely to always dominate investing.”
While the financial media focused on the FANGs and record stock prices last Friday, I enjoyed a pair of articles discussing the benefits of holding cash. On a day of considerable asset inflation and predictable market commentary, I found both articles to be refreshing reads.
The first article was by David Snowball of The Mutual Fund Observer. In his article, “The Dry Powder Gang”, David discusses the contrarian viewpoint of holding cash. He also provides a list of mutual funds that continue to practice patience (I’m often asked who is willing to hold cash, so thanks to David for providing his list).
In addition to discussing the benefits of practicing patience, David points out the challenges professional managers face when holding cash. He writes, “They bear a terrible price for hewing to the discipline. Large firms won’t employ them since large firms, necessarily, value “sticky assets” above all else. 99.7% of the investment community views them as relics and their investors steadily drift away in favor of “hot hands.”
However, as David explains, there remain a few managers that are willing to assume considerable career risk in order to protect shareholder capital. David states, “They are, in a real sense, the individual investor’s best friends. They’re the people who are willing to obsess over stocks when you’d rather obsess over the NFL draft or the Cubs’ resurgence. And they’re willing, on your behalf, to walk away from the party, to turn away from the cliff, to say “no” and go. They are the professionals who might reasonably claim…we’ve got your back!”
David is one of the few mutual fund analysts who closely covers absolute return funds and funds that hold cash. His site is a great resource for those wanting to learn more about unique non-index hugging funds.
One of my favorite absolute return investors, Frank Martin, also recently wrote about the benefits of cash. He views cash as a call option. Frank writes, “Current investment conventions maintain that cash—or, in my case, a portfolio of laddered short-term US treasuries—is a static holding. That’s a rather unimaginative perspective. Entertain the following thought: Cash is an option that can be valued. Think of it as a call option on any asset, with no expiration date, and with no strike price.”
When investors think of holding cash in a period of sharply rising asset inflation, they often think of opportunity cost. Frank thinks of cash differently and reminds us that while investors holding cash may incur a “temporary sacrifice of return” they are also positioned to take advantage of future opportunity. As the number of opportunities increase, so does the value of cash optionality.
Frank explains, “With market overvaluation induced by the current Fed policy and tail risks high, I think the price of the above-described call option is well below its intrinsic value. If that which most investors think improbable, or even impossible, happens (think no farther back than to 2006-2007 for the most recent extraordinary popular delusion – not counting today), the value of cash as a call option will skyrocket. In the irrationality of the moment, investors will sell other assets at absurdly low prices to acquire, of all things, cash!”
Frank also provides an answer to a question I’ve been asked frequently over my career, “Why should I pay you to hold cash?”
Frank writes, “Of course, most investors think they are not getting their money’s worth when they see their investment manager holding large amounts of cash. Some ‘enterprising’ investors may gradually realize instead that they are paying someone who has demonstrated the necessary expertise to buy cash as a call option when it is utterly out-of-favor and thus compellingly cheap, despite the agonizing wait for bargains to appear.”
Frank goes on to quote Nassim Taleb who wrote, “It’s much easier to sell ‘Look what I did for you’ than ‘Look what I avoided for you.’ Of course a bonus system based on [short-term] ‘performance’ exacerbates the problem. I’ve looked in history for heroes who became heroes for what they did not do, but it is hard to observe nonaction; I could not easily find any.” [my emphasis]
Frank concludes, “Look what I’ve avoided for you” falls on deaf ears when the auction crowd is bidding up prices to ridiculous heights. During those times it is nonaction—keeping the bidding paddle in one’s pocket—that can become the stuff of which tomorrow’s heroes are made. Self-control, understanding, compassion, patience —and a thick skin—are most of what is required to stay the course.”
Well said! To enjoy Frank’s entire article and check out his new blog please click on link below.