Thou Shalt Not Overpay With Other Peoples’ Money

Funds: How Much Cash Is Too Much?

There’s good reason for funds to have extra cash—as a cushion—but not two-thirds of their assets or more.

Barron’s recently published an article with the title and subtitle above. The article mentions several funds with very high cash levels and implies these funds are invested as if the world is coming to an end – doomsday funds so to speak. Instead of investing for Armageddon, is it possible these funds are simply staying true to their investment disciplines and objectives? If the funds’ objectives are to generate absolute returns, high cash levels during periods of record high valuations is not only possible, but should be expected. Moreover, in my opinion, today’s overvaluation is much broader than the bubbles of 1999-2000 and 2006-2007. This cycle’s broadness of overvaluation has significantly reduced the number of qualifying investments, increasing the need for cash above that of past cycle peaks.

For the past 18 years I’ve been running an absolute return portfolio with cash levels ranging from fully invested to over 80%. During this time, I’ve been asked every question imaginable as it relates to cash. I think the biggest misconception about portfolio managers who are willing to hold cash is that they are market timers. Although I can’t speak for other managers, I am not a market timer. In fact, I believe I’m an awful market timer. I have no idea where the stock market is headed. Although I believe stocks are overvalued (especially small caps) and they “should” decline, if I had to guess near-term I’d say they could go either way.

Stocks could go up. Policy makers appear determined to keep the game going by providing more and more stimulus and investors appear more than willing to play along. While valuation metrics are at nosebleed levels, one thing I learned in the late-90’s tech bubble is valuation isn’t a good predictor of stock prices in the near-term. Once prices and valuations are detached from intrinsic values, they can go anywhere they want and they can go there quickly. Given poor earnings and fundamentals haven’t mattered over the past several quarters, it’s possible they’ll continue to be ignored and multiples and overvaluation could continue to expand. Although the current market cycle is one of the longest in history and I believe we are in the later stages, the exact timing of this cycle’s demise is unknowable. The bull market could continue.

Stocks could go down. Let’s face it, we’ve never seen this type of investment environment before – global central bankers gone wild. We have no idea how these monetary experiments will end exactly or when they end. If central bankers can no longer maintain the perception that their balance sheets and bids are unlimited, investor demand for bonds yielding practically nothing (or worse!) would evaporate. We could wake up one morning and see the long bond down four or five dollars along with currencies in turmoil. A bond or currency collapse would most likely be blamed on failed central bank policies; therefore, more policy response would be perceived as a negative. At that point the central bankers’ “put” finally expires with no one left to bailout the markets. Stocks would crash.

So there you have it. I can see stocks continue to go up and I could see them crash. Real helpful I know and proves I have no idea where stocks are headed. Being 100% cash in my absolute return portfolio has nothing to do with my opinion on the stock market and everything to do with investment discipline and principle. On principle it’s pretty simple. While I’m no longer managing a public mutual fund, I strongly believe investment managers should never knowingly overpay for any asset with other peoples’ money. It’s a serious investment sin. In fact, it’s the first of my investment ten commandments – Thou Shalt Not Overpay. In other words, holding cash is a result of having a conscience and understanding overpaying is not only a poor investment decision, it’s just wrong.

Investment discipline is also a major factor in determining cash levels. None of the successful investors I’m aware of just wing it – they all follow strict investment disciplines, or a set of investment rules. As an absolute return investor, my discipline is founded on my desire to make money. It is driven by the fundamental analysis and valuation work I perform on hundreds of small cap stocks (it’s a bottom-up process). My discipline attempts to avoid overpaying and limit mistakes. To do this it’s essential to only take risk when getting appropriately paid relative to risk assumed.

Disciplined absolute return investors do not need to continuously hit home runs to achieve their investment objectives. By maintaining a high batting average and limiting mistakes (over a market cycle), absolute return investors can generate attractive returns while taking significantly less risk than relative return investors. As a reminder, relative return investors usually remain fully invested even in periods of inflated prices, elevated risks, and limited opportunities. Currently I do not believe most stocks, or bonds for that matter, will provide investors with sufficient returns relative to risk assumed. Prices and valuations are at record highs, overvaluation is very broad, risks appear unappreciated (VIX below 13), interest rates are artificial, and profit margins are extended.

It is during periods like we are in today that investors make their biggest mistakes; when conventional wisdom and crowd psychology suggests prices can only go up and there is “something different this time” (late 90s it was the new economy/productivity miracle, 2007 it was home prices never fall, and now it’s faith in global central bankers). This is when following discipline is most important and when I’m most thankful to be an absolute return investor. I’d be very uncomfortable if I was forced to be fully invested in this environment. Imagine being a bond manager right now with a fully invested mandate — yikes!

In my opinion, absolute return investors must have the willingness and ability to be patient, especially during prolonged periods of overvaluation and asset bubbles. In order to maintain a patient positioning, safe and liquid assets, such as cash are essential. I do not believe cash should be used in an attempt to time markets. Instead, cash levels should be determined on principle and by following a strict and thoughtful investment discipline. Cash provides investors with an alternative to owning overvalued assets. This makes a lot of sense to me as I’d rather hold cash than an overvalued asset. Wouldn’t you?