During 2008, cash was king. Now that stocks are headed higher, though, investors may be forgetting the hard-earned lessons they learned during the financial crisis.
For most investors, the red-headed stepchild in their portfolios is cash. When markets are advancing, it's easy to see cash as a weak, underperforming asset that needs to be put to better use. After all, who wants sit on an asset earning next to nothing when the markets are serving up double-digit gains?
But just because returns on many stocks have beaten the stuffing out of cash over the past six months doesn't mean you should just rush out and buy any stock. If you don't pay enough attention to the underlying fundamentals of the business, you could easily get burned.
Cash gets a bad rap
Until the bear market rolled around, it was often quite difficult to justify why you were holding cash. If someone asks you to name your favorite investment ideas and you say you're in cash, that's usually the end of the conversation. Folks would rather hear that you've discovered the next Wal-Mart (NYSE: WMT ) or that you're looking at companies in some hot, yet-to-be-discovered industry.
As an investor, the general assumption is that you always have to be invested; holding cash suggests that you're not investing but rather sitting idle. Yet this assumption couldn't be more misguided. Cash is actually the investor's most valuable asset. Most don't see its true value, however, until there's a cash crunch in the economy.
Charlie Munger, Warren Buffett's indispensable partner at Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) , summed it up best when he remarked: "There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn't awash in cash -- and I don't want to go back."
As stocks crumbled in the financial crisis that struck a year ago, Munger's words almost seemed prophetic.
Was anyone listening?
Back in 2007, no one wanted to hear about holding cash. Interest rates were low, and home prices were experiencing stock market-like gains, as were stocks themselves. The performance of cash was viewed as a losing bet amid all the "easy money."
As usual, Wall Street always seemed to think the party would never end. Yet when it did, companies and investors both found that they'd burned through a lot of money that they wished they could have back. Much of today's economic turmoil was ignited by the excessive leverage created by undisciplined lending practices. Adding fuel to the fire was the evaporation of liquidity.
The availability of cash enables the investor to avoid two pitfalls:
- Selling what's cheap so you can buy what's cheaper.
- Not having dry gunpowder to take advantage of compelling investments or special situations when they arise.
The big bad bear
Just how valuable is cash? Look no further than the Bear Stearns debacle. This one-time darling on Wall Street was on top of the world, and up until its final days, company management was saying that Bear had plenty of liquidity.
Then, though, that liquidity dried up. A bailout by JPMorgan Chase (NYSE: JPM ) was necessary to save Bear from complete failure, and the stock was eventually sold off for $10 per share, down more than 90% from its highs. Although Bear's troubles resulted from much more than a simple lack of liquidity, there's no doubt that its inability to get more cash was a primary factor in forcing the quick sale.
In addition, cash opens doors. Having cash helped Disney (NYSE: DIS ) successfully bid for Marvel Entertainment (NYSE: MVL ) , and supported Kraft Foods (NYSE: KFT ) in its initial attempt to buy Cadbury. Although the offers both involve a mix of cash and stock, having at least some cash in a deal makes potential mergers more attractive to shareholders.
Feast or famine
When fear and panic grip the markets, those with cash can feast on the bargain pickings that the markets serve up. In contrast, those without cash will have to sit on the sidelines and watch opportunity pass them by. So as stocks continue to rise, don't hesitate to keep some cash available, even at today's low interest rates. The next time a good opportunity presents itself, you'll be ready to pounce.