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Biggest Market Opportunity: Cash? (No, I'm Not Insane)

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What sort of insanity is this? How could cash be an opportunity at a time when three-month T-bills yield less than 10 basis points? No one gets excited earning virtually nothing on their cash balances, but stock investors should consider future opportunities in addition to existing choices: It's not about what you're not earning on the cash today, it's about earning premium returns on the investments you'll be able to make with that cash tomorrow.

Cash needn't be an anchor
In the words of super-investor Seth Klarman: "Why should the immediate opportunity set be the only one considered, when tomorrow's may well be considerably more fertile than today's?" At the head of the Baupost Group, a multi-billion dollar investment partnership, Klarman employs a value-oriented strategy, achieving exceptional performance in spite of -- or rather, because of -- the fact that he frequently holds significant amounts of cash. For example, on October 31, 1999, a few months before the tech bubble began to collapse, his Baupost Fund was approximately one third in cash.

Over the "lost decade" spanning 1999 through 2008, Klarman smashed the market with a 15.9% average annualized return net of fees and incentives versus a (1.4%) annualized loss for the S&P 500.

Don't go all in (cash or equities)
Let me be quite clear: I'm not advocating that you liquidate all your stocks and go all into cash; the market's current valuation simply does not warrant that sort of drastic action. Conversely, it shouldn't compel you to raise your broad equity exposure, either.

As I noted last week, the market doesn't look cheap right now: Based on data compiled by Professor Robert Shiller of Yale, at yesterday's closing value of 1,071.66, the S&P 500 is valued at over 19 times its cyclically adjusted earnings, compared to a long-term historical average of 16.3. Based on average inflation-adjusted earnings, the cyclically adjusted P/E ratio is one of the only consistently useful market valuation indicators.

As prices increase, so does your risk
All other things equal, as share prices rise, stocks will represent a larger percentage of your assets; however, logic dictates you should actually seek to ratchet down your equity exposure under those circumstances. As stock prices rise, expected future returns decline (again, all other factors remaining constant), making stocks relatively less attractive. Another way to express this is that as stock prices increase, so does the risk associated with owning stocks.

That risk may simply be earning sub-par returns or, in the worst case, suffering capital losses. Extremes in market valuations offer the best illustration of this principle: Owning a basket of Nasdaq stocks in March 2000: a high-risk or low-risk strategy? How about buying Japanese stocks in December 1989, with the Nikkei Index nearing 39,000 (nearly 20 years on, the same index trades at less than 10,500).

Don't misinterpret Buffett's words
So what are we to make of Berkshire Hathaway (BRK-B) CEO Warren Buffett's words when he told CNBC on July 24th: "I would much rather own equities at 9,000 on the Dow than have a long investment in government bonds or a continuously rolling investment in short-term money"? (Investors must have concluded the same thing, sending the Dow 8% higher since then.)

First, with just 30 component stocks, the Dow isn't a broad-market index; it's a blue-chip index. The stocks of high-quality companies have underperformed the broader market in the rally from the March market low, which has left them relatively undervalued. This is reflected in the Dow's 14 price-to-earnings multiple, against 17 for the wider S&P 500.

Buying pieces of businesses vs. owning the market
Second, keep in mind that Buffett likes to own pieces of high-quality businesses, not the whole market. As I mentioned above, there is reason to believe that there is still opportunity left in the higher-quality segment of the market. The following table contains six companies that trade with a free-cash-flow yield above 10% -- i.e., they're priced at less than 10 times trailing free cash flow (these are not investment recommendations):



Free-Cash-Flow Yield*

General Electric (NYSE: GE  )



UnitedHealth Group (NYSE: UNH  )

Health care


Bristol-Myers Squibb (NYSE: BMY  )

Health care


Raytheon (NYSE: RTN  )

Industrial goods


Altria Group (NYSE: MO  )

Consumer goods


Time Warner (NYSE: TWX  )



*Based on TTM free cash flow and closing stock prices on September 21, 2009.
Source: Capital IQ, a division of Standard & Poor's, Yahoo! Finance.

Summing up: What to do from here
To sum up: If, like Buffett, you have identified high-quality businesses that are undervalued, there is nothing wrong with buying them now. However, if you are mainly an index investor, it is probably ill-conceived to increase your exposure to stocks right now. Either way, whether you are a stockpicker or an index investor, there is nothing wrong with holding on to some cash right now -- not for its own sake -- but to take advantage of better stock prices at a later date.

Morgan Housel has identified three high-quality companies that are still cheap.

Quality matters. The team at Motley Fool Inside Value can show you how to build -- and manage -- a portfolio of high-quality company stocks trading at reasonable prices. To find out their top five recommendations for new money now, take advantage of a 30-day free trial today.

Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Berkshire Hathaway and UnitedHealth Group are Motley Fool Stock Advisor selections. Berkshire Hathaway and UnitedHealth Group are Motley Fool Inside Value recommendations. The Fool owns shares of Berkshire Hathaway and UnitedHealth Group. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Read/Post Comments (15) | Recommend This Article (56)

Comments from our Foolish Readers

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  • Report this Comment On September 23, 2009, at 4:15 PM, Seano67 wrote:

    Right. It's always a very good idea to hold a healthy cash reserve, just to be used for future opportunities, because you just never know when a fantastic, 'deal of a lifetime' buying opportunity might pop up. However for myself, that's much easier said than done, particularly in the case of a strong bull market (or rally). At those times, the temptation to go 'all in' on equities is very, very strong, despite the fact that's been somewhat detrimental to me in the past.

    At times like that, I see all these people making all this money, and the urge becomes overwhelming to throw every available resource into the market, as opposed to holding onto a chunk of cash that does relatively nuttin for ya at that time. But, I just have to fight those urges, and that's a continuing process. ;o)

  • Report this Comment On September 23, 2009, at 5:27 PM, Dannysea wrote:

    Still love the maxim, Cash is King, but implies the greenbacks.But through this cycle I have addressed investing as biggest bang for the buck. I also war with myself on moderation: rainy day needs vs. good bang for the buck now vs. great investment opportunities tomorrow vs. keeping cash on hand as a need for living if everything goes south.

    Having raised four kids, a lifestyle of always being cash-poor was the norm. I think of Charlie Munger's statement all the time, "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."

  • Report this Comment On September 23, 2009, at 5:41 PM, TWOTIMETUNA wrote:

    I saw the subprime mess coming and got out of the market before it crashed.

    I have a lot of cash and have been looking for the right vehicle to invest in for a while. I kept thinking about gold but asked around and found that they make money on it when you buy it and they make money on it when you sell it.

    I was thinking about real estate but has the market completed it's downward spiral yet?

  • Report this Comment On September 23, 2009, at 5:59 PM, Huayra wrote:

    Cash is peace of mind and as we've all seen in the last 2 years even the smartest people, with the best invest models and high-tech computing can get caught out by market big time.

    If you had your money safely put away in a bank account collecting annual interest over the last 10 years you will have beaten 85 procent of all investors.

    Does this mean you should not invest, of course not. But one thing it does mean, don't invest money that you may need within 12-14 months for expenses.

    Although you can't predict the markets you can see it's still based on macro-economics in the end. Normally you start buying once you see a recovery. Buy low, hold, sell high(er).

    Problem this time around is that we may not see a normal recovery patern due to the high individual and national debt loads in the "advanced" economies, that finally caught up with us. It's time to pay the bill and since there is still a possibility of recession in 2010 it's best to proceed with caution. Keeping some investment cash in reserve is king, more then ever!

  • Report this Comment On September 23, 2009, at 6:00 PM, hitekexec wrote:

    I loved the fact that when the market tanked my portfolio lost but 5%. A dear friend of mine told me "you only need to be rich once". He was right. I'd check out "safe" "Credit Union (federally insured) CDs that are paying nearly 3%. That's a solid number for the next 12 month.

    Why risk another downturn to try and squeeze a bit more upside in what is still an iffy market. Nobody really warned us before the last crash...

    Any other advice?

  • Report this Comment On September 23, 2009, at 9:23 PM, rpwooste wrote:

    Aren't these claims that the market is over priced because the current PE of 19 is higher than the average of 16.3 ignoring the likely possiblity that corporate earnings will increase substantially as we move out of this recession and everyone needs to replenish their now reduced inventories?

    The PE is of course high, because people are anticipating that earnings are going to increase significantly. At least in the Tech sector where I work, that appears to be the case. With my company's quarterly revenue for Q1, Q2, and Q3 being $7B, $8B, and hopefully $9B, this seems quite plausible.

  • Report this Comment On September 23, 2009, at 11:10 PM, LessGovernment wrote:

    As of this writing, I am all in cash and I have been for about a week. Yeah, I know I missed a little upside, but when I look at the market, I get a strange feeling. I realize that the last one in loses when the market changes direction, and I realize that buying at the top, whether in real estate or the stock market , is a good way to maximize losses.

    What I am seeing is a definite change in how the market is working. I see less and less investing, and more and more trading. What is long term now, a week? A month?

    I have never before in my lifetime seen anything like the Federal Reserve's current policy of creating money out of thin air. And when they basically said today that they are not going to change interest rates, and they are not going to stop buying mortgage backed securities until at least the middle of next year, it simply dawned on me that the Federal Reserve is not seeing a recovery.

    What we have done is poured money into the system and that money has found its way into investments like stocks, bonds, and gold. But I fear very little of that money so efficiently created by the Federal Reserve has found its way into the real economy in such a way as to create demand for goods and services. If demand stays low, employment stays low too, so how long can stocks stay high?

    Companies have laid off workers and cut inventories and reduced bottom line expenses to hit their reduced expectations, but the top line in very few businesses is looking any better than a year ago. This is not recovery.

    Ford announced a new car plant - that is the good news, however that plant is to be built in China - that is the bad news.

    Housing sales are up due to the Fed's buying mortgage paper which has allowed cheap mortgages and some slight improvement in sales of mostly distressed properties. But at what cost? To stimulate that increase in housing demand, we have created a huge increase in future taxation to pay for the deficits being generated.

    What are we doing that will have a lasting impact on the ability of stimulating demand at the consumer level of our economy that will in turn create jobs? Sadly, very little.

    Well here is my suggestion of what to do.

    First, stop payroll tax withholding from the workers' pay checks to stimulate demand. Doing so will not increase taxable income because the way that game was setup, Congress created the less than insightful plan to force the employee to cough up 7.5% of his gross wages and still get taxed (income tax) on the payroll taxes deducted as though they were not really deducted. Talk about a hidden income tax.

    I have always thought this was about the height of stupidity of Congress, although they do from time to time show me they can even exceed this high water mark of stupid. Taxing payroll makes payroll cost more which makes American workers less competitive in a global economy. That is stupid part one. Stupid part two is this also reduces discretionary income by 7.5% of gross which may very well be a 100% reduction in discretionary income for many workers. How many workers today have 7.5% left over after all non discretionary costs of living?

    This reduces economic activity and employment for all, which exerts downward pressure on wages which only makes the discretionary income issue worse. And discretionary income is the source of demand. Reduce discretionary income and you slow the economy. That is a no brainer, well, maybe for everyone that is not in Congress.

    I can't think of a worse thing to do to the American worker than to tax his pay for entitlement funds. Well, yes I can. Tax his pay and then spend the funds on something else and leave the entitlements unfunded (80 Trillion and counting) but that is another subject.

    We also need to stop the collection of payroll taxes from employers as well which is just a penalty on hiring workers and it increases the cost of labor another 7.5% making American labor less competitive. The combined effect is a non-competitive increase in labor costs of 15.3% currently, which is one of the reasons our jobs are leaving the country in such large numbers.

    You can improve productivity all you want, but it is very hard to overcome this 15.3% increase in labor costs as caused by this dumb funding mechanism.

    Since imported goods do not have to pay this tax, foreign producers are advantaged by bad tax policy to the tune of 15.3%. Think what that advantage might be when Congress gets through designing a "better" health insurance system. Scary does not begin to express my thinking.

    The solution to this should have been to raise these funds with a federal sales tax of about 6% on everything sold in America, including cars. The net to the worker is a 1.5% increase in pay if he spends everything he earns (6% sales tax minus 7.5% payroll no longer withheld plus with no increase i income tax ) so there is no penalty, and if some of the pay is saved, it then escapes the tax whcih would be an incentive to save.

    I know some folks will argue that the non working poor will not be able to buy as much to which I respond that is what being poor is all about. Being poor is being temporarily economically limited. Being poor is only a lifestyle if you subsidize it.

    You don't cure poverty by limiting opportunity by making American workers less competitive and sending jobs overseas which is exactly what the current payroll tax system does. You solve poverty with opportunity. You make the pie bigger instead of dividing it up by taking from Peter to pay Paul.

    What we gain by doing this is American wages would be more competitive, AND we would raise the tax on imported goods sold here that were made elsewhere, so in effect, imported goods sold here would help pay for our unfunded entitlements. What we would also gain is an immediate 7.5% increase in nearly everyone's discretionary income which would be a long term stimulant for economic growth, and, like I said, if you save it, you get to keep it.

    Bottom line, if we don't soon do something logical to invigorate demand without an even larger offsetting budget deficit (cash for clunkers, subsidized mortgages, etc.) which impairs future economic activity through higher taxes, which is what we have been doing, I fear we will dig ourselves into a deep hole out of which we might not be able to escape.

    I agree with the premise of this article. Cash is the best place to be for now. Until I see signs of recovery, real recovery, I am in cash.

  • Report this Comment On September 24, 2009, at 12:37 AM, PsycheDaddy wrote:

    Well, Less Government; you said it very well. Your advice was very well written and sounds like it's from a professional writer. Right now there is really no place to put your cash so I think that is why some have money in the markets. Gold, I should have bought, but being lazy. Gold (not gold stocks) seems not so liquid when you have to buy and sell via dealers and armored vehicle. I'm not familar with marketability of the product. Real Estate has not hit it's bottom yet. Interest rates are at record lows so there's no money to make on CDs. Your suggestion on national sales tax is very good. But this government administration are not going to give back taxes cause they want the money and need it. This administration is going to make government bigger and more costly. Taxes will eventually have to go up.

    If some big crisis takes place. They might be confiscating gold like they did in the "Depression" to pay are debts and we might lose everything that's cash in the banks (Another good reason for stocks).

    So this means were in big trouble or in a risky environment. There is now clear way to turn. The bad debt of the "Housing Crisis" will eventually catch up with us. I don't think you can coach this administration, but I know you have to try. I'm going to set back and watch and see what the year end retail sales looks like and how "Holiday Spending" goes and hope the books aren't cooked to a crisp;

    then see how the overall stability of the markets and economy look and revaluate and make a decission.

    Were in some crazy times right now both nationally and internationally. Today it looks like WWIII is going to take place. You would certainly want to reavaluate then. But I'm going to rest one more quarter and see what happens and then reavaluate my possession. I may have to relocate my possessions. lol

  • Report this Comment On September 24, 2009, at 3:10 AM, PoundMutt wrote:

    LessGovernment wrote: "...The solution to this should have been to raise these funds with a federal sales tax of about 6% on everything sold in America, including cars. The net to the worker is a 1.5% increase in pay if he spends everything he earns (6% sales tax minus 7.5% payroll no longer withheld plus with no increase i income tax )..."

    Only one thing wrong with this suggestion - with the Dumbocrats in power, we'll have BOTH the 7.5% tax AND a 6% national sales tax!!!

  • Report this Comment On September 24, 2009, at 6:22 AM, LessGovernment wrote:

    You are right PoundMutt. That is, as long a the status quo is tolerated.

    This is why I am a supporter of a new dynamic, a new order, a new movement.

    Fire Them All in 2010.

    Do not vote for an incumbent.

  • Report this Comment On September 24, 2009, at 6:55 AM, 8Lives wrote:

    I feel a little smarter for reading this thread -- seem like responsible ideas.

  • Report this Comment On September 24, 2009, at 1:57 PM, deano3d wrote:

    thanks, for the comments guys. I have the same quandery I guess I will stay in cash but I have purchased a small amount silver in case the dollar goes to nothing all our savings will have been in vain.

  • Report this Comment On September 24, 2009, at 11:37 PM, memoandstitch wrote:

    I was gonna write a similar article about cash. However, I would not recommend holding cash right at this time. Now is the time for short-term corporate bonds which are as safe as cash but yield superior returns.

    bond period = bottom until recovery

    stock period = recovery until boom

    cash period = boom until bottom

  • Report this Comment On September 26, 2009, at 5:09 PM, daveandrae wrote:

    Cash, except for emergencies, is an irrational long term holding, in the portfolio of the LONG TERM investor. Once you subtract inflation and it's evil twin, taxation, from the dividend yield that cash currently offers, the asset yields absolutely NO real rate of return. In fact, the real rate of return is quite negative.

    The only reason why someone would hold a large percentage of cash in their portfolio is because they FEAR all other asset classes, equities, bonds, real estate etc..etc... will be even MORE negative.

    Give someone that's made it past the sixth grade the choice of holding $10,000 worth of cash, or $10,000 worth of an s&p 500 index fund over the next twenty years, and it's not even a contest.

    There. I said it. End of story. Next subject.

  • Report this Comment On September 27, 2009, at 3:41 PM, BucketOfOnions wrote:

    When it comes to investing and life in general, it always pays to do your homework and have a plan. As a long term investor your goal is to diversify your investments to reduce risk and maximize your long term results. This involves the careful selection and distribution of assets among investment vehicles that support your risk tolerance, time horizon and individual needs, as well as the appropriate mix of negatively correlated asset categories.

    There is no denying the sexy allure of timing the market, or the fact that speculators can make money, and do get lucky investing in what's "hot". However, the reality is that they can't consistently beat the market. More times than not, speculators end up buying high and selling low in a panic. You will always hear how much money a speculator made on one or two investments, but you will rarely hear how much money they have lost on their other not-so-"hot" investments.

    It is wiser to develop a long term strategy and remain consistent even when the market misbehaves. After all, if we do our homework we would know what to expect in the long run and this includes expecting, that at some point or another, our portfolios will experience a few bad periods. What matters is the long term performance of our investments and most of all our peace of mind.


    Money without intelligence is like a car without a road.

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