For a value investor like me, this is the most difficult investment environment in at least 10 years. Not because the overall market is hugely overvalued -- given the apparent strength of the economy and the growth in corporate earnings, I think it's moderately overvalued. The problem is I can't think of any sector of the market, or any asset class at all, that is distressed, and that's the type of situation value guys typically buy into. Large caps, mid caps, small caps, growth, value, industrials, financials, tech, services, retail, commodities, private equity, high-yield bonds, treasuries -- the list goes on and on, and none of it is cheap.
So what is one to do? For most investors, especially institutions and mutual funds that have a mandate to be fully or nearly fully invested at all times, the answer appears to be to look for investments that appear cheap on a relative basis (and then, I suspect, cross one's fingers and pray). According to the Investment Company Institute, stock mutual funds today hold just 4.3% in cash, slightly less than the average of slightly more than 5% over the last seven years.
But investing in unattractive assets is a recipe for disaster. If you can't find something smart to do, which I define as a situation in which you're certain you've found a 50-cent dollar and are trembling with greed, then don't do anything! While it's no fun earning a microscopic return on cash, it's far more painful to make a bad investment and lose money (trust me, I know!). The beauty of investing is that, to use Warren Buffett's famous analogy, you're never forced to swing at a pitch.
I am always scouring the investment universe for juicy pitches, and I'm finding that they are few and far between these days, which is why the funds I manage are holding 35% cash, near their highest levels ever. I'd be worried that maybe I was looking in the wrong places or had set my hurdle for investing too high if other investors I respected were putting all of their capital to work, but as best I can tell, we value guys are pretty much all in the same boat.
Piles and piles of cash
Let's start with Warren Buffett, the head of our church (I call it the Church of Graham and Dodd). Berkshire Hathaway
Not surprisingly, Buffett's right-hand man, Wesco
Mason Hawkins and Staley Cates, who run the outstanding Longleaf Partners funds, are holding 23%, 24%, and 29% cash in the three funds they manage. And Seth Klarman, author of Margin of Safety and founder of the hugely successful Baupost Group, said recently that he's holding 50% cash. Finally, the 12 Buffettesque superinvestors that I profiled earlier this year are sitting on an average of 30% cash.
Difficulty holding cash
While one might think that it's easy to hold cash, it is in fact very difficult, especially for a professional money manager. Imagine sitting in a meeting with a potential investor who naturally asks, "So, what are your favorite ideas today?" To answer, "We really can't find much to buy these days, so our largest position by far is cash" isn't likely to result in an investment, is it?
And there's pressure from existing investors as well. Hawkins and Cates wrote, "Clients often want to see activity as proof that a manager is earning his fee. Some clients might wonder why they pay a manager to sit still."
There's also relative performance pressure. As Klarman noted in his 2003 annual letter:
In a short-term, relative-performance-oriented world, earning next to nothing on cash creates a compulsion to invest, even when all investment alternatives appear overvalued. Choosing their position, most investors prefer to hope that something expensive becomes even more expensive, especially when it has recently been doing exactly that. Holding cash, which they find barely tolerable when markets are falling, is anathema when markets are rising...
Today's investors remain almost single-mindedly focused on relative performance, their results compared to the market's. Their behavior is understandable in an environment where, for most professional investors, short-term underperformance is often rewarded with client redemptions. This is especially the case since "long-term oriented" looks a lot like "being wrong" until proven otherwise. Since no one can know if it is your long-term orientation or your incompetence that is causing poor performance results, it is hard for disappointed clients to stay the course. Career risk for individual managers adds to the pressure. To avoid underperforming in a rising market, many professional investors have a mandate to remain fully invested. After three years of a grueling bear market, one might have thought investors would have developed an appreciation for an absolute return focus consistent with capital preservation, but old habits and ingrained tendencies die hard. If keeping up with an overvalued and rising market is your goal, cash is an unacceptable anchor to drag around.
Finally, it's psychologically extremely difficult to sit on one's hands. Buffett wrote in his 2002 annual letter: "The aversion to equities that [we] exhibit today is far from congenital. We love owning common stocks...." And Klarman lamented in April that "psychologically, this is the hardest time in my career. We sit at the office and throw Nerf footballs around. We're figuring out what to order for lunch at 9:30 a.m." In his annual letter, he elaborated:
It is one thing for a value investor to know that in the absence of opportunity you should hold cash. It is quite another to actually do it. It is particularly difficult to sit on your hands when others are probably speculating. We find that it is not a temptation to speculate that pulls at you, so much as a desire to be productive. Doing nothing is doing something, we have argued again and again; doing nothing means prospecting for potential investments and rejecting those that fail to meet one's criteria. But emotionally, doing nothing seems exactly like doing nothing; it feels uncomfortable, unproductive, unimaginative, uninspired, and, probably for a while, underperforming.
One's internal strains can be compounded by external pressures from clients, brokers, and peers. If you want to know what it is like to truly stand alone, try holding a lot of cash. No one does it. No one knows anyone who does it. No one can readily comprehend why anyone would do it.
What holding is not
It would be easy to dismiss those of us who are holding so much as market timers, which is indeed a sucker's game. But that's not what we're doing. Hawkins and Cates wrote: "We are not making an asset-allocation decision. We are not making a bet against the market. Very simply, we have not found qualifying investments, and we are unwilling to force it." Klarman agrees: "It's not a timing thing. It's just a lack of opportunities. We don't try to time the market, regardless of our top-down views. We worry top-down, but we invest bottom-up."
Final thoughts
I'll conclude with two quotes: Here's Buffett in his 2002 annual letter:
We love owning common stocks -- if they can be purchased at attractive prices. In [my] 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns (which translates to 6.5% to 7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after tax, sitting it out is no fun. But, occasionally, successful investing requires inactivity.
Here's Klarman, from his 2003 annual letter:
Perhaps some of you will soon be asking why you are paying us a management fee to hold so much cash. Let us preempt you by saying that we are not. You are paying us to decide when to hold onto cash and when to invest it, to determine when the expected return from a prospective investment justifies the risk involved and when it does not....
We have always believed that successful investing involved recognizing and correctly choosing among a series of tradeoffs. Cash (in the form of short-term U.S. treasury bills) is a way of safely doing nothing until compelling investment opportunity arises. It offers positive albeit very limited yield, complete safety of principal, and full and instant liquidity. A low positive return with virtually non-existent risk is not a bad proposition in the absence of better alternatives. Our view is that investors should choose to hold cash in the absence of compelling opportunity, not because they are making a top-down asset allocation into cash, but based on the result of a bottom-up search for bargains. Baupost will make the decision to hold cash, even if it becomes a very large percentage of partnership assets, until better opportunities arise. Every investment must be compared to the alternative of holding cash. If an investment is sufficiently better than cash -- offering a more than adequate return for the risk involved -- then it should be made. Note that the investment is made not because cash is bad, but because the investment is good. Exiting cash for any other reason involves dangerous thinking and greatly heightened risk.
Many investors compare the current yield on cash (lousy) to the current yield on longer-term bonds or the dividend yield (or historic long-term expected total return) from stocks. Cash nearly always loses in this comparison, and investors feel quantitatively justified in doing what career and client pressures cause them to do anyway. It makes no difference how overvalued these alternatives may be in an absolute case.
Investors' immediate problem is being too short-term oriented. One of the biggest challenges in investing is that the opportunity set available today is not the complete opportunity set that should be considered. Limiting your investment opportunity set to only the one immediately at hand would be like being required to choose your spouse from among the students you met in your high school homeroom. Indeed, for almost any time horizon, the opportunity set of tomorrow is a legitimate competitor for today's investment dollars. It is hard, perhaps impossible, to accurately predict the volume and attractiveness of future opportunities; but it would be foolish to ignore them as if they will not exist....
Also, believing that better opportunities will arise in the future than exist today does not ensure that they will. Who can tell what investors will be willing to pay for securities tomorrow? Waiting for bargains to emerge may seem like a better strategy than overpaying for securities today, but tomorrow's valuations may still be higher still. Standing apart from the fully invested crowd for significant periods of time can be a grueling, humbling and even demoralizing experience.
Contributor Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned shares of Berkshire Hathaway at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. To read his previous columns for The Motley Fool and other writings, visit here . The Motley Fool is investors writing for investors.
