What should an individual investor do if the overall stock market isn't expected to return much over the next few years? That tricky question has been on my mind since I read legendary value investor Bill Nygren's comments in the December 2004 issue of Outstanding Investor Digest (yes, I know that's a while back... you know how magazines can pile up).
Instead of increasing cash holdings to take some big swings at future discounted stocks, Nygren is buying what can be considered "quality stocks" during this time of uncertainty. Should individual investors like you and me follow in his footsteps?
Nygren decided to pay up now for quality. There's nothing wrong with that. Warren Buffett has been espousing that idea for decades. And Nygren didn't just buy any old stock willy-nilly. He decided to employ the "pay up for quality" strategy because today's premiums for quality are cheap relative to the premiums of a few years ago.
For example, Nygren recently added Wal-Mart
That said, Nygren might feel some pressure to stay invested. He manages billions of dollars for lots of investors. They want him using the cash, not sitting on it. Moreover, with all that capital to invest, there may not be enough opportunities in smaller companies to take meaningful positions. Wal-Mart and Citigroup, on the other hand, have huge market caps.
What other pros are doing
Bill Miller of Legg Mason, arguably the best mutual fund manager over the past decade, is fully invested. But he's always fully invested. He never appears to have much of a problem stuffing money into ideas (and he's got some serious capital to allocate). And while InterActiveCorp
Wally Weitz is doing things differently. According to the latest data available, his equity funds have approximately 70% of their capital in stocks and approximately 30% in cash. He has decided to keep more money on the sidelines in search of deeper discounts. Part of the reason Weitz holds cash is that he has been selling stocks such as Alltel
We see three professional investors purchasing various amounts of quality stocks and holding different amounts of cash. It's clear that there is no one-size-fits-all strategy to investing in an uncertain market. So what's an individual investor to do? Thank goodness the standard business school answer still works: It depends.
Don't be afraid to hold cash
First of all, if you're fully invested and you like your picks, stay fully invested. Do not be swayed by market expectations. You bought your stocks for a reason. And hopefully, the reason was not based on what the market was going to do.
If you have cash on the sidelines, I think it is a good idea to keep it on the sidelines. Cash affords you flexibility, lets you avoid unnecessary transaction costs, and prevents negative returns.
Individual investors do not feel the same pressure as the pros do. Waiting for the right opportunity can be best for our portfolios. In addition, we don't have the same-sized constraints. Our universe is considerably larger than is someone's with $1 billion to invest. Have we learned nothing from the greatest investor of all time, Warren Buffett, and his war chest at Berkshire Hathaway? We should invest when we are ready, not because we have cash.
No transaction costs
Holding cash can save us money. Getting in and out of stocks as smaller investors can be costly. And if we are moving in and out of different types of stocks, transaction costs are lowering our returns. Sure, there are some opportunity costs associated with waiting -- we may even miss out on some decent returns -- but it is a cost we should be willing to bear until we find the best values for our money.
Don't lose money
Lastly, holding cash also protects our downside (assuming inflation doesn't rear its ugly head). And that's good because negative returns kill overall returns. We don't want to seek out risk in the hope of higher returns. Instead, we want to be confident about our margin of safety. Nygren is right that Wal-Mart is a much better buy today than it was five years ago. But does that mean we should pay up for a piece of Wal-Mart as well?
Waiting has worked for me in the past. I held a considerable amount of cash from 1999 to 2002. And by doing so, I was able to pick up AES
If you are out of the market
With cash in hand, here are some dos and don'ts to consider:
Don't put your money in an index fund. Taking more risk without much hope of any returns is decidedly un-Foolish, if you don't think the market is going to return anything.
Do look to see what kinds of stocks have been beaten down recently. If there are lots of managers making a flight to quality, perhaps there are some unloved stocks that have fallen too far.
Don't think that cash needs to be deployed immediately. You can wait and pick your spots. Great basketball players have a knack for taking over a game by letting the game come to them. Let the market do the same for you.
Do as much research as you can, and always remember: No matter which stocks you decide to buy, valuation is important. You want the best value for your money. Whether it's searching for deep discounts like Wally Weitz or less traditional values like Bill Miller, valuation should be at the core of your investment thesis. And that's exactly why Philip Durell's Inside Value newsletter should be a part of your research. Valuation is the cornerstone of his approach, and his recommendations have outperformed the market. Join Philip and his team for a free 30-day trial to see for yourself.
Fool contributor David Meier owns shares of AES and will wait as long as it takes to find another great opportunity like that one. He does not own shares in any of the other companies mentioned. The Motley Fool has a disclosure policy.