Last July, Jeff Opdyke of The Wall Street Journal reported increased cash holdings by fund managers, a trend also outlined by Whitney Tilson in The Joy of Cash.
Both referred to Berkshire Hathaway's (NYSE: BRK.A)(NYSE: BRK.B) huge current cash holdings: At the end of the first quarter, cash and equivalents stood at almost $35 billion, a greater than 100% increase year on year (over the same period, total assets excluding finance and financial products rose only 13%). The respected Clipper Fund
According to the Journal's Opdyke, this trend is not yet observable across the fund management industry as a whole, and he cited seven funds and fund groups that he regarded as "smart money" at the vanguard of an increasing movement toward cash. Still, Opdyke's article didn't connect the dots and describe the commonalities between these investors. Interestingly, of the seven funds cited in the article:
- Five are clearly run by managers that follow a value investing approach. Indeed, a couple of them make explicit references to Benjamin Graham in their shareholder letters or on their websites. All of them espouse a fundamental, research-driven process in unearthing investment opportunities.
- At least three of the seven managers/investment advisors are either important or the largest shareholders in the funds they oversee. Robert Rodriguez of FPA Funds
(FUND:FPNIX)holds approximately equal levels of cash in his personal portfolio (35% to 40%) and in the fund he manages (37%).
If you're invested in equity mutual funds, those observations raise some unsettling issues. As Opdyke rightly pointed out, one of the reasons that this "flight to cash" is not broadly visible across mutual funds is that "many mutual funds are mandated -- often by their management companies -- to remain fully invested, no matter what, skewing the trend." The mandate to be fully invested is an arbitrary imperative that shows little regard for -- and is, in fact, contrary to -- the interests of fund investors. To think about this another way, which attitude would you prefer to adopt in negotiating a business transaction:
- I will seek an outcome on favorable terms, all the while secure in the knowledge that I can walk away from the transaction if such terms cannot be achieved.
- I must complete this transaction, as Opdyke put it, no matter what.
Investing in stocks is a decision to enter into a business agreement through the purchase of a negotiable interest in a company. The price you pay (the stock price) is one of the defining terms of that agreement. If your imperative to close the transaction (to remain fully invested) trumps all other considerations, your economic interests are not well protected. If you own a mutual fund, find out whether the fund manager is bound by such guidelines. If so, are you comfortable knowing this mandate runs contrary to the way in which you'd approach your own business dealings?
There's another question mutual fund investors should ask: How does my fund manager invest his own assets? As we saw earlier, the prominent managers in Opdyke's article are often substantially aligned financially with their investors. That, along with their record of prior success, lends a lot of weight to their decision to hold high levels of cash. No one likes to earn a low short-term interest rate on a substantial proportion of a portfolio when there are more attractive opportunities for higher return. These managers admit such other opportunities are currently scarce, and they don't commit their investors' funds to investments they wouldn't consider for their personal portfolios.
Although there may be others, I see two obvious reasons that would motivate an investment manager not to invest a significant part of his wealth alongside that of his investors:
- His management of fund assets is bound by guidelines he feels are unacceptable in allocating his own assets (such guidelines might include a mandate to remain fully invested, for example).
- The investment manager isn't confident in his ability to produce superior absolute returns.
In either case, I wouldn't be confident in putting my money in the care of that manager. (If you're looking for recommendations on superior fund managers, try a 30-day free trial of Motley Fool Champion Funds.)
For individual stock investors, the "flight to cash" raises a different set of questions. As you navigate this market, keep in mind that some very smart investors with enviable records of success are up front in describing an environment in which they are, by and large, unable to find new investments. This, despite an enormous advantage in terms of the resources (first among them is time) they can dedicate to this process. I don't advocate you rush to convert all your holdings to cash, but I think the following advice will help increase your confidence in your current and future holdings.
Be sure to review your significant holdings in light of the current prices. Does the price appear justified in terms of the cash flows you expect the company to generate? Does the price offer any margin of safety to cushion you from errors in your own estimates of the company's value or adverse developments affecting the company's operating performance?
In evaluating new investments, do a reality check on your valuations by asking yourself some simple questions. Are my assumptions regarding the company's business prospects and operating results realistic? Err toward conservatism and resist the temptation to work backward from the stock price to reverse-engineer a set of assumptions on growth and profitability. Of course, you might be willing and able to consider these assumptions in a dispassionate manner. (If you find yourself thinking, "The current price only implies a 40% annualized growth rate in cash flows for the next 10 years and 15% thereafter -- the company's a strong buy at this level," then you'll be pleased to know our expanding universe won't be an obstacle to this type of growth.) Taser International (Nasdaq: TASR) sports a P/E near 140. (See When to Sell Taser.) If I were considering buying the stock, I'd definitely want to put some numbers on what the price implies in terms of growth (one quick way to do this is using growth duration).
Also, think about the downside: Try to quantify the impact on company value of operating results that fall short of your expectations. If you're less than 100% certain regarding your baseline expectations, have you factored this into your buy price?
One advantage you do have over institutional investors is size (lack of it, that is). The funds they direct often total hundreds of millions or billions of dollars. Many managers have a floor on the size of the companies they can invest in that excludes many or all micro- and small-capitalization stocks from consideration. The average individual investor simply doesn't face that same constraint and may find this relatively underfollowed segment of the market offers more opportunity.
I must stress that the lack of following is relative in that there are many small-cap-oriented funds out there. In fact, one of the companies we referred to earlier, Longleaf Partners, runs a small-cap fund (FUND: LLSCX), and its current cash allocation is virtually the same as that of their two other funds. In addition, people in the know say that small caps have had a good run lately -- it's far from clear whether the segment as a whole offers better value at this stage.
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