Cash is king
As you already know, Magellan Financial Group are approached regularly by smaller equity managers seeking an investment. To date, Magellan have only invested in one manager – Montgomery – and Magellan remain the only external investor in our company.
One reason for the relationship is that we share a number of common bonds. And a very long-term perspective and the preservation of our investors’ wealth are right at the top of the list.
In my video last week (Crushed by Cash), I discussed our thesis that the market could grind higher, thus fuelling an asset bubble; while interest rates in the US and Australia remain low. I also note that the rational pricing of risk is not working because low rates are corrupting everyone’s view of risk.
Even though low rates, yield-chasing baby boomers and large amounts of cash should spur further stock market gains, investors are right to dance – while the band is playing – close to the door. There’ll be no cabs to take you home safely if you wait until the music stops! The slow-moving train wreck we can see will cause untold pain for many investors.
As I mentioned in the video, we are actively seeking great opportunities but we note that our process is continuing to suggest and produce high levels of cash. In The Montgomery Fund, 24 per cent of the portfolio is held in cash, and in The Montgomery [Private] Fund, 35 per cent of the portfolio is invested in the safety of cash.
To be clear, we don’t like cash – our preference is outstanding businesses generating high returns on incremental equity. Cash is generating a negative real return and it produces an anchor-like effect on our returns if the market does indeed continue to grind higher.
Nevertheless, we believe that it’s worth considering whether the gains made from this point on are ultimately wiped out when the music stops. And this was the question that my friend Hamish Douglass asked over at Magellan in last week’s Global Equities Update.
Here’s an excerpt:
“In the last week, we have increased the cash weighting in our Global Equity Strategy to approximately 10%. The last time we materially increased our cash weighting in the Strategy was at the commencement of the European sovereign debt crisis in early 2010. We are lifting our cash weighting to increase the defensiveness of our portfolio in response to the massive compression in risk premia across multiple asset classes over the last 18 months. We believe there is an elevated probability that this risk compression will unwind over the next 12 months or so as the US Federal Reserve ends Quantitative Easing (QE) and investors focus on a normalisation of US interest rates. An unwind of the compression of risk premia combined with rising long-term interest rates could lead to a material correction in credit and equity markets.
While we are not predicting that there will be a market crash, we consider it prudent to be cautious as it is unknown how investors will react when US interest rates start to normalise. There are scenarios where US long-term bond yields do not rise, risk premia do not revert to more normal levels, and markets remain benign or even strong. In such scenarios, our decision to increase our cash weighting will be a drag on short-term performance. In our view it is better to be prudent and cautious, given the current set of facts, than be complacent.”
You can read the full report here