The king is dead, long live the king: The importance of cash

The king is dead, long live the king: The importance of cash

When cash is earning returns on a million-dollar term deposit that amounts to less than the poverty line, it’s easy to say that cash is not king. As a result of the poor returns, investors have migrated up the risk curve, investing in everything from hybrids to mezzanine finance, seeking better returns.

But the 2.5 per cent return offered by cash is a darn sight better than minus 20 per cent, and that is always a possibility when asset prices are elevated, which they are today. Don’t ever forget, the higher the price you pay the lower your return.

The common argument trotted out against a fund manager holding cash is that the client should not have to pay fees to a manager to undertake an activity they can perform themselves. Holding cash is not rocket science, so the argument goes, and investors in a managed fund should be insisting the managers are fully invested at all times.

What an absurd proposition.

Let me now build an argument for actively managing a flexible approach to cash in an equity portfolio and for being able to hold vastly higher amounts of cash than has traditionally or conventionally been accepted by the investment community.

If we have decided that we are going to approach the market as a venue through which we can acquire part ownership stakes in extraordinary businesses – rather than a casino at which we gamble on the rises and falls of ‘stocks’ – those businesses are going to continue to compound their profits and equity over time, in turn adding economic value to their worth. On this basis, provided we can assemble a collection of qualifying businesses, then we should be 100 per cent invested at all times.

Unfortunately however, we must report our results each month. Somewhat disturbingly, our results aren’t measured by how much the business we own has increased their balance sheet equity, profits or margins. Instead the monthly measure of success is the change in price over a month!

The 31^st-best opportunity? Or cash?

What should one do, if according to strict and tested criteria, an insufficient number of companies can be found to fill a portfolio? Should they invest in their 31^st best opportunity, or should they park their clients’ funds in the safety of cash? We believe the best option is the safety of cash.

In order to both protect and enhance the investors’ purchasing power, a manager has to manage a portfolio that is different to an index constructed without concern for return to investors. In this context being prudent has nothing to do with investing to an index.

As Yale University’s David Swenson observes: “Active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel.”

Direct investors measure risk by the likelihood of permanent loss of capital. They take comfort not from the manager who produces negative returns that beat a benchmark, but from the minimization of both the quantum and frequency of drawdowns. This protection can be offered by a mandate that has the ability to hold relatively large amounts of cash.

Some years ago Dr Leah Kelly and Paul Umbrazunas wrote:

There should be more focus on minimising the ‘points’ lost rather than maximising the gains required. The reason is clear. Upon incurring a market loss a larger return is required simply to get back to where you started. As a simple example, consider the following two investors, both investing $10,000 at the end of May 2000.

• Investor 1 invests $10,000 in the ASX 200. Here the volatility is approximately 12 per cent a year.
• Investor 2 is more conservative and invests $10,000, 40 per cent in the ASX 200 and 60 per cent in cash. Here the volatility is approximately 5 per cent a year.

What were their experiences like?

Both investors had a good time up until September 2007. At this point, they were fine, with about $30,000 and $20,000 in capital for Investors 1 and 2 respectively. Then disaster struck. Investor 1 was hit with a drawdown period that lasted from September 2007 until January 2009, culminating in a total loss of 49 per cent. Meanwhile, Investor 2 did not escape unscathed. A total loss of 17 per cent was accumulated from September 2007 until January 2009. In order to return to the equivalent capital balance prior to September 2007, the total required return for Investor 1 was 92 per cent while Investor 2 was 22 per cent.

We assume for this illustration that both investors kept the faith and did not change their asset allocation.

How long did it take these investors to return to break-even? For Investor 1, it took six years to recover. For Investor 2, it took two and a half years. As an aside, by the end of January 2014, the annual realised return since May 2000 for Investors 1 and 2 was 5.5 per cent and 4.7 per cent, respectively. The realised annual volatility over the (nearly) 14-year investment was 13 per cent and 5 per cent, respectively.

If you believe an equity manager is better positioned to know when the market is cheap or expensive, and if you believe a market correction is possible if not probable, why insist your equity manager remains fully invested at all times?

If cash is not king for you, think again.

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.