This guest post discussing if top performing value investors hold cash was submitted by The Broken Leg Investment Letter subscriber Xavier Hill. The thoughts and opinions expressed here are those of the author and may not reflect those of anybody else at Broken Leg Investing.
Should value investors hold cash?
The US stock market is on a tear, a massive tear. In fact we are now in the second longest bull market since World War Two.
Contrast this to the fact that value investors are naturally contrarians - we are delving into places in the stock market that few care to look. So as all of you reading this have a natural contrarian bent I know you have a niggling thought that is always in the back of your mind but with every new high the Dow is rapidly reaching…
So, should value investors hold cash? Should you take some money off the table?
Whether Value Investors Hold Cash Or Not Should Hang On Two Simple Truths
It is a natural reaction of course. If your portfolio has been performing like mine or Evan’s you are seeing strong returns and you think “if the rest of the crowd are buying maybe it is time for me to be selling.”
I am here to argue that selling would be wrong. Very wrong ...and while I will present a series of backtested studies to convince you of this really the logic boils down to two simple truths:
- No one can time the market. If a significant number of market participants could time the market, then prices would quickly adjust, quickly removing any overvaluation in the first place
- Overtime as technology improves productivity improves and economies and stock prices will rise in response.
It is these two simple concepts that lead investment legend Peter Lynch to say:
"Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves."
Selling your holdings expecting a stock market crash amounts to market timing. The problem with trying to time the market is that you need to be right twice. Once to sell at the peak of the market and a second time when you buy back in at the bottom. I liken it to the hare and the tortoise. By trying to be in and out of the race vs methodically sticking at it, you eventually lose. And the research backs this up.
Should Value Investors Hold Cash? Here's Tweedy Browne's Answer
Investment legends Tweedy, Browne conducted a series studies on the subject and found that 80%-90% of an investment’s return occurs between 2% and 7% of all trading days. If value investors hold cash they they'll almost certainly underperform. Missing any of these days has a devastating impact on your long term returns. Here's what Tweedy Browne had to say about value investors holding cash:
"With stocks, you have to be in to win. We believe that value-oriented stocks with extreme investment characteristics are likely to beat the returns from cash over the long run. Index funds stay fully invested with no cash. The long-run odds of having your portfolio generate returns in excess of returns from fully-invested index funds are enhanced by keeping cash to a minimum and staying as fully invested as possible. (Note: It is a little painful for us to write this section because, in our past, we often sat on our thumbs with too much cash in clients’ portfolios before empirical research and 3 our own analysis convinced us of the error of our ways. We were not knowingly markettiming, but were overdiversifying: Instead of investing 3% of portfolios in a perfectly good bargain stock, we invested 1% because we wanted to buy more at even lower prices. Cash, and lower investment returns, were the residual of this process. Over the last 22 years, the after-fee return on the portion of our clients’ portfolios invested only in stocks (not cash), 21.4%, beat the return on cash, 7.1%, by 14.3% per year.)"
In a 20 year study of the 300 largest stocks listed on the Australian stock exchange, Acadian Asset Management found that missing these tiny windows of surging prices just kills your returns. In fact if you had missed the best 30 days for the ASX between August 1995 and August 2015, you would receive just a 2.7% return vs a much larger 9%.
I can hear you saying that by nearly every metric, such as the Price to Book or Price to Earnings Ratios, the market is overvalued so you’re still getting out. No doubt that is true. Historically, the S&P 500 P/E Ratio has averaged 16.5x, but is sitting near 26x as of early 2017! I cannot argue with this - on the surface the market relative to history is overbought.
But consider this. Between 1926 and 2007 the S&P 500 recorded an average yearly return of 10.2%. Over that period the most violent upswings have occurred after down years. In fact the first positive year after a down year has an average return of 27% and the first positive year after more than one down year has an average return of 34%.
If you accept you cannot pick the market then there is no other logical choice but to be fully invested in the highest performing deep value strategies because even if you have a down year, history tells us that you will dramatically make up for the downturn in the next positive year. Overtime, and on average, this cancels out any losses you made in the down year.
Invest Wisely and Value Investors Should Not Have To Hold Cash
By focusing on solid deep value stocks (A.K.A. Broken Leg Stocks) you provide yourself with further insurance in the event of a down year.
Warren Buffet’s great friend and partner in Berkshire Hathaway speaks about the superiority of value investing during bear markets in the book Charlie Munger: The Complete Investor.
“The Graham value investing system is intentionally designed to underperform an index in a bull market; this is confusing to many people. The underperformance of the Graham value investing system during a bull market is an essential part of this style of investing. By giving up some of the upside in a bull market, the Graham value investor is able to outperform when the market is flat or down.”
Munger of course is right about value holding up during bear markets and for proof check out the SPIVA mutual fund scorecard where you will see the dramatic outperformance of value oriented funds during the ‘08 crises vs growth oriented funds.
Evan’s portfolio, on the other hand, has drastically outperformed the market during our current bull market - so it’s important to recognize that select deep value strategies can outperform in both bull and bear markets. Evan's a firm believer that if small value investors hold cash they will underperform. We show you how in Broken Leg Investing's VIP Newsletter. Enter your email at the bottom of this article.
While it is hard for the contrarian in us to buy when the market is reaching record highs we need to always think long term, with the cost of not being in the market being far greater than being in the market. We also need to remember that by buying value stocks we have already given ourselves insurance for a bear market.
Of course need I add that through filtering our deep value stocks through additional quality filters we provide ourselves even greater insurance in a bear market. This is because Evan’s team only picks stocks that meet its strict criteria. Of the principles (beyond staying away from Chinese reverse mergers that often end up being frauds) perhaps the most important in a bear market is a low Debt to Equity Ratio. This means if credit does become tight at the bottom of a bear market, the stocks in Evan’s (and my) portfolio are unlikely to be desperate for cash and and are in a far stronger position to survive.
It also means when the market eventually turns their strong Balance Sheet allows these stocks to gain upon their weaker competitors, which will eventually lead to superior returns.
But Don't Professional Value Investors Hold Cash?
Yes, but if a professional investor jumped off a cliff, would you?
More seriously, professional investors suffer a crippling disadvantage: size. They're managing billions of dollars each year and this size severely limits the number of firms that they can invest in. This almost necessitates that large value investors hold cash.
Most money managers want to only ever own a small amount of any company, less than 10%, which forces them to spread their holdings among a large number of firms. These firms also have to be reasonably large and liquid in order for a manager to put a decent amount of money to work. This inevitably means that professional investors have to pick among the 500 (or if they're lucky 1000) largest companies.
While there are hundreds of thousands of money managers, unfortunately, there just aren't that many great value investments. Great value investments are scarce and become more so as markets rise. This forces professional managers to choose between holding sub-par investments or cash.
Small investors like you or me, by contrast, have over 50,000 stocks to choose from since we are putting a comparably small amount of money to work. By virtue of our small portfolios, we can invest all the way down the market capitalization ladder. We can invest in firms smaller than $100 Million USD and professional investors can't. We have far more opportunities available to us and this means that there is always a fantastic value stock to buy.
So, should value investors hold cash?
No. Not if you're managing less than $100 Million USD, or so.
For the sake of your own financial future, develop the emotional strength to ride out periods of volatility or crashes so you can remain fully invested. In the long term, your fully invested portfolio will drastically outperform both the market and your emotionally fickle neighbours’ investment account.
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