How Cash Can Boost Long-Term Returns
Summary Liquidity management is one of the most critical aspects of investment. Cash earns a 0% nominal return, but allows investors to take advantage of higher-return opportunities that may emerge. By holding more cash, one is betting that the purchasing power will increase at a future point. Moderation is key with holding cash; it’s rarely advisable to go to 100% cash or 0% cash. I’d recommend a cash position in the 20% – 40% range for most investors right now due to higher than average risks in the market. Buying stocks at depressed prices (i.e. with a large “margin of safety”) is the best way to generate superior returns over time. Cash, on the other hand, generates a 0% return. Absent a highly unlikely episode of hyper-deflation, you cannot become wealthy holding cash. In spite of this, I’d recommend holding 20% – 40% of your portfolio in cash right now. The reason for this is that there is value to liquidity, particularly in an inflated market environment. By holding cash, what you are actually doing is betting that the future value of your money in the market will be worth more than the present value. How can cash help you generate better returns? The key is to understand intrinsic value and the mathematics of investing. Intrinsic Value Price is what you pay for an asset. Intrinsic value is the fundamental worth of an asset. Therefore, an asset could be priced at $20,000, but have an intrinsic value of $30,000. In that instance, you are getting a bargain, because you are paying 33% less than the intrinsic value. In reality, it’s impossible to know the exact intrinsic value of a stock. None of us can see the future. Yet, we can come up with reasonable estimates of intrinsic value through a fundamental analysis of a company. That said, in order to explain why holding cash can be beneficial, we’ll first need to assume we can read the future. In this scenario, let’s say we know with absolute certainty that the intrinsic value of XYZ Company’s stock is $20. Now, we’re going to be able to live in five different alternate realities. In the first scenario, XYZ Company’s stock is selling at the depressed price of $5. In the second scenario, the stock sells at a still somewhat depressed price of $10. The third scenario will allow us to purchase the stock for $20; which is precisely the intrinsic value. In the fourth scenario the stock will sell at an inflated price of $25, and in the fifth scenario, it will sell at an even more inflated price of $30. Now, we’ll say that in each of our five alternate realities, we will purchase the stock and hold it for five years. We also know for a fact that the intrinsic value will grow 10% per year. You can see how the intrinsic value grows in the chart below. With that, let’s take a look at what happens. The Power of Compounding Now that we’ve created the set-up, you can see the return figures for all five scenarios below for a five-year holding period. It immediately becomes clear how dramatic the difference is between purchasing XYZ’s stock at a depressed price versus an inflated price. The “inflated price” only yields a 1.4% annual return, while the “depressed price” yields an astronomical 45.1% annual return! To put this further in perspective, if you started with $10,000 and generated a 45.1% annual return for the indefinite future, you would have $100,000 in a little over 6 years. On the other hand, if you generated a 1.4% for the foreseeable future, it would take you 166 years for you to turn that $10,000 into $100,000. That’s not a misprint! That’s the power of compounding. This is also the reason why an investor that generates a 17% annual return over 10 years is significantly better than one generating a 15% annual return. It may seem like a very small difference, but over a long-term timeframe, it really adds up. An investor making 15% annually on a $10,000 initial investment for 25 years would have $329,000 at the end of that timeframe. An investor generating a 17% annual return, on the other hand, would have $507,000; roughly 54% more. Why Cash is Valuable Given this math, it starts to become clearer why holding cash can sometimes led to higher long-term returns. Let’s say that XYZ’s stock was selling at the inflated price of $30, but you could see the future, and knew it could fall back down to $15 in 3 years. For simplicity’s sake, we’ll still assume that you plan to sell off at the end of Year #5 at the intrinsic value of $32.21. What would be your best option? (1) Buying the stock immediately and earning the 1.4% return for 5 years, (2) Holding cash for 3 years and then buying in at the semi-depressed price of $15 The answer is that option #2 is much more profitable. After five years, you’ll only generate a total return of 7.2% in Scenario #1, but you’ll achieve a 114.7% return in Scenario #2, in spite of the fact that you made a 0% return the first three years. This example showcases why the relationship between price and value are so important. It also shows why value investing works so well. What may seem like small differences in price can drive very large differences in return. Hold Some Cash Given the inflated market environment we are currently seeing, I believe it’s prudent to hold 20% – 40% of one’s portfolio right now. It’s true that you’ll likely underperform in the short-term (e.g. 1-3 years) as a result of this strategy. However, in the long-term, it makes more sense to take the 0% return now (on a part of your portfolio), and then use the liquidity to strike later when the returns become much more attractive. Of course, this should not dissuade you from taking advantage of bargains as you see them become available. And while I believe the broad market is overpriced, on a micro level, there will always be bargains out there. Yet, even if you can find a lot of bargains, I’d still recommend holding a good clip of cash, because even better bargains could become available the next time we find ourselves in a recession or a falling market environment. How much cash you hold in your portfolio depends upon your preferences and personal situation. If you’re in a situation where you can’t afford to lose much right now (i.e. you might need your cash for other purposes), I would recommend playing things fairly conservatively and holding a very large cash position. Even if you’re not worried about pulling out cash, I do think a minimum 10% cash position is prudent; and frankly, I wouldn’t dip below 20%. Conclusions Holding cash and generating a 0% return may seem like a poor option on the face of it, but once you understand the math behind returns, it makes a lot sense. By holding cash now, you’re hoping that you can generate higher returns in a future environment with lower prices. It’s never wise to go 100% cash, because at that point, you’re merely speculating. In an environment where stock prices seem inflated and there are few bargains out there, it makes sense to hold an elevated cash position in the range of 20% – 40% of your portfolio. On the other hand, in a depressed stock environment (such as the one we saw in late 2008 and early 2009), you should try to be as fully invested as possible, holding no more than 5% cash. Right now, I view us as being in an inflated environment and holding a 20% – 40% cash position is a prudent strategy. Your returns will lag in the short-term, but if there’s a market correction, you’ll more than make up for it in the long-term. This article appears in the February 2015 edition of Jake Huneycutt’s Contrarian Value Newsletter Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
