Cash is a controversial subject among many fund investors and fund managers. Some fund managers wish to periodically hold or accumulate cash in anticipation of better investment opportunities in the future. However, many fund investors believe that equity mutual funds should operate at all times with as little cash as possible. Typical reasons cited by fund investors for their “minimal cash” worldview include:
- cash earns virtually nothing; and
- investors use funds for equity exposure and want that equity exposure maximized while leaving the broader cash weighting decision to them.
Such investor imperatives, combined with pressure to outperform the broad market at all times, have predictably led to a general reluctance among equity funds to hold much cash. Among the largest 200 US Large Cap Growth funds, the average cash weighting at present is approximately 1.5%, according to Morningstar.
These concerns about cash range from factual (cash indeed earns virtually nothing) to understandable. Cash is not an asset that holds, let alone increases, purchasing power over the long term. We get it! However, we have a distinctly positive take on the role and importance of cash and believe that fund investors can be well served by its disciplined use.
The Value of Cash
To us, the value of cash has very little, if anything, to do with the return one earns on it directly. Rather, the investment value of cash is fortitude. In a bear market, cash is the “thin green line” that separates crisis from opportunity. This view is expressed well by Morgan Housel in his book The Psychology of Money:
No one wants to hold cash during a bull market. They want to own assets that go up a lot. You look and feel conservative holding cash during a bull market, because you become acutely aware of how much return you’re giving up by not owning the good stuff.
But if that cash prevents you from having to sell your stocks during a bear market, the actual return you earned on that cash is not 1% a year–it could be many multiples of that, because preventing one desperate, ill-timed stock sale can do more for your lifetime returns than picking dozens of big-time winners.
In other words, the value of cash is not the return it provides but the behavior it promotes. Because long-term investment success has more to do with behavior than just about anything else, we believe investors that are willing to hold or accumulate cash when valuations are frothy are more likely to behave better during tough times when opportunities abound. By “behave better,” we mean sell less and/or buy more.
“Cash Drag”
We believe that cash’s “drag” on portfolio returns is routinely overestimated. Attuned investors rarely have to wait long to put cash to work opportunistically. Consider the gap between any given stock’s 52-week high and low share price. According to 2016-2020 data compiled from Bloomberg for all of the companies in the S&P 500, the median gap between calendar year low and high stock prices averaged 35%. Said differently, over each of the past 5 calendar years, investors could buy shares of any company in the S&P 500 at a median discount of 35% from that year’s high price. This speaks to opportunities routinely presenting within a year’s time, hardly long enough for cash to be a meaningful drag on returns.
Reframing Opportunity Cost
The meager return on cash is often cited to justify poor risk/reward decisions. Said differently, cash is often mistakenly used to frame opportunity cost. For example, say an investor targets 15% annualized returns on equity investments but has “excess” cash accumulating in his or her portfolio. The best discernible equity investment at present offers an expected annualized return of 10%. What to do?
Many investors frame this as a choice between earning 10% on the equity investment or 0% by keeping the funds in cash. But framing this as a choice between earning 0% and 10% is to frame it as not a choice at all! Framed this way, the investor chooses the equity investment. Granted, the expected return is less than the targeted (now merely preferred) 15%. Nevertheless, 10% is still decent and much, much better than earning 0% in cash, right?
Thus is valuation discipline suspended, all in the name of minimizing cash.
We frame this differently: not as a choice between 0% and 10% but as a choice between 0% and negative 20%. Where does the -20% come from? Over a 5-year investment horizon, the difference between getting a 10% annualized return and a 15% annualized return–holding all else equal–requires a 20% drop in the stock price. The table below shows that paying $62 today for a stock that will trade at $100 in five years will generate a 10% annualized return. To get 15%, the price has to drop from $62 to $50, a decline of 20%.
|
Stock Price Year 0 |
Stock Price Year 5 |
Annualized Return |
|---|---|---|
|
$62 |
$100 |
10% |
|
$50 |
$100 |
15% |
-20% Price drop required for 15% annualized return
Now framed as a choice between earning 0% in cash or suffering a 20% decline before the stock reaches the buy price, how would you choose? Of course, framing the question this way is also to frame it as hardly a choice at all. But consider how the choice of frame might affect subsequent behavior. If an investor bought this stock at $62 and the price promptly drops to $50, is the investor likely to buy more or sell it in disgust? Paying $62 in this example, the buyer has already foregone the opportunity to make 15% annually. But selling at $50 also deprives the investor of earning the 10% initially settled for. At this point, the investor has suffered a 20% loss of principal and, ironically, the proceeds of that sale at $50 are sitting in cash earning nothing, fear of which prompted the decision to buy at $62 in the first place!
The example above contemplated a 5-year investment horizon. Interestingly, the shorter the time horizon, the less the stock price decline required to be true to one’s valuation discipline. As shown in the table below, over a 2-year investment horizon, only a 9% price decline separates a 15% annualized gain from 10%. The shorter the time horizon, the less excuse there is to abandon valuation discipline in order to minimize cash.
|
Stock Price Year 0 |
Stock Price Year 2 |
Annualized Return |
|---|---|---|
|
$83 |
$100 |
10% |
|
$76 |
$100 |
15% |
-9% Price drop required for 15% annualized return
Virtually any investment with a positive expected return could be justified when compared to cash’s 0% return. This is precisely what makes cash such a specious factor when framing risk/reward and opportunity cost.
In Conclusion
We prefer to invest cash opportunistically, not routinely, and to do so in accordance with our valuation discipline and not arbitrarily to minimize cash. Cash does not burn a hole in our pocket in the absence of opportunity. In short, we do not look at cash levels to determine whether to buy stocks; we look at stocks to determine whether to invest cash.
Our views on the role and value of cash may not be widely shared. Given the importance of the subject to our investment process, we thought that ample reason to provide a better understanding of how we think about cash.
The investment examples included herein have been selected based on objective, non-performance selection criteria, solely to provide general examples of the research and investment processes of Akre Capital Management. The investment examples should not be construed as an indicator of future performance. The information presented above should not be considered a recommendation to purchase or sell any particular security. There can be no assurance that any securities discussed herein will be a part of any portfolio or, if sold, will not be repurchased.
