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Cash is king when the market holds the aces

Editor’s note. I asked Roger this question about holding cash.

“I heard you on Mark Todd's programme last week say your funds are now 30% in cash.

If I have an investment with an Australian equity fund manager, it is part of my overall portfolio. I have decided in my asset allocation I want x% in Australian equities, and I allocate money to other asset classes including cash. If my Australian equity manager then puts the money into cash, my asset allocation is upset. I want exposure to the specified asset class. At its extreme, for example, if an equity manager went to 100% cash, and the market rallied, I would feel it was more than a poor call, but that it went against my allocation wishes.

When I ran the geared share funds at CFS (which at one stage held $10 billion), we explicitly stated that we would gear the funds to their maximum. Everyone knew that's what they were buying, and I did not have the skills to second-guess the market. It was a supercharged portfolio in both directions, and we told investors and advisers to look elsewhere if they did not want the associated risk and volatility.

I know many top quality managers see a need to protect capital, and as you said on TV, you have hurdle rates which companies must meet. But I go to equity managers like you for Australian equity exposure.”


Cash. For such a simple investment, it can cause an awful lot of grief.

Has there ever been a time in history when investors had so much to worry about? Not a day passes here at Montgomery that a client or blog subscriber doesn’t express some concern about Brexit, the perils of asset prices inflated by unprecedented central bank intervention, the coming collapse of China or the Japanese-led deflationary spiral. Charlie Munger and Warren Buffett once observed, “Market forecasters will fill your ear but will never fill your wallet.”

But in reality, there has always been a time with an equally-worrying frequency of concerns. Consider the investor in the 1920’s, the 30’s, the 40’s, the 60’s, the 70’s, the late 80’s, the early 2000’s, the late 2000’s and so on. With monotonous regularity, fears concentrate and abate. It is safe to assume that stocks must be an incredibly risky asset class to invest in. In fact, cash is riskier.

Cash seems safe but erodes purchasing power

In the age of retiring baby boomers demanding income, cash might seem like the safest option but cash returns currently guarantee your purchasing power will be eroded the longer you remain invested in it. It is as certain as the sun rising in the east tomorrow.

Check out the Top 200 Rich List. How many decades did many of those entrants take to achieve their wealthy status? And how many black swan events hit the market and the economy in that time? And how many of them listed ‘cash’ under the heading, Source of Wealth?

Of course most investors in the stock market don’t think of their portfolio as a selection of stakes in operating businesses. They instead think of their portfolio as a group of ‘stocks’ that rise and fall with every latest fad and fear. To them, risk is the volatility in the share prices. But if the temporary movement in the prices of stocks is compared to the permanent erosion of purchasing power from holding cash, should not we be endeavoring to hold as little cash as possible?

The answer is yes. Our aim should be to fully invest in the assets that produce the highest long-run returns. And that’s pieces of the types of wonderful businesses we have defined here at Cuffelinks previously.

What if equities are expensive?

The problem and subsequently-required decision however emerges when the preferred assets are not available at an attractive price. Share prices should be so attractive that even a mediocre performance from the underlying business produces an attractive return.

And while the current rate of cash is likely to produce sub-inflation returns, so too will the overpayment for equities and property.

The decision must then turn to the more immediate probability or risk of capital destruction. On that score, equities possibly have higher downside risk. Stan Druckenmiller recently highlighted 1981 as a beautiful time to be invested in equities. Interest rates were at 15% and the real rate was 5%. Those high rates ensured companies were careful with their capital allocation and interest rates were about to commence a long decline. Productivity received a boost from the advent of the internet and debt was so low that a long-run credit-fuelled expansion was possible. The S&P500 Price to Earnings ratio was just 7X. Between 1981 and 2000, the S&P500 produced a return of almost 15% per annum, creating a 16-fold increase of your wealth.

Today, we have almost the mirror opposite image. Debt is double that of 1981 and appears to have reached its limit. Full employment and declining productivity suggests corporate profit margins are about to decline and interest rates cannot fall much further, and may begin to rise.  Since 2011, earnings per share in aggregate have not grown but US company payout ratios have increased from 55% to more than 75%. Combined with elevated levels of debt, it suggests little earnings growth will be experienced in the near future. And investors are paying 18x earnings. So how can the polar opposite of 1981, be an equally attractive time to invest? It cannot.

The current market justifies a cash holding

In that scenario, holding some cash seems prudent, and cash is particularly valuable when no one else has it. On cash being to a business as oxygen is to a body, Warren Buffett said: “Never thought about it when it is present, the only thing in mind when it is absent."

The only people who can benefit from a correction and take advantage of cheaper prices are those who hold cash. As India’s Warren Buffett, Prem Watsa, recently noted;

“Cash gives you options, gives you the ability to take advantage of opportunity but you have to be long-term. The cash gives us a huge advantage in terms of taking advantage of opportunity as and when they come. At the moment, we don’t think they’re many, so we are building cash.”

Remember Warren Buffett’s observation that fund managers are playing a baseball game where the investors in the bleachers are always yelling out “don’t just sit there, swing at something!” Private investors aren’t playing a game where they have to listen: they can sit there and wait for the perfect pitch.

Cash provides that opportunity, even though it is a terrible long term investment. It should be thought of as a call option over future cheap shares with no strike price and no expiration. Cash is guaranteed to avoid one risk - the risk of permanent capital loss - but it is also guaranteed to adopt another risk – the loss of purchasing power. Having all your assets in cash all the time makes no sense.

In the long run, share prices will always follow the performance of the underlying business. In the short run, the share price will bear no resemblance to business performance. That is why Ben Graham observed that in the short run the market is a ‘voting machine’ but in the long run it is a ‘weighing machine’.

It follows then that owning equities for a week or a month or even a quarter is risky. The corollary is that owning cash for a short period must be safe. When investing for a multi-decade period, daily share prices are meaningless and being fully invested should be the goal. Building a diversified equity portfolio over time is the process

And there’s your answer. You are buying ‘over time’. In the meantime, hold some cash. It’s an option over future lower prices. Don’t hold all your assets in cash, that’s not sensible. But don’t eschew the wealth-protecting and wealth-building power of cash either.


Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘’. This article is for general educational purposes and does not consider the specific circumstances of any individual.

June 24, 2016

Following today's Brexit news and the resulting ASX slump, I imagine Roger will now be putting his cash to good use.

Steve Martin
June 23, 2016

I am far happier for a managed fund to hold cash when there are no opportunities for sensible investment, than I am with closed end funds. The fact is, we invest to make money and we trust the managers to do a better job of investing than we can do as individuals. The great downside with managed funds is when investors rush to cash when the markets fall, resulting in managers needing to liquidate assets to meet the calls for redemptions. This, to my mind is the biggest risk of investing in managed funds and, I think the risk is mitigated when managers are holding a store of cash in volatile times or when the market is fully priced.

Worse, I think is when you invest in a closed end fund which maybe trading on the market at a surplus. This happened with one of my LICs which I invested in a couple of years ago on the basis that it was an 'active' manager. The word at that time, was that there was to be volatility in the market and value would be difficult to find. I decided to seek out CEF managers who could short the market and try to take advantage of the volatility. The problem was, the fund I invested in had been trading at a healthy premium to NTA as it had a good track record of performance. When things got tough, rather finding positions to take advantage of the volatility it rushed to cash, and as a result, the surplus left the share price and traded either at NTA or at a discount. This created a permanent loss of capital for me.

Of course closed end fund managers really do not care so much about the share price or the effect that going to cash will have on the share price for that stock. Lesson learned.
I am starting to learn, that it is better to have fund managers who have a wide mandate for investing, including the ability to go to cash at appropriate times, and as is often warned, only buy listed Closed End Funds when they are trading at NTA or at a discount.

I find myself once again agreeing with the approach taken by Roger Montgomery. He is a fellow who I think is incredibly insightful and very clever. I will invest in one of his funds one of these days!

June 23, 2016

Do I want my managers to invest in stocks that they believe will lose me money? Maybe you do but I certainly do not!

Do they do this? They must certainly do. Our research shows that the typical (US) equity manager invests in 87 stocks but only less than 20 of these stocks are worth investing in. Further they are very capable of identifying the better of the stocks so at any point in time they know that the majority of the stocks they hold are not worth investing in. Why do they do it? They do it because we tell them to. We give them mandates with benchmarks, constraints on tracking error and cash holdings, and tell them they have to be diversified. Of course, we have been told by our teachers, our advisers and even our managers that these are all good ideas to which I would add is the equally senseless message to religiously stick to our asset allocation).

Who benefit from these wealth destroying (and price distorting) rules? Our teachers, our advisers and our managers but certainly not us. However that is a story for another day.

Is there a solution to the problem at hand? Yes have the managers be fully invested across the (often very small) number of stocks they think worth investing in. In other words hold concentrated portfolios as is suggested by Keynes, Buffett, Munger and many other successful investors, most of whom have the advantage of being too old to have the concept of diversification for diversification sake preached to them in their formative years. One small problem is that there are very few managers worth employing but that is a fact of life.

I recommend that your readers should read the material on "The Curse of Benchmarking" by Vayanos and Woolley - I am unable to provide a link at the moment but I am sure that Graham can help out.

Andrew Brown
June 23, 2016

Roger's piece shows why long-only domestic equity funds are increasingly being ignored by folks who are gravitating towards overseas funds. Where I struggle is two-fold:

(1) paying active fees (1%+) to benchmark huggers; and
(2) paying performance fees on top of a sometimes high base fee to use their stock picking skills and research to be long only.

It stands to reason if a manager is struggling to find value and is 30% cash that they must be able to find over-valuation, poor businesses and catalysts for degradation of share price, thereby pocketing performance from shorting. I accept the theory of "infinite losses" but can't accept that this cannot be practically managed by a professional with position limits and derivatives if available.

I've had a public debate previously about shorting "valuation excesses" but in the same context of finding the holy trinity of valuation, accounting return and management, the same works the other way. I've personally found plenty of scope in Australia (retail is an especially fertile field...) to do this and earn extra returns.

I accept that proper long/short funds may mess up the "asset allocator" at the margin, but at least you would be certain of getting what you pay for: investment management expertise of research and portfolio construction.

Graham Hand
June 24, 2016

Hi Andrew, I'll leave Roger to respond to some of your points if he wishes, but I point out that his funds are not 'benchmark huggers'. I agree that paying active fees for a manager who has a tiny tracking error to an index is not money well-spent, but as I understand Roger's approach, he is a stock-picker not a hugger.

Andrew Brown
June 25, 2016

Hi Graham, Sorry that comment not aimed at Roger - very aware he is not a "hugger" - but at funds generally. I'm keen to see managers who tell me stuff is overpriced to provide a benefit to that view where possible.

June 23, 2016

I agree that long only equity funds should be 100% long. Leave the asset allocation decision to the asset allocation function. Equity managers should stick to 100% long exposure in local currency of the stock they are picking, and leave AA and currency decisions to others.

Berkshire Hathaway is more of an unconstrained hedge fund than a long-only equity fund. It happened to have been in the right place at the right time – ie mostly US equities over the past 50 years. Plus some great stock picking.

June 23, 2016

For a value manager, seems to gloss over the real value point here.

It comes down to fees, and performance fees. Fund management/admin fees of 1.5% on 'cash' seem excessive. Who doesn't know how to park money in a bank account?

Moreover a performance fee of 15.38% on the cash - if the market goes down then the cash 'beats its index' - and the bet here is mkt is overvalued, so expecting it to go down; is fine for some I suppose.

bottom line, if you are paid to enter the arena and invest, so be it. But don't sit in the stadium and expect to pocket match fees.

I would have a happier view if the fund excluded the cash portion from fee charges ... but no such luck

June 24, 2016

Good point John,
Asset fees should be on invested capital and performance on the fund growth over the benchmark

Ashley Owen
June 23, 2016

Stephen, I'm with Roger on the issue of cash eroding purchasing power much of the
time. In Australia cash has suffered negative real total returns 38% (according to my data base) of the time since Federation (and that's before tax - it's even worse after tax).

Cash suffers longer and deeper drawdowns in total returns than shares or virtually any other asset. Cash is risky indeed – periods of 30+ years of real losses and 60+ years to
recover real value. Far worse than shares or other so-called ‘risky’ assets!

Cash is also the least tax efficient - with the entire return taxable at full marginal rate.

June 23, 2016

Roger says that hiding cash erodes your purchasing power but in Australia we have had 25 years of pretty much positive cash returns. The story changes a bit if you go back further.

SMSF Trustee
June 23, 2016

That answers Graham's question, but does it really address Graham's issue?

In my SMSF I have allocations to equity managers that I expect to be in equities. I understand that there may be times when cash builds up a little, but 30% would be excessive. I am comfortable for that part of my portfolio to wear the volatility of markets - including when they become over and under valued.

I have other allocations to tactical managers, where I expect them to move around asset classes based upon deviations from value and other fundamental and technical factors. I expect them sometimes to have heaps of cash, ready to deploy when value reappears.

I would not want the Colonial Geared Share Fund to try to be in the latter.

So what you're telling me, Roger, is that were I to consider your fund I would have to look at it in the context of my tactical allocation funds rather than my core equity funds. Because you could cash it up quite a lot, contrary to what I want that part of my portfolio to do.

To be honest, I wouldn't want to do that with a fund that had the choice between Australian equities and cash only. I want the multi-asset funds that might go into global sovereign bonds or local bank sub-debt or property or somewhere else rather than just cash. If they go into cash so be it, but that shouldn't be the only option.

So I hear what you're saying, which is a good answer to Graham's question. But it doesn't satisfy me that the issue Graham was asking about has been adequately addressed.


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