New ways to think about your cash position (#10)
Should you consider look-through cash? How about the relative change in a cash position as asset values fluctuate?
A common discussion point among investors and portfolio managers is how much cash is the “right” amount. On one end of the spectrum, you have those who say you should always be 100% invested. Others (like me) tend to echo Buffett and consider cash an expire-less option on every other asset class. I’m not here to advocate either approach only to get you thinking more about it.
1. Should you consider look-through cash? In Issue #7, I expanded upon Warren Buffett’s look-through earnings approach to consider the look-through exposure of a hypothetical bank investor. How about cash? Should you consider the cash on the balance sheets of your investees as part of your portfolio? There are a few considerations.
First, are you okay letting that management team allocate the cash on the books for you? As a passive investor, you have no say in how that capital is allocated.
Second, what is the opportunity set of your investees compared to your own? I tend to fall in the middle on this. Berkshire Hathaway (BRK.B; disclosure: long) has about $135 billion in cash/equivalents on its books. If half is readily deployable, then about 10% of Berkshire’s market cap is cash, and therefore 10% times my allocation to Berkshire = my look-through cash position from Berkshire.
2. How should you look at the allocation considering when it’s likely to be valuable? What I mean here is, if you have a 10% cash position (implying 90% stocks for simplicity), a 25% decline in the stock portion is going to put your cash position at 13%. Let me illustrate:
$100,000 portfolio is $10,000 cash (10%) and $90,000 stocks (90%).
Stocks decline 25%: $90,000 x (1 - 0.25) = $67,500
The portfolio is now worth $77,500 with $10,000 in cash or 12.9%.
Question: Is your cash position what it is today, or does it have some sort of hidden or latent value in its increased value upon a market crash? The answer to that depends on if you’re holding cash for a market crash (which could be considered speculation), or simply because you can’t find something intelligent at the moment. Perhaps it’s best to think about this conundrum as follows: the current allocation is the amount of cash (10% in our example) that could be used today if a one-off or unique opportunity arises. If an overall market correction occurs which takes down the quoted values of your current portfolio, that 10% could have more power in its larger relative weight. (The reverse is true too. If stocks go up your cash position will fall as a percentage.)
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