According to Warren Buffett, the world’s greatest investor, cash is an option on future equity purchases: moreover it’s a call option with no strike price or expiry date.
However, holding more than a token amount of cash in an equity fund doesn’t meet with universal approval. Advisers may object that they have made an allocation to equities for their clients and therefore don’t want that allocation diluted.
They may see it as an attempt to exercise market timing, usurping their role. They may also object to paying fees for what might look, on the surface, like indecision.
For most fund managers, who are measured against an equity based benchmark and are seeking relative outperformance, holding cash is too risky. What if the market rises strongly?
Relative returns will look poor and your fund will drop down the quartile rankings, rendering it unattractive to many fund selectors. Even absolute returns will be diluted in the present low interest rate environment.
Regulators agree: the maximum amount of cash you can hold in a UK authorised open-ended investment company is 20 per cent of net assets. Go above that and you are forced to invest the excess immediately.
What then do we make of Buffett’s comments on optionality?
I start from the viewpoint that absolute returns are what matter in the end. You cannot spend a relative return.
Also, it is the underlying business that generates the return for the investor over time, rather than the stock market. This is known as business perspective investing.
Under this philosophy, the task of the fund manager is to find good businesses and then to invest in them at below their intrinsic value, letting the businesses themselves then do the work of compounding returns. Intrinsic value is in essence the present value of future cash flows.
Share prices move around the intrinsic value of businesses all the time, and sometimes move to a significant discount. This is where the optionality of holding cash comes in: it gives the fund manager the ability to pounce on an undervalued business without having to make disposals elsewhere in the portfolio to do so.
A recent example for us was Revolution Bars, which issued a trading statement in May warning of rising costs.
This caused profit forecasts to be reduced by some 20 per cent but the shares nearly halved, to a level where the business was trading on a PE multiple of 7.5 times normalised earnings in the current year. Moreover Revolution Bars carried no debt.
We added to our holdings at these bargain levels. With significant cash in readiness, the purchase was easily accomplished. Three months later the company received a takeover bid.
If the stock market as a whole sees a correction, many businesses may suddenly trade below intrinsic value simultaneously. In this scenario, the business perspective investor will feel like a kid in a candy store.