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The Importance of Holding onto Cash

By Roger Montgomery

The Importance of Holding onto Cash

What Next?

Montgomery Investment management holds both a research meeting and an investment committee meeting weekly.  We recently held our shortest investment committee meeting.  I timed it.  It went for 22 minutes.  What gives?

The impact of the histories greatest monetary experiment is now upon us.  Low interest rates, flat yield curves and the pursuit of yield have rendered it difficult for value investors like us to find interesting new opportunities.  Make no mistake we are invested already in a portfolio of extraordinary businesses, generating above average returns on equity, with below average debt and with bright prospects for continued earnings growth.  Companies like REA Group, Challenger Financial, Altium, TradeMe, Vocus, CBL Limited and Vita Group have made the grade but finding reasonably priced new opportunities to invest a growing cash pile is challenging.

Recently released, The 2016 Long-term Investing Report, co-authored by the ASX and Russell Investments, has backed up our previously-published concerns that low returns are here to stay.

Citing meagre returns from listed property and cash (1.7 per cent and 3.1 per cent, respectively for the decade to December 2015), as well as cracks appearing in direct property, and higher expected volatility from shares and bonds, the report suggested investors “seeking to achieve their required rate of return, at a risk level they can tolerate, should consider dynamically managed real return funds to gain exposure to a more diversified investment opportunity and be able to quickly respond to changing market conditions.”

I’d go one step further and suggest building up some cash. 

Back in 1981, the risk free rate of return in the United States - as represented by 5-year treasuries - was 15 per cent.  Real rates were close to 5 per cent. In order to compete with high risk free rates, assets were priced very cheaply.  And the 15 per cent hurdle rate forced companies to invest capital wisely and where necessary restructure.  Financial leverage as measured by Total Credit Market Debt to GDP was less than half of what it is today. Back then credit-fuelled growth lay ahead.  Today it does not.  GFC-response policies have discouraged de-leveraging. In fact leverage has risen.

The period that followed 1981 was one of the greatest bull markets in financial history.

So my question is indeed one that is being asked by several investment luminaries; how can precisely the opposite environment (historically low interest rates, expensive asset prices and historically high levels of debt) to that which existed in 1981, also be a great investment environment?

It simply cannot.

Former Soros Funds Management Director, Stan Druckenmiller, in early may observed, “In 1982 the market sold for 7X on depressed earnings and with dozens of rate cuts and productivity improvements ahead.  Today we’re at 18X inflated earnings, with productivity (margins) declining and no further ammo on interest rates.  While policy markers have no end game, markets do.”

And that brings me back to cash.

We tend to think that cash is safe but it is not.  Cash is not a risk-free asset at all.  What could be riskier than being guaranteed to lose more purchasing power the longer you hold it?  As Warren Buffett explained in 2015, during the fifty years from 1964 through 2014, the S&P 500 Index returned 11,196%, including reinvested dividends. During those years, the value of a dollar fell by 87%.  Investing for long periods in cash is not desirable.

But in the short run cash is like an option over every asset class, with no expiration date and no strike price.

Cash provides the option to sweep up a bargain when it becomes available and this must have some value above the fact it earns almost nothing.

If the purpose of an investment portfolio is to grow as well as protect the wealth you’ve accumulated over the years, doesn’t it make sense, if you can afford it, to also hold an option? 

At this juncture there is value in holding some cash. Not most of your money, but some.

Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!