Is it better to move to quality instead of cash if market feels fully valued?

[rpadebet]

I have been thinking about this for a while. I have not seen many studies, so thought would ask the members on the board on how they would feel about such a strategy.

 

Market seems to be fairly valued to me. But I am no market timing expert and I have no clue what it will do over the next few years. Parts of my portfolio have reached fair valuation and I am building cash by selling those. I understand the optionality cash provides during a market crash, but it is also a drag on the portfolio returns if you sit on it for a long time.

 

So I was wondering, if it is better to reallocate cash to some fully valued (not absurdly over valued) quality names like Coca Cola, Walmart, Mastercard, American Express, Berkshire Hathaway, Wells Fargo etc. Names with the highest likelihood of survival in case of deflation/inflation/general panic.

 

It is conventional wisdom over here that, such names are best bought in a panic, but who knows when that happens. Also if you look at the last panic in 2008, if you allocated your cash to quality companies at the market bottom, you did well, but not as well as people who invested in some truly undervalued cyclical stuff. Reason being quality names rarely become absurdly undervalued i.e. they tend to hold their value well, so upside is limited to the intrinsic business performance and some multiple expansion.

 

So isn't it better to not hold cash, allocate to these names along side the typical value portfolio, let them run along with the market and if/when panic hits, sell the quality names to raise cash (maybe to opportunistic value investors) and reinvest proceeds in the undervalued stuff?

[ukvalueinvestment]

Agree.  A portfolio of high quality companies at fair value should earn more than cash but be resilient during a downturn.  That said, I believe there's always 8-10 bargains out there.  You just have to search harder.

[Andy Dufresne]

A great question!

 

First, one needs to consider whether there are alternative asset classes that can provide for better return - e.g. real estate (but I assume the prices of these asset classes are also high ...);

 

Assuming everything seems expensive, but you do not want to be left out of the dance, so to speak, you have several alternatives:

 

1. Buy insurance = puts. This limits exposure but can be expensive - sometimes not so much, though - e.g. you can buy the Jan 2016 125$ strike put on BRK.B for 8.45, which is an annualized cost of about 4% ... BUT BRK.B was at close to 100 at the end of 2007 and around 47 in early March 2009, so perhaps its decent insurance ... you'd need to do the math and decide how far out of the money you are comfortable buying ... also, if the market advances you can roll up but this will increase the cost ...

 

2. Hold good defensive companies with a good/great dividend yield, e.g. KMP, Extendicare etc.

 

The last two market corrections took between 18 and 24 months from peak to trough (I'm using the S&P500, so 8/2000 to 2/2002 and 9/2007 to 3/2009), so if you own companies that have good dividend yields (say 4% and up), they can provide you with anywhere from say, 5% to 15% of your pre-crash portfolio dollars (assuming no taxes and not adjusting for whn you bought them which should increase this number) which you can then invest. The trick, of course, is to hold on to your stocks when everyone is dumping their own - not easy!

 

3. Hold cash

 

The debate about this will always rage - Packer likes to be fully invested, some other equally smart and experienced people are 50%+ in cash as we speak ... I like to think in terms of how many years of market involvement are lost when a correction happens ... again taking the S&P500:

 

(a) The 99-00 market - at the bottom, in Oct. 2002, you could have been in cash for roughly 5.5 years (from May 1997!) and bought the index at roughly the same level (this excludes dividends, I know but);

 

(b) The 08-09 market - at the bottom, in March 2009, you could have been in cash for roughly 12.5 years (from Nov. 1996!!!!) and bought the index at roughly the same level

 

So ... cash is also useful :)

 

For me it all comes down to knowing your own psychological tendencies and remembering the adage of one WEB (I'm paraphrasing here) - "Don't risk what you must have for something you want to have" - at the end of the day when there is a market panic it takes real guts to stay calm and if you rely on your investments to provide a living, that is mighty hard to do ....

 

Cheers,

 

Andy

[Kraven]

A great question!

 

First, one needs to consider whether there are alternative asset classes that can provide for better return - e.g. real estate (but I assume the prices of these asset classes are also high ...);

 

Assuming everything seems expensive, but you do not want to be left out of the dance, so to speak, you have several alternatives:

 

1. Buy insurance = puts. This limits exposure but can be expensive - sometimes not so much, though - e.g. you can buy the Jan 2016 125$ strike put on BRK.B for 8.45, which is an annualized cost of about 4% ... BUT BRK.B was at close to 100 at the end of 2007 and around 47 in early March 2009, so perhaps its decent insurance ... you'd need to do the math and decide how far out of the money you are comfortable buying ... also, if the market advances you can roll up but this will increase the cost ...

 

2. Hold good defensive companies with a good/great dividend yield, e.g. KMP, Extendicare etc.

 

The last two market corrections took between 18 and 24 months from peak to trough (I'm using the S&P500, so 8/2000 to 2/2002 and 9/2007 to 3/2009), so if you own companies that have good dividend yields (say 4% and up), they can provide you with anywhere from say, 5% to 15% of your pre-crash portfolio dollars (assuming no taxes and not adjusting for whn you bought them which should increase this number) which you can then invest. The trick, of course, is to hold on to your stocks when everyone is dumping their own - not easy!

 

3. Hold cash

 

The debate about this will always rage - Packer likes to be fully invested, some other equally smart and experienced people are 50%+ in cash as we speak ... I like to think in terms of how many years of market involvement are lost when a correction happens ... again taking the S&P500:

 

(a) The 99-00 market - at the bottom, in Oct. 2002, you could have been in cash for roughly 5.5 years (from May 1997!) and bought the index at roughly the same level (this excludes dividends, I know but);

 

(b) The 08-09 market - at the bottom, in March 2009, you could have been in cash for roughly 12.5 years (from Nov. 1996!!!!) and bought the index at roughly the same level

 

So ... cash is also useful :)

 

For me it all comes down to knowing your own psychological tendencies and remembering the adage of one WEB (I'm paraphrasing here) - "Don't risk what you must have for something you want to have" - at the end of the day when there is a market panic it takes real guts to stay calm and if you rely on your investments to provide a living, that is mighty hard to do ....

 

Cheers,

 

Andy

 

Andy, do you still believe that hope is a good thing, maybe the best of things, and no good thing ever dies?

 

 

[Andy Dufresne]

Well Red Kraven, I believe in it  8)

[alwaysinvert]

I dislike this kind of thinking. An investment should be able to stand on its own as a case. "Instead of cash" reads like rationalizing to me. Cash is a lousy long-term holding, but I think you are kidding yourself if you think blue chip stocks give you remotely the same kind of optionality as cash in a distressed situation.

 

This is speculation on how the market will value certain names in the future, not an investment thesis. It could still be wise, I don't know, but you should call a duck a duck.

[LC]

I dislike this kind of thinking. An investment should be able to stand on its own as a case. "Instead of cash" reads like rationalizing to me. Cash is a lousy long-term holding, but I think you are kidding yourself if you think blue chip stocks give you remotely the same kind of optionality as cash in a distressed situation.

 

This is speculation on how the market will value certain names in the future, not an investment thesis. It could still be wise, I don't know, but you should call a duck a duck.

 

I agree with you, I think if one can't find any suitable investments, then don't invest in anything. Seems pretty simple, and I'm pretty dense so I have to keep it simple otherwise I'll throw all my money at silly things. And if I "underperform", well that's ok. I think the fear of "underperforming" leads to people buying things they shouldn't just to keep up with whatever benchmark they feel they need to beat. Much better to stick with absolute goals that are individual in nature to each investor IMHO.

[SharperDingaan]

Reframe the question in terms of risk, & cash comes out the clear winner.

 

We invest in XYZ because we expect to earn a reasonable return for the business risk that we are taking. If we are no longer a buyer (because everything is fairly valued) we are really being told to hedge. Therefore sell 50% of the portfolio & replace with long dated calls/leaps. Fortunately it is only possible if you are a private investor.

 

If your PM did this you would instantly fire him/her - you are paying them to be fully invested.

Hedging you can do yourself, & at any time.

 

SD

 

 

[no_free_lunch]

Not to be rude, but maybe going to a basket of blue-chips is a cop-out?  By that I mean why give up on stock picking?  It seems that even if you want to buy blue-chips, and in general they are fully valued, you can still do a selection process and try to identify which ones are more undervalued.  Failing that, I personally would probably just buy some kind of an index.

[rpadebet]

Not to be rude, but maybe going to a basket of blue-chips is a cop-out?  By that I mean why give up on stock picking?  It seems that even if you want to buy blue-chips, and in general they are fully valued, you can still do a selection process and try to identify which ones are more undervalued.  Failing that, I personally would probably just buy some kind of an index.

 

Yes, I can agree with that- Investing in the most undervalued blue chips as defensive placeholders.

 

I did not mean to suggest we give up on stock picking just because we might think the overall market is fully valued. My question was about the excess cash build in your portfolio which some very smart investors seem to hold because they aren't able to find stocks which meet their "value" thresholds.

 

The idea is also not to play the relative to benchmark return game, but it is to avoid something some of us might not be great at, market timing. Holding large % of cash in your portfolio to me seems like market timing. If you held 100% cash and were waiting for the crash and right time to invest, everyone would agree that it is market timing. What if that cash is 70%, 50%, 40% or 25%. At what point can you deterministically say you are "not timing the market"?

 

[Guest deepValue]

In my experience, high-quality businesses trading at reasonable valuations outperform the market when it crashes and lower-quality businesses trading at low valuations outperform when the market picks back up again. High-quality business will outperform cash if the market doesn't crash, so it's not a terrible idea to put your 'cash' in blue chips.

[no_free_lunch]

I think that anyway you want to phrase it, if you are holding cash then it is market timing unless you permanently hold a percentage in cash.  So what though?    Lots of investors hold cash from time to time.  You just have to realize that you may under-perform the market.  If you are fine with that, do it.

 

Personally, I am starting to move to cash.  I have been fully invested for too long and I am now (just this week) up to about 20% cash.  Is it market timing? yes.  I just don't believe in this market as much now and having gotten smacked around twice by 2 brutal bears (2000-2002, 2008-2009) I very much appreciate the optionality of cash.  At the end of the day, if I under-perform by a few percentage points but still generate decent inflation adjusted returns then I am happy.  If there is some wicked bear market where the S&P drops 70% and I out-perform by 5%, I am probably only happy in a theoretical sense.

[BG2008]

I don't get why market timing gets such a bad name.  I am a believer that we should "watch what people do and not what they say."  We all worship Buffet here.  Yet, if we analyze his actions, Buffet actually liquidated his partnership after a decade of out performance.  He cited that he "couldn't find bargains of any sort" so he decided to liquidate and return funds to people.  Buffet in his early days put 1/3 of his portfolio in "workouts and special situations" which included merger arbitrages and a few other market neutral strategies.  Back then merger arbs earned 20% IRR.  His workouts and special sit basket consistently earned a 20% annualized return.  Why did Buffet bother to invest in workouts and special sits while acknowledging that in the long run, it will lead to lower IRR than his general investments? 

 

Many people have mentioned that one of Buffet's greatest trades is walking away from managing a fund and avoided the 73-74 selloff that crippled a lot of value investors.  Munger's fund was down 53.4% in 73 and 74.  Even with the 73.2% gain in 75, he was still down 19.3% from 1972.  By then Buffet was running Berkshire Hathaway with an insurance operation and other operating businesses that generated cash that he can re-deploy.  http://www4.gsb.columbia.edu/null?&exclusive=filemgr.download&file_id=522

 

Don't under estimate the value of holding cash.  In addition to providing optionality during a market sell off, it also achieves another goal, ensuring that you only allocate capital to the most asymmetrical risk/reward opportunities.  If I can find 20 ideas that are all 2-3 baggers in 1 year, I will allocate evenly to all 20 ideas, when the ideas start to dry up, I'll concentrate on the 10, when the ideas dwindle down to 3 or 4, it's best not to stretch and force yourself to put money to work on the 5th, 6th, or 10th best idea. 

 

"

23. In 1970, with the dissolution of the Buffett Partnership, Buffett becomes 29% owner of Berkshire. Since then he has owned 474,998 shares of Berkshire - page 350.

 

24. In 1970 Berkshire's profits were:

i) Textiles - $45k

ii) Insurance $2.1 million

iii) Banking $2.6 million.

 

25. 1972 - Berkshire's insurance business had a float of $100 million of which only $17 million was invested in stocks.The rest were invested in bonds because Buffett was not able to find any bargains - page 148.

"

 

Was Buffet not a market timer?  I think he says a lot of the things that he says about buying quality and holding it forever because he's speaking to main street.  He's not speaking to a bunch of enterprising investors who are actively looking for ideas. 

 

 

 

 

[yadayada]

the market is almost always fully valued. The whole idea of valueinvesting is finding the stocks that arent.

[clayroad]

I think that anyway you want to phrase it, if you are holding cash then it is market timing unless you permanently hold a percentage in cash.

 

Its not necessarily market timing if one is simply unable to find undervalued stocks. I believe Seth Klarman does something like this, i.e. lets cash accumulate "naturally" (selling overvalued or fully valued stocks and buying nothing if he does not find compelling enough opportunities). At most one might call it market timing in the sense that it implies the expectation that there will be opportunities in the near future.

 

[Uccmal]

I don't get why market timing gets such a bad name.  I am a believer that we should "watch what people do and not what they say."  We all worship Buffet here.  Yet, if we analyze his actions, Buffet actually liquidated his partnership after a decade of out performance.  He cited that he "couldn't find bargains of any sort" so he decided to liquidate and return funds to people.  Buffet in his early days put 1/3 of his portfolio in "workouts and special situations" which included merger arbitrages and a few other market neutral strategies.  Back then merger arbs earned 20% IRR.  His workouts and special sit basket consistently earned a 20% annualized return.  Why did Buffet bother to invest in workouts and special sits while acknowledging that in the long run, it will lead to lower IRR than his general investments? 

 

Many people have mentioned that one of Buffet's greatest trades is walking away from managing a fund and avoided the 73-74 selloff that crippled a lot of value investors.  Munger's fund was down 53.4% in 73 and 74.  Even with the 73.2% gain in 75, he was still down 19.3% from 1972.  By then Buffet was running Berkshire Hathaway with an insurance operation and other operating businesses that generated cash that he can re-deploy.  http://www4.gsb.columbia.edu/null?&exclusive=filemgr.download&file_id=522

 

Don't under estimate the value of holding cash.  In addition to providing optionality during a market sell off, it also achieves another goal, ensuring that you only allocate capital to the most asymmetrical risk/reward opportunities.  If I can find 20 ideas that are all 2-3 baggers in 1 year, I will allocate evenly to all 20 ideas, when the ideas start to dry up, I'll concentrate on the 10, when the ideas dwindle down to 3 or 4, it's best not to stretch and force yourself to put money to work on the 5th, 6th, or 10th best idea. 

 

"

23. In 1970, with the dissolution of the Buffett Partnership, Buffett becomes 29% owner of Berkshire. Since then he has owned 474,998 shares of Berkshire - page 350.

 

24. In 1970 Berkshire's profits were:

i) Textiles - $45k

ii) Insurance $2.1 million

iii) Banking $2.6 million.

 

25. 1972 - Berkshire's insurance business had a float of $100 million of which only $17 million was invested in stocks.The rest were invested in bonds because Buffett was not able to find any bargains - page 148.

"

 

Was Buffet not a market timer?  I think he says a lot of the things that he says about buying quality and holding it forever because he's speaking to main street.  He's not speaking to a bunch of enterprising investors who are actively looking for ideas. 

 

 

 

 

 

Well said.  We all market time to some extent.  I have 75% of my BAC 2016 Leaps protected at a low level.  This is not because I believe BAC has much downside in and of itself.  If there is a market crash BAC will get slaughtered, as will JPM, WFC, FFH etc.  The puts will generate cash in such a situation to invest another day. 

 

The longer I play this game the more I work toward Rule #1.  You are further ahead if you avoid long term losses than going through a full cycle.  One qualification: This is for experienced investors, not passive investors.  Buffett's advice applies to lay persons.

[KCLarkin]

I don't get why market timing gets such a bad name.

 

Because it is almost impossible to do right. Getting into cash before the crash is relatively easy. Getting back in at the right time is the hard part. See Hussman for example. He sat out the 2009 rebound because he was worried that we were having another depression. Or you get back in too soon. Having cash sitting idle can also tempt you to do stupid things (e.g. Buffett and Salomon Brothers, US Air).

[BG2008]

Here's my 2 cents on market timing and getting back in. 

 

If you see a lot of net nets that are cashflow positive and actually have a decent business and management attached, buy them.  If you see merger arb spreads of 10% in 5 days where the offer is all cash, do those trades.  You deploy cash by assessing the opportunities available, if they are not "stupidly asymmetrical" hold cash.     

 

I don't get why market timing gets such a bad name.

 

Because it is almost impossible to do right. Getting into cash before the crash is relatively easy. Getting back in at the right time is the hard part. See Hussman for example. He sat out the 2009 rebound because he was worried that we were having another depression. Or you get back in too soon. Having cash sitting idle can also tempt you to do stupid things (e.g. Buffett and Salomon Brothers, US Air).

[ASTA]

My taking is the more noise I hear from respectable investors the more cautious I get.

So my list is as following

Seth klarman                                                                                                                  50% cash

David Tepper(Todd Combs most respected investor :D)                                                60% long

the list goes on inside my small brain that have been bearish now or forever(cough cough houssman he got to be right some time(betting on the losers most hated)) :D

 

So I will most likely sell my apple(7%) and get 20% cash.

I have a new rule that that is my maximum cash is 20% as a big part of my wealth is in a stable house so I am always safe for disasters.

[SharperDingaan]

Imagine a well diversified, all equity, portfolio valued at $1M. Now assume the entire portfolio is sold & replaced with long dated calls on the same stocks, at strikes equal to the selling prices, for a total cost of $100K. The 100K of calls produces identical upside exposure, but I now also have 900K of cash. Apparently this is market timing ...

 

If the market now rises 10% the value of the calls will increase 100K. If the market falls 10% the calls go to zero, but my 900K will now buy back the same number of now cheaper shares that I had previously; ie: nothing changed. But if the market rises - or falls - by more than the 100K (10%) cost of the calls, I make a bonus. What most are calling market timing - is actually hedging.

 

You might find it useful to read Talebs Anti-Fragile. This hedging call/T-Bill portfolio is just Talebs bar-bell example - & it works best when markets are choppy.

 

SD

 

 

 

 

 

 

 

 

[bennycx]

And if the market stays flat the calls go to 0 and you have 900k but all an all equity portfolio is still at 1M. So using this strategy is still speculating that the markets will be choppy.

[SharperDingaan]

Agreed, but it is no different to the decision to remain fully invested. You are speculating the stock will continue to rise, and against your position that the stock is already fully valued.. You could be wrong & make an opportunity bonus, or wrong & make a loss - with 50% probability in each direction. There is zero short-term net benefit to remaining fully invested.

 

Remaining fully invested is also akin to betting on a succession of red flips, & letting it all ride on each flip; eventually a black will surface & you go home broke. Periodically going to cash, just ensures that you go home richer than you started.

 

SD

[KCLarkin]

I tend to agree with Bill Nygren:

http://online.barrons.com/news/articles/SB50001424053111904125704579594493262894338?mod=BOL_hp_popview

 

Many quality stocks are very reasonably valued right now. Especially relative to the market and bonds.

[Liberty]

I don't get why market timing gets such a bad name.  I am a believer that we should "watch what people do and not what they say."  We all worship Buffet here.  Yet, if we analyze his actions, Buffet actually liquidated his partnership after a decade of out performance.  He cited that he "couldn't find bargains of any sort" so he decided to liquidate and return funds to people.

 

If you watch all that he does, you must watch it all, not just one thing. This is a good overview;

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-1-partnership.html

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-2-berkshire.html

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-3-berkshire.html

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-4-berkshire.html

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-5-berkshire.html

[thefatbaboon]

I have been thinking about this for a while. I have not seen many studies, so thought would ask the members on the board on how they would feel about such a strategy.

 

Market seems to be fairly valued to me. But I am no market timing expert and I have no clue what it will do over the next few years. Parts of my portfolio have reached fair valuation and I am building cash by selling those. I understand the optionality cash provides during a market crash, but it is also a drag on the portfolio returns if you sit on it for a long time.

 

So I was wondering, if it is better to reallocate cash to some fully valued (not absurdly over valued) quality names like Coca Cola, Walmart, Mastercard, American Express, Berkshire Hathaway, Wells Fargo etc. Names with the highest likelihood of survival in case of deflation/inflation/general panic.

 

It is conventional wisdom over here that, such names are best bought in a panic, but who knows when that happens. Also if you look at the last panic in 2008, if you allocated your cash to quality companies at the market bottom, you did well, but not as well as people who invested in some truly undervalued cyclical stuff. Reason being quality names rarely become absurdly undervalued i.e. they tend to hold their value well, so upside is limited to the intrinsic business performance and some multiple expansion.

 

So isn't it better to not hold cash, allocate to these names along side the typical value portfolio, let them run along with the market and if/when panic hits, sell the quality names to raise cash (maybe to opportunistic value investors) and reinvest proceeds in the undervalued stuff?

 

You might want to read up on Bruce Berkowitz.  I'm almost certain that for many years prior to 2008/2009 he used Berkshire Hathaway as a cash alternative in his fund portfolios.  I think he ended up regretting it.  But then again you must remember he managed other people's money that was redeemable during market declines.

 

My two cents:  don't think there is an objectively right or wrong answer, it depends on your skills, preferences, risk tolerance, goals and perhaps, net worth.  Think Klarman at one end of the spectrum and Malone at the other.