Portfolio Management and Cash
Today’s S&P 500 is one of the three most overvalued markets in U.S. history based upon a number of metrics, including price-to-GDP, price-to-sales, price-to-book value and the CAPE (Cyclically Adjusted PE).Historically – 1929, 2000, 2007 – these conditions of overvaluation resulted in significant corrections of 50% or greater. This is not to suggest a correction is imminent, as central bankers seem dedicated to respond aggressively to any market weakness. However, it is important to recognize that entry price – buying an asset below a conservative estimate of fair value – is the key determinant of future return.
The chart below is from Robert Shiller’s 1999 book Irrational Exuberance. This simple study proves that value matters for the long-term investor…and not much else (rendering most of the efficient market hypothesis study we endured in business school and Wall Street somewhat meaningless):
Robert Shiller is a Yale professor who developed the CAPE (Cyclically Adjusted PE), which he employs in the above chart. Going back to 1890, each dot represents the monthly value of the stock market (color coded for the era), plotted against the subsequent 20-year annualized return. The relationship is simple – the cheaper the market (lower the PE), the better the investment returns during the subsequent 20-year period.
Buying good assets at cheap prices is the oldest and most successful approach to investing. Benjamin Graham developed and tested this criterion in the early 1930s. The work has been furthered by notables such as Warren Buffett, Seth Klarman (Baupost), Howard Marks (Oaktree), Irving Kahn (Kahn Brothers), Christopher Brown (Tweedy Browne) and Roger Ibbotson (Ibbotson & Associates). In contrast to the many investing fads that have come and gone (day trading, internet investing, the endowment model, etc.), a disciplined value approach has been tested time and time again, consistently proving an effective strategy for compounding capital over a complete market cycle.
All successful practitioners of value-oriented investing recognize that their highest conviction ideas consistently drive returns, while institutional factors promoting over-diversification and full investment detract from performance. A host of studies confirm that over an entire market cycle, performance has little to do with being fully invested – – in fact, owning assets that are priced above intrinsic value ultimately proves detrimental. As a result, sound portfolio management often necessitates patience, as chasing deals and acting on a purchase that doesn’t represent a “best idea” is typically punitive. 1
Since inception, our concentrated Core Equity portfolio has significantly exceeded the performance of the S&P 500 while averaging 30% cash.2 Importantly, our cash balance has nothing to do with an overall market call, as we have no idea where the market is going next week, next month, or next year. However, we do have clear biases toward high-quality companies and strong opinions as to when a stock is cheap or expensive. As the weighting of a position is our best expression of our conviction in an idea, cash is both a byproduct and an important tool. We can buy great assets cheap when others are forced to sell, while avoiding allocation of capital in less than ideal situations. Further, we don’t have to overweight any position, only buying more of a stock when the risk / reward opportunity becomes increasingly attractive. Finally, this optionality is cheap. It costs most of our clients less than 0.2% annually in performance (via the management fee) to preserve this return-producing flexibility. (Of note, this cost exercise assumes a client subscribes to the erroneous mindset of “I don’t want to pay fees on cash”. We suggest fees pay for stock research, portfolio construction and risk management).
Although our use of cash has allowed us to provide market-beating returns with less risk, we recognize cash is a hated asset these days. It yields nothing (thank you ZIRP) while asset prices rise with little interruption (thank you QE). If one believes that “this time is different” and market cycles are now permanently suspended due to unprecedented central bank activities, the best course of action might just be to ignore historically high valuations and buy passive index funds. However, please note that since our inception in 1999 the S&P 500 has endured two approximate 50% drawdowns.3 Many market participants don’t have the risk tolerance for such a volatile investment vehicle, as recovering from a 50% loss necessitates a 100% return. It’s important to remember that equities can be risky – especially if entry price is ignored.
1 Best Ideas – Randy Cohen, Christopher Polk and Bernhard Silli, March 2008
2 This material is intended to be a broad overview of St. James’ investment style, philosophy, and process, and is subject to change without notice. Information contained herein has been obtained from sources believed reliable, but is not necessarily complete, and accuracy is not guaranteed. Account holdings and characteristics may vary since investment objectives, tax considerations, and other factors differ from account to account. Any securities mentioned are not to be construed as investment or trading recommendations specifically for you. St. James, and/or one or more of its affiliated persons, may have positions in the securities or sectors recommended in this presentation, and may therefore have a conflict of interest in making the recommendation herein. Please consult your advisor for investment or trading advice. Past performance is not indicative of future results.
3 August 2000 to September 2002: -45.2%; October 2007 to February 2009: -51.4%