Cash balances in equity portfolios generate debate among investors. Currently, a number of managers, including Southeastern Asset Management, have cash balances above normal levels. Should equity managers always be fully invested? This paper attempts to answer that question and define why a manager might hold cash. We specifically discuss Southeastern’s investment approach and how periodic elevated levels of cash can be beneficial. Finally, we present data demonstrating that holding relatively high cash balances has not negatively impacted long-term relative or absolute returns for either the general equity universe or for Southeastern’s Longleaf Partners Funds.
Longleaf: Why Hold Cash?
Indices are fully invested. Because most managers focus heavily on index-related returns, the large majority of funds never have meaningful cash balances. Managers who deviate from a fully invested policy normally employ cash for one of two very different reasons – either they have a top-down view that the market is going to decline, or they invest from a bottom-up approach and stocks are not meeting their fundamental criteria.
We adhere to the same bottom-up, qualitative and valuation-based disciplines that we have followed for four decades. In order to commit capital, we must believe we have a strong business run by honorable, capable management and priced at a deep discount relative to intrinsic worth. Compromising on these criteria, particularly the discount, introduces more risk of permanent loss than we are willing to take with our own capital, which is invested across the Longleaf Funds. Likewise, when a stock no longer has what Ben Graham termed a “margin of safety” between its price and the company’s value, we sell the security, regardless of whether we have a qualified investment to replace it. Cash in our portfolio is, therefore, a by-product of adhering to our longstanding investment discipline and represents the opportunity to buy the next qualifying investment in the future.
We hold cash only at points when we cannot find equities that meet our strict investment criteria. We have found that a low return on cash for limited periods is dwarfed by the return opportunity from the next deeply discounted qualifying investment that we buy. With cash on hand, we are positioned to be a liquidity provider and can immediately purchase stocks at what we believe to be advantageous points without being forced to sell holdings at unfavorable valuations.
Contrary to conventional wisdom, we believe our returns would have been lower if we had not held cash. Our performance record reflects returns in stocks that met our investment criteria when purchased. If we had forced ourselves to be fully invested at all times, we would have stretched beyond our strict criteria into less qualified holdings with lower return upside. Mathematically, a stock that goes from 60% of corporate intrinsic value (our normal buying point) to 100% (our normal selling point) generates a 67% return, while a stock at 85% of value earns only 18% when it rises to corporate worth. In the absence of qualifiers, we chose to hold cash in the short run rather than potentially compromise our long-term returns. As Charlie Munger described in Poor Charlie’s Almanack, “It takes character to sit with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”
Longleaf: Holding Cash Has Not Penalized Long-Term Results
We cannot model what returns would have been without cash, but we can assess whether periodically holding high cash hurt relative results for equity funds in general and for Southeastern.
In this analysis, we defined high cash as 15% or more. This threshold clearly distinguishes managers who are willing to hold cash from those who acquired temporary cash from short-term inflows or stock sales. This level also is representative of where many managers, including Southeastern, are today. We analyzed quarterly Morningstar data for 2,873 equity funds from 3/31/1988 – 12/31/2013.1 From each quarter-end when a fund had cash of 15% or more, we analyzed the fund’s cumulative return, as well as its benchmark for the subsequent one, five and 10-year periods. We did the same analysis for Longleaf Partners Fund, Longleaf Partners Small-Cap Fund, and Longleaf Partners International Fund.
See full Longleaf On The Benefits of Periodic Cash in Equity Portfolios in PDF format here.