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Scottish Independence: Sheep & Threats

Scottish independence has been viewed as a low risk, low probability scenario for some time.  Conventional wisdom hasn’t changed much in this regard despite recent polls which displayed a surge in position for independence.  And because no one expected the vote to be close, there has not been a lot of preparation for this event. As a result, expect a corresponding surge in volatility if the vote on Thursday is even close.

There are broader issues here.  A recent article from Foreign Affairs does a good job outlining Scottish sentiment. History shows that when people are asked, they almost always say yes to independence.

The Guardian looked at about 50 independence votes since 1846, and the vote for independence has averaged 83%, and came out on top in 88% of the votes. The median winning margin across the votes is 93 percentage points.

This is a union that has existed for over 300 years. A very complex sharing of assets and liabilities makes it very unclear how it would split. The linkages between Scottish and British financial institutions raises the risk for financial market instability. The fact that banking assets in Scotland would total 12x national GDP does not help matters.

Needless to say, the break-up of a 300-year union would not bode well for the rest of the Eurozone. We would expect nationalism to intensify across the EU with implications for risk formally knows as the European sovereign debt crisis.

On a somewhat related note, I learned tonight that the Scottish National Animal is actually the Unicorn, which isn’t even a real animal the last time I checked.  Then again, bears are as hard to find as Nessie in this market, so what do I know.  Probably best to just leave this debate to someone closer to home.  The clip below from John Oliver is another must see.  Is there anyone better on late night television today?

Posted in Policy, Portfolio Strategy.

Common Sense

“It wouldn’t be overstating the case to say that investors face a crisis of low returns: less than they want or expect, and less than many of them need. Investors must choose between two alternatives. One is to hold stocks and bonds at the historically high prices that prevail in today’s markets, locking in what would traditionally have been sub-par returns. If prices never drop, causing returns to revert to more normal levels, this will have been the right decision. However, if prices decline, raising prospective returns on securities, investors will experience potentially substantial mark to market losses, thereby faring considerably worse than if they had been more patient.”

“Betting that the markets never revert to historical norms, that we are in a new era of higher securities prices and lower returns, involves the risk of significant capital impairment. Betting that prices will fall at some point involves opportunity cost of uncertain amount. By holding expensive securities with low prospective returns, people choose to risk actual loss. We prefer the risk of lost opportunity to that of lost capital.”

 - Baupost Limited Partnerships’ 2004 Year End Letter

Posted in Letters & Links, Portfolio Strategy.


In Atlanta this week, checking in on a few existing and potential investments.  But couldn’t resist following up on Night Moves with a couple additional data points.

The first comes from David Bianco compliments of Zero Hedge.  This should sound familiar to those who’ve reviewed the previous targets put out by MS.

We still expect a long lasting economic expansion of moderate growth, which should rival the US record of 10 years with S&P EPS growth averaging 6% until the next recession, on 5% sales growth, flat margins, 1% share shrink. Despite entering the latter years of a typical expansion and high margins vs. history, we now think the trailing S&P PE should average 17 vs. 16 until elevated recession risk returns. This is because we now expect long-term real interest rates to stay below normal through 2016 and thus lower our S&P 500 real cost of equity estimate from 6.0% to 5.5%.

The two major threats to the S&P 500 are either a recession or a rapid increase in interest rates. However, assuming that the US avoids a recession – and no other global factor causes a significant decline in S&P EPS – and that US interest rates climb slowly and rise to a level that plateaus below historical norms, then 2500 is within reach for the S&P 500 by 2018.

So in summary – assuming nothing bad happens for the next five years – and assuming we extrapolate the same linear trend for another 4 years, the S&P 500 can rally to 2500 without any meaningful downside risk.

Why not take this logic a step further?  With interest rates at zero for as far as the eye can see, isn’t a 5.5% cost of equity a bit expensive?  We can justify just about any valuation for any asset if we just go ahead and use a zero percent discount rate, can’t we?

Bianco Target

The same day we picked up this DB report, we caught this gem – Morgan Stanley’s chief international economist, Joachim Fels, appears to be fueling the bullish calls from the firm’s strategy group. Per Bloomberg, he sees recovery from the great recession potentially lasting as long as a decade thanks in part to loose money. “While the expansion is already five years old, it could easily extend another five,” Fels wrote.

Never mind that global expansions have historically lasted between four and eight years and six on average. “The glass is half full,” says Fels. It’s certainly hard to argue that the glass is half full today, but shouldn’t we at least consider the risk that investors may look at the glass differently, some time this decade?

Then again, maybe we give the street too much credit.  After reading our last post, a colleague asked, “Does anyone actually believe the stuff these guys are putting out?” Experience would suggest that many unfortunately do.

Believe it or not, it certainly feels like sentiment is reaching an extreme.  According to Investors Intelligence, bears have fallen to the lowest level since 1987.  Last weekend’s Barron’s survey of market strategists highlighted this sentiment. Nobody thinks markets will go down. Maybe it’s time for some of us to take a page out of the average bear’s play book.

Yogi Bear: Hang on Boo Boo!
Boo Boo: What do we do now?
Yogi Bear: Did you check the safety manual?
Boo Boo: It’s just a picture of us screaming!
[Both scream and flail their arms]
Yogi Bear: We have to deject, Boo-Boo!
Boo Boo: Don’t you mean “EJECT”?
Yogi Bear: Eject is up, deject is
[Both fall]
Yogi Bear: doooooooown!


Posted in Portfolio Strategy.

Night Moves

Woke last night to the sound of thunder
How far off I sat and wondered
Started humming a song from 1962
Ain’t it funny how the night moves
When you just don’t seem to have as much to lose
Strange how the night moves
With autumn closing in
-Bob Seger

With the multi-year Summer of Love for stocks inexorably moving towards the early evenings of an Autumn of Discontent, it’s time to brush up on those rusty, bearish night moves. It’s easy to become dazzled by the stars at night, but this is no time to be pulling out the beer goggles for investments analyses, but rather the binoculars.  Careful scrutiny and selectivity are the names of the game in these late stages of bull markets.

With the S&P’s first close above 2000 after nearly tripling from its 2009 low, the talking heads are out in full force.

  • In a recent interview with the FT, Brian Belski at BMO, put a 4200 target on the S&P 500 by just compounding the current level of the S&P forward for a decade.  ”Based on historical evidence, stocks typically enter a very long period of expansion after emerging from a period of negative 10-year returns. We found that, on average, these periods last for roughly 15 years and deliver average annual returns of about 16%. Given that 10-year holding period returns emerged from negative territory a little over a year ago and currently stand at 5.5%, it is not unreasonable to assume that there is about 10 years and 10% of average annual returns left to the current bull market. To get to an S&P 500 level of more than 4200, we have assumed that 2 percentage points of the return is dividend, and just compounded the current 1962 level of the S&P forward for a decade.”
  • Morgan Stanley reached a similar conclusion in a recently published report, titled 2020 Vision.  Rather than simply extrapolate annual stock returns forward, at least the US Equity Strategy Team at MS considered fundamentals.  There 3000 target on the S&P was based on extrapolating 6% annual earnings growth through 2020.  ”The current expansion is more than five years old and there are no signs as yet that the global economy is overheating. The current US expansion has already lasted longer than the average expansion in the post-WWII period, but it isn’t unreasonable to expect that this expansion could be the longest on record. The US Equity Strategy team notes that EPS growth of 6% per year from 2015-2020 would drive S&P500 earnings to near $170. A 17x multiple would translate into a peak level for the S&P500 near 3000 under this scenario.”
  • To top it off, the WSJ ran a story this weekend titled, The Case for Sticking with Stocks – No Matter the Price.  ”To be sure, many money managers insist that there is no way of knowing in advance whether the stock market is overvalued or undervalued. Investors, they say, should instead focus on issues like diversification, costs, their own risk tolerance, and their investment horizon—owning more stocks when they are young and fewer when they are older, for example.”

We agree that investors should always focus on “issues like diversification, cost, risk tolerance and time horizon,” but would suggest staying away from money managers that “don’t know” if the market is overvalued or undervalued.  It’s a pretty good bet that they are either lying (and have pretty good incentives to sell stocks and/or stock funds) or have simply not done their homework.  In either case, you are better served by moving on.

We’d also suggest that owning more stocks when they are cheaper and fewer when they are more expensive is a better strategy for generating long-term, sustainable returns while minimizing the risk of large draw-downs. Short term market timing gets a bad rap, but long-term, value-driven shifts in asset allocation remain an important tool at investors’ disposal.  Annual equity returns have averaged 21.6% when the Shiller P/E is at its lowest decile versus a meager 1.7% when valuation is at the highest decile, where it sits today.

Our friends at Emerald Asset Management, recently ran an analysis (chart below) comparing a hypothetical investment in a static balanced portfolio to a strategy rebalanced according to the Shiller P/E.  When valuation was in the highest 25% of historical observations they shifted a portion of the portfolio from stocks to bonds.  Conversely, when valuation was in the lowest 25%  of historical observations, they shifted a portion of funds from bonds to stocks.

A $100,000 investment in a balanced portfolio of half stocks and half bonds would have grown to more than $65 million from 1928 through 2013.  This sounds impressive.  At least until you realize that a value-driven allocation would have nearly doubled these results, growing to more than $123 million, over the same period.

The difference in ending values is largely due to the ability of measures of normalized valuation to pick up extreme levels of sentiment. When valuations are in the top quartile, sentiment is often extreme and euphoric markets are present. On the flip side, when valuations are in the bottom quartile, sentiment is often extremely pessimistic.

A recent Barron’s survey highlighted today’s current euphoric sentiment.  Nobody thinks the market is capable of falling. Bearish sentiment has fallen to levels last seen in 1987.  As a result, equity allocations have recovered to previous highs while cash levels are at record lows, despite what you might hear from the market pundits.

The market may appear “cheap” to many money managers that don’t know any better, so we’ll give them a clue as to why.  The chart below shows S&P earnings relative to trend.  It also shows that Morgan Stanley was at least partially right in their analysis – earnings have historically grown at 6% annually.  This can be seen by the trend growth in real earnings shown here (net of inflation).  But one thing should be painfully obvious here – earnings ALWAYS revert back to trend.

Trend Earnings

Today’s extreme levels are what makes forward and trailing earnings ratios appear cheap to the untrained eye.  But it is extremely dangerous to extrapolate today’s extreme level of earnings forward assuming trend growth from these levels.

Dow 36K

Doing so, would leave you susceptible to reaching just about any conclusion you’d like. Why stop at three or four thousand on the S&P when Dow 36,000 makes for such a better headline? Oh, right.  That book was already written . . . in 1999.

Workin’ on our night moves…


Posted in Portfolio Strategy.

Quote of the Day

“A lot of what I do is challenge assumptions . . . which often looks like you are asking stupid questions.” - Sergio Marchionne


Posted in Security Analysis.

POST Chief Needs More Protein

Last week, we took a look at William Stiritz and how he produced a track record worthy of Outsiders fame. While many of the Outsiders are no longer among us or have been so successful as to be almost universally associated with investment acumen (we’re talking to you Warren Buffett), some continue to work their magic in relative obscurity.

Our Ralston Purina story, A Public LBO, concluded with the company’s sale to Nestle in 2001.  But the action didn’t stop there.  In 2007, Ralston Purina acquired Post Holdings from Kraft Foods and folded it into the Ralcorp division, which had a history in the branded cereal business. After Ralcorp itself was spun off from Ralston Purina in 2011, Post Foods was spun off by Ralcorp in early 2012. Enter Mr. Stiritz.

There is nothing sexy about breakfast cereal.  The business has been in secular decline for some time, although we believe the trend is more like a slow bleed than a death blow (it’s entirely possible that I am biased by recent experience watching Lucca pound a box of Cheerios per week).


Despite Lucca’s growing appetite, Stiritz took the reins at Post with an eye toward the new trends shaping modern breakfast and began a rapid transformation of the company, guided by Buffett’s timeless advice:

“Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”

Stiritz identified changes taking place at the breakfast table. First and foremost is the shift towards higher protein diets (which coincidentally has been accompanied by new haircuts, popped collars, muscle milk and Jägerbombs).

The second factor transforming breakfast routines is increased mobility of families during the morning hours. Gone are the days where many families sit down for a quiet breakfast before skipping off to school. Families today are much more likely to grab a breakfast bar as they sprint out the door or slow down just enough to grab a McGriddle through the drive-through window on the way to the office.

Last but not least, a growing portion of consumers are moving to healthier options, including gluten-free, organic, and non-GMO foods.

Since the spin-off, Stiritz has moved quickly to position the company for these shifting dynamics through an aggressive acquisition program. POST has completed half a dozen deals in under two years, paying reasonable multiples of 8-10x cash flow and transforming the business from a stale cereal manufacturer to a diversified portfolio with a much improved organic growth profile.

Organic Growth

Starting with Attune Foods, an organic cereal marketer, Post’s acquisitions have addressed one or more of the underlying trends in the breakfast segment.  Among these acquisitions, Golden Boy Foods offers almond and other nut butters, Premier Protein offers protein shakes, and Dakota Growers produces organic private label pastas. So far, these brands have not contributed materially to performance but they generally occupy faster growing segments and serve as platforms for future acquisitions.

Post’s largest acquisition occurred earlier this year when it purchased Michael Foods, a value-added egg and potato product manufacturer, for $2.5 billion. The company has been owned by three successive private equity owners since 2000, demonstrating the company’s ability to generate consistent cash flows. More importantly, we believe the business opens doors for Stiritz via increased penetration into additional channels and broadening distribution capabilities.

POST’s buying spree has reduced the company’s exposure to its highly cash generative cereal business (which made up 100% of sales when the company came public). Michael Foods accelerated this process as new POST now generates nearly three-quarters of its revenue from more highly fragmented, faster growing segments of the market.

POST Portfolio

Stiritz has moved quickly to “change vessels” and looks poised to make further acquisitions after closing on the previously announced PowerBar acquisition this fall. His strategy is not without risk, as demonstrated last quarter. POST has employed leverage liberally to make acquisitions and as a result, a significant downturn in Post Cereals or Michael Foods could meaningfully limit management’s flexibility.

We have patiently waited and watched the stock’s levitation higher during the past year as investors continually bid up the Stiritiz Premium.   With the stock trading more than 40% below recent highs and at a discount to peers, investors can buy POST today and get Stiritz for free.  The company’s 2013 Annual Report illustrates the value in this option:

As our name implies, Post Holdings is a holding company for operating assets. For a holding company to add value, it must demonstrate to its stakeholders that ownership of operating assets through the holding corporation is a superior alternative to direct ownership of these assets. We add value by:

  • Identifying opportunities to invest in categories that are growing relatively faster than our core, but may lack independent scale (e.g. private label and active nutrition).
  • Acquiring or recruiting management teams capable of driving consolidation.
  • Maintaining Centers of Excellence that allow for enterprise wide resource sharing while not inhibiting the adaptive cultures that make each unit successful.
  • Utilizing strategic portfolio management rather than maximum synergistic efficiency.
  • Encouraging, enabling, and when warranted, rewarding appropriate risk taking.

Post Holdings competes for your capital allocation. To earn it we must deliver risk adjusted returns commensurate with your assessment of risk and your alternatives. Perhaps uniquely, we view Post as a hybrid of a traditional public company and a private equity fund. We use many of the same tools as a private equity company – relatively higher leverage, investment analysis and adaptive management. We also view our portfolio as dynamic, reacting to opportunities as they develop. However, unlike most private equity firms, we also provide Centers of Excellence to create competitive advantages for our operating companies. And we do this in the public forum allowing our investors greater transparency and, most importantly, the ability to act on their own accord.

As you can see, we are pretty excited about the shifts taking place at the breakfast table and just as excited to go along for the ride with Bill Stiritz.

Lucca Breakfast

Posted in Security Analysis.

Return of the Grave Dancer

Although there was no mention of Grave Dancers in Thorndike’s Outsiders, we’d add Sam Zell to the list of Capital Surgeons. Here are a few excerpts from the above-captioned classic:

The emergence of the Grave Dancer reflects an alteration in the risk reward ratio of real estate investment. The classic motivation for real estate investment is passive reflecting a desire for stability, security, inflation protection and growth. However the Grave Dancer is an active investor seeking greater risk by acquiring property in distress and even greater reward by earning the economic benefit from successful resurrection. The Grave Dancer’s measure of reward is reflected by improving the value of real estate, which if successful far outpaces the performance of the economy.

Grave Dancing is not for the faint of heart. Opportunities arise from the distress of others, but such distress does not assure success for the Grave Dancer. Careful assessment of the risk/reward ratio will increase probability of success. The institutionalization of real estate has brought many investors to real estate. The short term perspective of today’s lenders materially reduces the size of an potential reward which may be achieved by a successful effort. In past periods, lenders were willing to alter the terms of their loans and leave them for 15-20 years. Now concessions are achievable, but only in a short term perspective of 5-7 years.

The lack of discipline that creates the Grave Dancer’s opportunity is contagious. The undisciplined Grave Dancer can easily become a victim rather than the savior. Taking risks today for tomorrow’s reward is both the most challenging and difficult of tasks. Unbridled optimism must be tempered with reality. The Grave Dancer’s motto must always be, “I suffer from knowing the numbers.” His success will emanate from an understanding of supply and demand, the basic premise of Economics 101.

Grave Dancer: See also William McMorrow.  See also Kennedy Wilson

The Return of the Grave Dancer

Posted in Guru Focus, Security Analysis.

A Public LBO

In our last post, we highlighted a few lessons from Thorndike’s Capital Surgeons. With this sound advice in mind, we’ll take a closer look at one Outsider’s history of success before analyzing the platform he is constructing today.

Ralston Purina was a fairly typical packaged food company during the 1970s. Led by CEO Hal Dean, the company invested mountains of cash flow into a jumbled collection of operating businesses until Dean’s retirement in 1980.

The stock hadn’t budged in a decade, when Bill Stiritz earned the top job by providing the board with a detailed strategy for the company. He wasted little time in implementing his plan, restructuring the company by divesting less profitable businesses, and positioning Ralston as a focused branded products company.

Stiritz proved to be a shrewd seller.  He knew what assets were worth and was a willing seller for the right price – there were no sacred cows and these asset sales were an important source of cash for the company early on.

After selling off noncore operations, Stiritz initiated an aggressive stock repurchase program in the early 1980s, a time when repurchases were controversial and signaled a lack of investment opportunity to the average investor. Contrary to conventional wisdom, Stiritz believed that repurchases were the highest probability investments he could make and went on to repurchase 60% of Ralston’s stock with multiples at cyclical lows.

Once the initial round of divestitures was complete, Stiritz focused on sourcing deals directly from sellers, preferring companies that had been mismanaged by prior owners. He bought businesses that Ralston could improve via marketing expertise and distribution efficiencies.

Stiritz only pursued opportunities that presented compelling returns under conservative assumptions and he disdained the false precision of detailed financial models (so do we).  “I really only cared about the key assumptions going into the model. First, I wanted to know about the underlying trends in the market: its growth and competitive dynamics.” The approach featured a single sheet of paper and an intense scrutiny on only the most important variables, not a laundry list of projections.

Stiritz leveraged (no pun intended) a private equity mindset. He appreciated that businesses with highly predictable cash flows could employ debt to enhance returns. As such, Ralston consistently maintained industry-high debt ratios.  He financed two large acquisitions in the 1980s by taking on debt totaling 30% of the company’s value before making his largest purchase ever, buying Energizer from a motivated seller.

Throughout the 1990s, Stiritz focused on opportunistic share repurchases and occasional acquisitions before developing an appreciation for a relatively new structuring device to rationalize Ralston’s brand portfolio. As some of the company’s businesses were not receiving the attention they deserved, he began to use spin-offs to release entrepreneurial energy while deferring capital gains taxes. In Thorndike’s words:

From the outset, Stiritz had been a believer in decentralization, working to reduce layers of corporate bureaucracy and giving responsibility and autonomy for the company’s key businesses to a close-knit group of managers. He viewed spin-offs as a further move in this direction – the ultimate decentralization – providing managers and shareholders with an attractive combination of transparency and autonomy and allowing managers to be compensated more directly on their operating results than was possible in the larger conglomerated structure of the mother company.

Stiritz began spinning off a collection of small brands in 1994 and concluded the program in 2000 with the spin-off of Energizer, transforming Ralston into a dominant pure play pet food company. In 2001, the company was sold to Nestle for a record price of $10.4 billion.

Stiritz himself likened capital allocation to poker, in which the key skills were an ability to calculate odds, read personalities and make large bets when the odds were overwhelmingly in your favor. He was an active acquirer who was also comfortable selling or spinning off businesses that he felt were mature or underappreciated by Wall Street.

In 1981, it would have been impossible to predict the transformation Bill Stiritz would achieve at Ralston or the remarkable impact he would have on the company’s shares.  Pretax margins grew from 9% to 15% and ROE more than doubled under his stewardship. When combined with a shrinking share base, this produced exceptional growth in earnings per share. A dollar invested with Stiritz when he stepped into the driver’s seat at Ralston was worth $57 nineteen years later.

Investors may not have nineteen years to look forward to with Stiritz today, but we think it’s worth taking a look at what he’s up to.  More to come.


Posted in Security Analysis.

The Outsiders: Capital Surgeons

William Thorndike’s “Outsiders” has sat on my desk since first reading the book last summer.  Recent market action presented us with an opportunity to refresh our work on The Outsider’s Mindset.  

Thorndike’s Outsiders operated in a “parallel universe” defined by a strict devotion to a shared set of core principles. These CEO’s were not marketing or technical geniuses. They simply understood capital allocation and thought carefully about how to deploy resources and create shareholder value.

Outsiders only moved forward with investments that offered attractive returns using conservative assumptions and had the confidence to do things differently than peers. This is easier said than done. “In many ways the business world is like a high school cafeteria clouded by peer pressure,” Thorndike accurately portrayed.  “Particularly during times of crisis, the natural, instinctive reaction is to engage what behaviorists call social proof and do what your peers are doing. In today’s world of social media, instant messaging and cacophonous cable shows, it’s increasingly difficult to cut through the noise.”

A handful of lessons stand out and serve as a good starting point for evaluating corporate management today:

Always Do The Math.  The Outsiders always started by asking what the return was. Every investment generates a return and the math is just fifth grade arithmetic, but these CEOs did it consistently, used conservative assumptions and only went forward with projects that offered compelling returns. They focused on the key assumptions, did not believe in overly detailed spreadsheets and performed the analysis themselves, not relying on subordinates or advisors. They believed that the value of financial projections was determined by the quality of the assumptions, not by the number of pages in the presentation and many developed succinct, one-page analytical templates that focused on key variables.

The Denominator Matters. These CEOs shared an intense focus on maximizing value per share. To do this, they didn’t simply focus on the numerator. They also focused on managing the denominator through the careful financing of investment projects and opportunistic share repurchases. These repurchases were not made to prop up stock prices or to offset option grants but rather because they offered attractive returns as investments in their own right.

A Feisty Independence. The Outsiders were master delegators, running highly decentralized organizations and pushing operating decisions down to the lowest levels in their organizations. They did not, however, delegate capital allocation decisions. In addition to thinking independently, they were comfortable acting with minimal input from outside advisors.

Charisma Is Overated. The Outsiders were also distinctly unpromotional and spent considerably less time on investor relations than peers. As a group, they were not extroverted or overly charismatic. They did not seek the spotlight. Their returns, however, more than compensated for this introversion.

A Crocodile Like Temperament. Armed with their return calculations, all were willing to wait long periods of time for the right opportunity to emerge. Many created enormous shareholder value by simply avoiding overpriced strategic acquisitions, staying on the sidelines during periods of acquisition feeding frenzy.

With Occasional Bold Action. This penchant for empiricism and analysis did not result in timidity. Just the opposite: on the rare occasions when they found compelling projects, they could act with boldness and blinding speed.

The Consistent Application of a Rational, Analytical Approach to Decisions. These executives were capital surgeons, consistently directing capital toward the highest-returning projects. Over long periods of time, this discipline had an enormous impact on shareholder value through the steady accretion of value-enhancing decisions and the avoidance of value-destroying ones. This unorthodox mindset proved to be a substantial and sustainable advantage for their companies – cutting through the glare of peer activity and conventional wisdom to see the core economic reality and make decisions accordingly. These CEOs knew precisely what they were looking for – they didn’t overanalyze or overmodel and they didn’t look to outside consultants or bankers to confirm their thinking – they pounced.

A Long Term Perspective. Although frugal by nature, The Outsiders were also willing to invest in their businesses to build long-term value. To do this, they needed to ignore the quarterly earnings treadmill and tune out Wall Street analysts and the cacophony of cable shows like Squawk Box and Mad Money, with their relentless emphasis on short-term thinking. This perspective often leads to contrarian behavior.


Posted in Guru Focus, Security Analysis.

Why Hold Cash?

“There’s a lot to be said when the world is going a little crazy around you, to at least put yourself in a position that if something really unpleasant happens, that it might be unpleasant but will be a non-event in terms of changing your life.”  

- Charlie Munger, Wesco 2006 Annual Meeting

In our view, the best way to prepare for a “non-event” is to keep some dry powder on hand.  With that in mind, here are a few points from a recent Long Leaf white paper on The Benefits of Periodic Cash in Equity Portfolios:

  • 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.
  • 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.
  • On average, funds that held 15% or more in cash outperformed their benchmark indices for the following one, five and 10 years. The outperformance relative to the benchmark indices increased the longer the investors’ time horizon.
  • The returns suggest that low-returning cash not only offered the expected buffer in occasional down markets, but access to liquidity also enabled the purchase of new investments that served as the foundation for future successful compounding.

Nobody can predict when “something really unpleasant” will happen.  But it is safe to assume that “the world is going a little crazy” after five years of money printing and zero percent interest rates. Consequently, the average cash balance in our equity portfolios is north of 40% today as we’ve continued to reduce investments where price has advanced more quickly than value.

High Cash Returns

Posted in Portfolio Strategy.

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