The Hidden Value of Cash - Bellwood Capital

When we put together a new portfolio, we always invest at least 70% into our best investment ideas, adequately spread across different industries and geographies. The stock market has been a leading source of long-term investment returns for the last century, and we don’t believe this is about to change. Further, although the market is prone to sharp drawdowns at times, we don’t believe that these drops can be timed accurately/consistently, and it is therefore better to remain invested in the stock market through thick and thin.

Why then do we not always invest 100%? Are we timing the overall level of the market? – No. Can’t we find investments with a better expected return than cash? – It depends how you view the expected return on cash.

Let’s start then, by defining the long-term return on cash. It is not equal to the current yield. It is equal to the current yield for the period that you hold it, plus the return on the asset that you invest it in for the remainder of the investment term. Example: If you invest today in something priced for 10% p.a. for a 10 year term, then the return over the 10 year period is 10% p.a. If cash earns 0% today and next year you invest it in something priced for 15% p.a. for a 9 year term, then the return on your cash is 13.4% p.a. over the 10 year period. Deciding whether or not to invest cash today depends on the probability of earning a significantly better return over the investment horizon by waiting instead.

Since we are making investments with a 5 to 10 year horizon, time is on our side, and every time we make an investment we need to decide whether it would be better to wait for other opportunities or not. This depends on a) the current yield on cash, b) how much cash we have left, and c) the expected return of the asset we are buying. Obviously a higher yield on cash demands a higher expected return on a potential investment. What is much less obvious is that the less cash we have left, the higher the expected return on the asset under consideration needs to be for us to make the investment. We’ll explain this by way of an example:

By our estimation, there are currently about 660 stocks across the globe that are of sufficient quality and are sufficiently liquid for us to invest in – at the right price. Assuming we invest 3% per position, we would hold 33 positions when fully invested.

Let’s assume that we are currently 96% invested (i.e. we hold 32 positions) and the best available investment that we don’t already hold is priced for 10% p.a. While 10% p.a. is certainly better than 0% on cash, the likelihood that at least one of the 628 remaining investments becomes priced for significantly better than 10% within the next year is very high (the probability of any 1 stock out of 628 dropping significantly is much higher than the probability of all 628 dropping significantly). Therefore the expected return of holding our last remaining cash is higher than 10% and we should rather wait for a better opportunity, even if the cash is a drag on our performance in the short term.

Working backwards from this point, it becomes clear that the more cash we have to invest and the higher the return of the potential investment, the lower the probability of beating that return over the investment horizon becomes. E.g. If we are 51% invested (we hold 17 positions), and we are considering investing in an asset priced for 15%, the probability of finding 16 better opportunities in a reasonable space of time is quite slim. It makes sense to make the investment.

At the extreme of holding 100% in cash, the implicit assumption is that there isn’t a single asset out of 660 worth buying and that you are sure to find 33 better investments than your current best opportunity quite soon. When your cash yield is 0% and the best investment opportunity is priced for 20%, the chance of this assumption holding true is very slim.

The less cash we have, the higher its expected return is, and the more valuable it is. The decision to part with our last bit of cash is not taken lightly.

When we put together a new portfolio from 100% cash, we start with our best long-term investment ideas and keep adding the next best investment until the expected return of the marginal investment opportunity is lower than the expected return implied by holding cash and waiting. Under current market conditions we estimate that this equilibrium is struck when we are 70% to 80% invested. We believe that holding the remainder in cash and waiting for better opportunities is likely to deliver a better return over 5 to 10 years than what could be earned by investing in the next best opportunity today, even if cash is a drag in the current market.