Why Hold Cash?

[racemize]

I take back my statement about the cash % always being all or nothing.  I found a situation where the ideal cash number was 35%, interestingly. 

 

Back to the models...

 

How is that even possible? I had also assumed it would be all or nothing always. Are you using fixed income for cash?

 

Thanks

 

Vinod

 

I'm not entirely sure--either there's an error in several of my examples, or the behavior is something I didn't expect.  I'm looking at it more now.

 

Edit: Looks like it is a trade off between the value of the normal returns versus the bonus return and how often the cash is deployed.  I think it makes sense, but where that point is is not intuitive.

[vinod1]

 

I'm not entirely sure--either there's an error in several of my examples, or the behavior is something I didn't expect.  I'm looking at it more now.

 

Edit: Looks like it is a trade off between the value of the normal returns versus the bonus return and how often the cash is deployed.  I think it makes sense, but where that point is is not intuitive.

 

You would get a "rebalancing bonus" when you add a non-correlating asset and you rebalance periodically. See http://www.efficientfrontier.com/ef/996/rebal.htm

 

I wonder if you are capturing that effect.

 

Vinod

[bargainman]

 

Under community property laws here in the US, when either you or your spouse dies all of the capital gains held in the marriage community are forgiven via a full step-up in basis upon the death of the first spouse.  You might find yourself a billionaire, with a ton of unrealized capital gains, separated from your wife and living with another woman.  It would be better not to formalize the divorce under community property law.

 

wow interesting...  checked it out...

http://www.paytaxeslater.com/stepup.htm

 

 

 

[randomep]

You are correct if you have long-term patient capital.  I don't know if Monish's comments were in the context of a fund where he has to be concerned with redemptions.  The other factor being fully invested is the volatility of a portfolio versus one with cash.  If was in context of a fund, I think it makes sense if it is long-term patient capital not required for a long period of time then your approach is more appropriate.  The opportunity cost is indeed high if say the long-term expected return on equities is 10% and you think with your approach you can beat that.

 

Packer

 

I have a serious question, why do we care what Monish thinks. His record is terrible. I calculated that his flagship fund from 2008-2013 returned around 3% CAGR. Those five years are a great indication of performance because it is a full peak-trough-peak cycle. He as I recall was fully invested in 2008-2009 so he had so ability to take advantage and had to rethink his whole investment strategy. So he is basically saying he is learning as he goes, so then why does anyone want to learn with him, as opposed to learning from someone else with a good track record, like the Bruce fund, or Buffett, or many others?

 

 

[SharperDingaan]

A few additional considerations ....

 

Your optimal hurdle rate is your margin cost, not 15%. Until you know what you want, you would be temporarily invested in a margined low risk preferred - with a div yield above the cost of your margin; and maximizing your cash-flow. Div yield on your cash, + (div yield - margin cost) spread on your margin (ie: Banking 101). Zero cash drag.

 

You invest based on value proposition, not because ROI is > 15%. This is not equipment where you have reasonable certainty over the direction, magnitude, & timing of the cash-flow stream. NPV is not particularly useful in an investment application.

 

Most hold a passive nominal cash weighting to cover foreseeable outflows; usually via short-term laddered FI. The 2 years of living expenses that posters have already alluded to.

 

The amount you can temporarily invest reflects BS strength, not your cash on hand. Margin agreements, credit lines, quality investments, & deep liquid markets for those investments, etc. are all passive liquidity convertible into cash. If you are optimizing, as long as you can earn more than the service cost on this debt, you should be investing it.

 

You might also want to keep in mind that cash optimization is at the expense of rising risk, & that risk increases exponentially .... ie: plot the functions & the intersect is your optimization point.

 

SD

 

 

[jay21]

Race, you may also want to think a little more about your frequency of high return ideas. Opportunities can arise even without a broad market crash.  Off the top of my head there have been quite a few good risk/reward situations that popped up since 2010:

 

BAC, JPM whale scandal, News Corp scandal, JEF, etc.  There's probably a lot more, but I've been following financials the closest over the last few years.

[Guest]

You are correct if you have long-term patient capital.  I don't know if Monish's comments were in the context of a fund where he has to be concerned with redemptions.  The other factor being fully invested is the volatility of a portfolio versus one with cash.  If was in context of a fund, I think it makes sense if it is long-term patient capital not required for a long period of time then your approach is more appropriate.  The opportunity cost is indeed high if say the long-term expected return on equities is 10% and you think with your approach you can beat that.

 

Packer

 

I have a serious question, why do we care what Monish thinks. His record is terrible. I calculated that his flagship fund from 2008-2013 returned around 3% CAGR. Those five years are a great indication of performance because it is a full peak-trough-peak cycle. He as I recall was fully invested in 2008-2009 so he had so ability to take advantage and had to rethink his whole investment strategy. So he is basically saying he is learning as he goes, so then why does anyone want to learn with him, as opposed to learning from someone else with a good track record, like the Bruce fund, or Buffett, or many others?

 

His annualized return since 1999 I believe is around 26%.

 

As far as the Bruce fund goes (I like those guys) but their returns were terrible, compared to the S&P 500, from like 1987-2000.

[Packer16]

I think another part of Monish's appeal is that he has thought through and lived through changes in investment issues, like concentration, checklists and cloning.  His observations to mind have been spot on and his performance after the crash has reflected that.  The only other person I have seen do a better post mordum of mistakes is Tim McElvaine.

 

 

Packer

[randomep]

You are correct if you have long-term patient capital.  I don't know if Monish's comments were in the context of a fund where he has to be concerned with redemptions.  The other factor being fully invested is the volatility of a portfolio versus one with cash.  If was in context of a fund, I think it makes sense if it is long-term patient capital not required for a long period of time then your approach is more appropriate.  The opportunity cost is indeed high if say the long-term expected return on equities is 10% and you think with your approach you can beat that.

 

Packer

 

I have a serious question, why do we care what Monish thinks. His record is terrible. I calculated that his flagship fund from 2008-2013 returned around 3% CAGR. Those five years are a great indication of performance because it is a full peak-trough-peak cycle. He as I recall was fully invested in 2008-2009 so he had so ability to take advantage and had to rethink his whole investment strategy. So he is basically saying he is learning as he goes, so then why does anyone want to learn with him, as opposed to learning from someone else with a good track record, like the Bruce fund, or Buffett, or many others?

 

His annualized return since 1999 I believe is around 26%.

 

As far as the Bruce fund goes (I like those guys) but their returns were terrible, compared to the S&P 500, from like 1987-2000.

 

Your analysis is exactly what I have issue with. What you say is correct but Pabrai had the following AUM:

 

2000 ~ $1M

2001  ~ $4M

2002  ~ $15M

2003  ~  $60 M

2004 ~  $110 M

2005 ~  $250M

2006 - current  = $300M

 

So in the huge bull market when he was a tiny shop he did well return wise, but if you weight his return by the AUM, his return is barely above water.  In other words, his typical investors are better off never investing in his fund but rather investing in an index fund. (here I say typical in the probabilistic sense)

 

And speaking of the Bruce fund, it is a fund that is around for 30yrs, so wouldn't you want to take the CAGR of the entire period to guage their results? The last 30yrs have been the most turbulent 30yrs in stockmarket history. The link below is their result for all time vs the market. 

 

http://bovinebear.blogspot.com/2012/09/why-i-own-bruce-fund.html

 

Bear markets separate the men from the boys. The following writeup shows who are the men and who are the boys.

 

http://bovinebear.blogspot.com/2013/06/5-years-after-great-recession-whats-next.html

 

 

 

 

 

[merkhet]

I don't understand what you mean by weighting the return by the AUM. Can you explain that?

 

Also, I'm pretty sure Pabrai's AUM is currently about $700M.

[randomep]

Sure!

 

What I meant is we should look at money managers by how many dollars have returned to investors. So for Pabrai's fund in the first year returned say 20% with $1M AUM, so he returned for investors $0.2M that year. In 2008 say he lost 50%, with $400AUM, so he lost $200M. So one can assume that by the end of 2008, he has possibly lost more for his investors than he ever gained from 2001-2007.

 

 

**note** my numbers are for illustration only, they are my estimates only,  so yes I wouldn't doubt you that it is $700M today, I am just saying it is probably over 300M since 2006, so all the more reason to look at his results since 2006.

 

 

[merkhet]

Ah, I understand now. Thanks!

 

I would then ask you to consider the following:

 

If we are to use an AUM weighted measure, then should we note that his increase to some "threshold" AUM also coincided with a large drawdown in the general markets?

 

Let's present you with the returns of another investor:

 

Year 1    +20.6%

Year 2    +  7.3%

Year 3    - 31.9%

Year 4    - 31.5%

Year 5    +73.2%

 

Total return from Year 1 to Year 2 is about 4.55% with a CAGR of 0.89% per year.  This return also occurred at the peak assets for the individual's firm, and it happened to coincide with a closure of the firm in Year 5.

 

Now, three things to note:

 

(1) Years 3 & 4 occurred during serious down years in the overall market, and the partnership actually underperformed during that period of time

(2) Perhaps a longer-term track record is required to see whether this person is a good investor

(3) The record is Charlie Munger's record, and if he were 30 years younger and willing to take my money, I'd give it to him...

 

Now some people might think that it's a fund manager's job to outperform in both up markets and down markets.  That's a quaint notion, and I wish I went to bed with a different Victoria's Secret model every night -- but neither the former or the latter are likely to happen.

[CorpRaider]

I don't think it is fair to hammer Pabrai's position on cash and liquidity based upon underperformance during the great recession period which was likely caused by not holding enough cash and is probably the exact scenario his current views on liquidity are intended to address. 

[racemize]

I don't think it is fair to hammer Pabrai's position on cash and liquidity based upon underperformance during the great recession period which was likely caused by not holding enough cash and is probably the exact scenario his current views on liquidity are intended to address.

 

Well, I'm mostly trying to figure out if it makes sense.  We want to be sure we learn the right lessons from 2008 and do not overreact to it.  Marks said something similar, e.g., if we try to prepare for 2008 scenarios, we can only own cash and gold, or something along those lines.

[CorpRaider]

I see what you're saying.  His stated position on liquidity, as set forth above, has not been proven to outperform through a serious bear market, for sure.

[randomep]

Ah, I understand now. Thanks!

 

I would then ask you to consider the following:

 

If we are to use an AUM weighted measure, then should we note that his increase to some "threshold" AUM also coincided with a large drawdown in the general markets?

 

Let's present you with the returns of another investor:

 

Year 1    +20.6%

Year 2    +  7.3%

Year 3    - 31.9%

Year 4    - 31.5%

Year 5    +73.2%

 

Total return from Year 1 to Year 2 is about 4.55% with a CAGR of 0.89% per year.  This return also occurred at the peak assets for the individual's firm, and it happened to coincide with a closure of the firm in Year 5.

 

Now, three things to note:

 

(1) Years 3 & 4 occurred during serious down years in the overall market, and the partnership actually underperformed during that period of time

(2) Perhaps a longer-term track record is required to see whether this person is a good investor

(3) The record is Charlie Munger's record, and if he were 30 years younger and willing to take my money, I'd give it to him...

 

Now some people might think that it's a fund manager's job to outperform in both up markets and down markets.  That's a quaint notion, and I wish I went to bed with a different Victoria's Secret model every night -- but neither the former or the latter are likely to happen.

 

woah, not me!  volatility does not equal risk, but possible permenent loss of capital is risk,

 

Correct me if I am wrong but in 2008 I believe Pabrai reshuffled his entire portfolio. When you close a position on a loser, that's it, that is a permenent loss of capital. In any case, we can look at one example that sticks out in my mind: Pinnacle Airlines. Back in the good ole days before the recession Pabrai gave a thesis about how it was a good investment (which I don't need to get into) and I guess he bought much of his position at the $10-$20 range. He held most of it till last year, when it was $0.10. So I have yet to see an satisfactory post mortem on it. But then again I probably never will from anyone. It isn't enough to say oh I didn't know this or I didn't know that. The key is why did you trust your analysis to make such a bet. The size of your bet should be a function of your confidence in your analysis.

 

The bottom line is, if you made a wrong sized bet before, how do I know you won't do it again.

 

... and regarding Munger, it would be hard to know his genius back in 1976, HOWEVER, I doubt, he reshuffled his investment strategy the way Pabrai did, so he did not suffer a permanent loss of capital...

 

cheers, and we are all entitled to our opinion :)

[merkhet]

My sense is that he closed some positions to buy other positions that were cheaper.

 

Though I agree with you that he shouldn't have gone from 10 positions to > 10 positions --> but I think he's not moved back to 10 positions.  (Feel free to correct me if I'm wrong.)

[racemize]

Though I agree with you that he shouldn't have gone from 10 positions to > 10 positions --> but I think he's not moved back to 10 positions.  (Feel free to correct me if I'm wrong.)

 

You are correct.

[racemize]

Ok, so as another test, I just went and recalculated what Pabrai's performance would have been if he had held cash most of the time and put it all in after the big downturns (2009 and 2012).  Results are interesting:

 

For PIF2, adding any amount of cash reduced overall performance

For PIF3, ideal cash amount turned out to be 33%

For PIF4, ideal cash amount turned out to be 98%

 

So, mixed bag!  Pabrai's returns seem to be more prone to needing cash than the market, which I've never gotten a positive result for holding cash.

[randomep]

I don't think it is fair to hammer Pabrai's position on cash and liquidity based upon underperformance during the great recession period which was likely caused by not holding enough cash and is probably the exact scenario his current views on liquidity are intended to address.

 

Why is it unfair, if he made a monster mistake that cost millions in his fund it should be recorded on his resume.

 

As for your second point that he is addressing this cash issue, I see a red flag. He seems to be a general who is fighting the last war. An unoriginal thinker will not seek to understand the world but to look for a pattern that he hopes will repeat. The secret is out of the bag on that one which is one people had been taking money out of stocks into cash even through 2010-2012. That in part explains why 2013 was such a surprise......

 

Others like Buffett, Berkowitz, Bruce all had ample cash going into 2008. I am looking for the next great idea from a truely original thinker. 10 yrs from now we will hear about another book of people who foresaw something great, like Michael Burry, Paulson and Einhorne foresaw the mortgage meltdown.....

 

cheers

[CorpRaider]

Ok, it is logically flawed, because you are criticizing his current cash and position sizing philsophy based upon the very shortcomings it was designed to remedy (whether successfully or not, remains to be seen).  It is like one of those quantum paradoxes from a Star Trek episode with time travel. 

[LongHaul]

Alice Schroeder talked about how Buffett thinks of cash as a call option with no expiration, and no strike on any asset class.

The cost is the opportunity cost of holding cash.  I am still trying to fully understand it.

 

http://www.portfoliomanagement.ca/warren-buffett-article.html

 

A couple of times when Buffett went largely to cash:

1.  1969 - he closed his partnership because he could not find anything.  I think the Dow was down about 30% after that.

2.  1987 - He sold a lot of stocks into the bull market before the crash.

 

 

I think Bernard Baruch and Joseph Kennedy had a lot of cash going into the Great Depression. 

Howard Marks had a fund ready with cash for the 2008 crash.

 

I don't think I can time the market, but if almost everything is overvalued I will just wait it out in cash.

 

I have usually been able to find new ideas on average within 2 years so base my calculations off that time frame. 

I would rather sit in cash earning 0% for 1 year, then deploy it in an idea with an expected IRR of 20%+ for a few years rather than buying something with an expected return of 10%.

 

   

 

 

 

 

 

 

 

[LC]

 

I would rather sit in cash earning 0% for 1 year, then deploy it in an idea with an expected IRR of 20%+ for a few years rather than buying something with an expected return of 10%.

 

 

 

I agree: Especially when it's one of Buffett's "great businesses", that you can just sit on. Then it's better than cash because even when you can't find anything to buy, your great business is earning an excellent return on capital.

 

So that 10% business might be a mediocre one, and once it's reached fair value or whatnot, you sit there earning a relatively mediocre return. So what's the benefit of holding it? Not much, so you sell it and now you're left with the same problem: having cash and either trying to find another 10% mediocre business to invest in.

 

But that 20% business...if that's a real good business...you almost don't need to do anything unless prices get really out of hand.

[randomep]

Ok, it is logically flawed, because you are criticizing his current cash and position sizing philsophy based upon the very shortcomings it was designed to remedy (whether successfully or not, remains to be seen).  It is like one of those quantum paradoxes from a Star Trek episode with time travel.

 

 

Oh ok I take back my rebuttal to your critique because I didn't realize you were talking about me talking about Pabrai's cash argument. I don't really know what is Pabrai's current strategy about cash. I don't care. My entire point is Pabrai doesn't deserve mention in such a high quality forum like this, unless it is used to illustrate what not to do.

 

His cash strategy now is probably good, but that is so 2007, yaya tell me something I don't know. BTW, I had cash going into 2008, but you don't see me bragging about it. Nor does Buffett, etc.

[constructive]

I don't think it is fair to hammer Pabrai's position on cash and liquidity based upon underperformance during the great recession period which was likely caused by not holding enough cash and is probably the exact scenario his current views on liquidity are intended to address.

 

Why is it unfair, if he made a monster mistake that cost millions in his fund it should be recorded on his resume.

 

As for your second point that he is addressing this cash issue, I see a red flag. He seems to be a general who is fighting the last war. An unoriginal thinker will not seek to understand the world but to look for a pattern that he hopes will repeat. The secret is out of the bag on that one which is one people had been taking money out of stocks into cash even through 2010-2012. That in part explains why 2013 was such a surprise......

 

Others like Buffett, Berkowitz, Bruce all had ample cash going into 2008. I am looking for the next great idea from a truely original thinker. 10 yrs from now we will hear about another book of people who foresaw something great, like Michael Burry, Paulson and Einhorne foresaw the mortgage meltdown.....

 

cheers

 

You are aware that Pabrai's total return since he started managing money has crushed Berkowitz and Buffett over comparable time periods, right?