This is my favorite way to reduce risk…
It’s an asset that isn’t priced in a large, liquid market. There aren’t millions of people trading its option value back and forth millions of times a day. It has no expiration date. And you aren’t locked into buying or selling at a particular time.[ad#Google Adsense 336×280-IA]It’s a “call option” on any asset you like, with no pricing constraints, and no erosion of value over time.
The option I’m talking about is cash.
And in today’s essay, I’ll show you why holding it is the easiest way to eliminate three types of risk in your portfolio…
You don’t have to time markets to have plenty of cash on hand at the right moment. You just value equities…
In Extreme Value, when our bottom-up, one-at-a-time research approach fails to turn up a new bargain, we’re effectively saying investments are too expensive and there’s little value to be found in the market. In that kind of environment, holding cash is more desirable than spending it on expensive stocks that may have limited upside potential left.
Cash is what you stick with when you can’t find a great idea.
It avoids the two risks we care about most and the one we don’t care about much at all, but which most investors are obsessed with…
One of the benefits of holding cash is the lack of market risk.
The risk most investors are focused on is market risk, the risk that their stocks and bonds will be quoted at lower prices, reducing the value of their accounts. That’s a rational fear for most investors, who are prone to selling out for big losses at market bottoms in a panic.
You’ll never see your $1 of cash quoted at any price but $1.
For investors buying stocks in the U.S. with U.S. dollars, small fluctuations in the value of the dollar relative to other currencies won’t make much difference and won’t damage the option value of cash. Finding great ideas should cancel out the effects of inflation.
During the financial crisis, money market accounts were quoted below $1, but that’s because they weren’t holding cash in its purest form. They were holding derivatives that proved illiquid and volatile during a financial calamity.
I remember contacting brokers back then and telling them not to sweep my cash into a money market account, as is the standard practice at most brokerage firms every night.
A second benefit of holding cash is the lack of valuation risk.
Valuation risk is the risk of paying more than the asset’s true value.
Most people who buy stocks today are likely exposing themselves to valuation risk. Facebook (FB), for example, is a popular name that generates plenty of free cash flow, $4.4 billion of it over the last four quarters. But its market cap is $289.5 billion, 66 times free cash flow. It’s hard to believe Facebook is worth that.
I’m willing to bet there’s more valuation risk there than most investors currently believe. Even the best business is a terrible investment if you pay too much.
When valuations fall to more reasonable levels, anyone who paid too much for Facebook will lose money… and anyone who waited in cash will be ready to seize an opportunity to buy a cheap, fast-growing cash-gusher.
A third benefit of holding cash is the lack of fundamental risk.
Fundamental risk is the risk of a permanent reduction in intrinsic business value.
Many investors are exposing themselves today to fundamental risks by owning difficult businesses like electric car maker Tesla (TSLA).
Tesla is a new company with flashy products and a charismatic CEO. It experiments in a highly competitive, low-margin, capital-intensive industry with no prospects for generating a profit any time soon. It makes expensive cars that don’t run on the cheapest, most abundant transportation fuel on the planet (gasoline).
Tesla also contains what superinvestor Warren Buffett might call “cat risk,” or catastrophe risk – the risk that the whole enterprise will fail. That happens to brand-new, unprofitable businesses all the time. I bet if Tesla turns profitable, the market will give it a much more rational valuation than the current eight times sales.
Look at other big car companies… Toyota (TM) trades at 0.8 times sales, Ford (F) at 0.4 times. Even if you love Tesla, be patient. If you’re right about it, it’s highly likely you’ll get it cheaper one day.
We try to avoid valuation risk by recommending stocks that are extremely undervalued, have competitive advantages and good balance sheets, and generate large amounts of excess cash flow.
By avoiding stocks and implicitly recommending cash, we eliminate most valuation risk. A sudden reduction in the value of your cash would require a massive overnight currency shock, something nobody could anticipate, that would not be preceded by any warning signs or steady drops in the value of the currency. That is highly unlikely to occur. Your $1 of cash will still be worth $1 when you wake up tomorrow.
Holding cash is by far the easiest, most reliable way to reduce risk in an equity portfolio. The more cash you hold, the less risk exposure you have. For most investors, holding a lot of cash seems like a mistake or a copout.
If it is a mistake, you will only pay for it with the unearned value of a lost opportunity. You won’t pay for it with the loss of capital. It’s guaranteed you’ll lose some opportunities by holding cash – that’s just the cost of the option value. But you won’t lose money.
Cash is a strategic asset that can be unleashed on any asset you desire. Its option value is substantially greater than the intrinsic value of Treasury bills or cash-savings accounts. If you don’t understand that, you may behave impulsively and take on valuation risk or fundamental risk.
Be confident. Be patient. Hold your cash proudly. Brag about it at cocktail parties. Don’t deploy it until you find a good business that’s undervalued and not likely to stay that way for long.
Source: Daily Wealth