2003 – Klarman: Holding Cash in the Absence of Compelling OpportunityVW Staff
Found this gem 2003 where Seth Klarman talks about the value of holding cash. Some will see similarities to today (although valuations now are much higher than in 2003, most would argue) – See below for some excerpts from 2003 letter to investors.
Hedge funds have boosted their exposure to stocks (relative to their “benchmarks”) to the highest level in the past year, International Strategy & Investment reported last month. And the firm added, “This suggests that hedge funds have indeed started to play the long side in an effort to boost relative performance.” If there’s one asset calculated not to boost relative performance in a rising market, it’s cash. Cash yields nothing and is nobody’s takeover candidate. Furthermore, if held in more than trace amounts, it constitutes prima facie evidence of professional incompetence in the portfolio manager who forgot to spend it. All of which will introduce the fact that portfolios managed by the Baupost Group, Boston, today hold cash equivalent to about 45% of their overall assets.
A year ago, just 15% of Baupost’s assets were so deployed. At the other extreme, on the eve of the 1987 stock market crash, 55% lay fallow. Who will answer for these deviations from standard fund-management operating procedure? Responsibility must rest with the president, Seth A. Klarman, and Klarman readily accepts it. He should. Over the past 20 years, Baupost’s results have surpassed, by about a mile, the returns on every relevant U.S. market index. Yet, clearly, if there’s a secret to this success, rolling T-bills isn’t it. The secret concerns when to roll them, and when to roll them up. Klarman, one of value investing’s brightest lights, strives not to overpay, but to underpay. His energy is devoted to identifying wonderful ideas that, by definition, would not be wonderful if they were overpriced. To most of us, it is impossible not to think better of a prospective investment if it is “going up.” Try as we might, we can’t help but think worse of an investment if it is “going down.”
Klarman and his Baupost colleagues seem to have surmounted these deeply rooted psychological barriers to moneymaking. Cash, for Baupost, is the steady-state asset. It’s what an investor should hold in the absence of a commandingly better idea. During the rout in distressed debt in the summer of 2002, Baupost was buying what others were selling, and cash as a percentage of assets under management was falling. During the bull market in distressed debt in the summer of 2003, Baupost was selling what others were buying, and cash as a percentage of assets was rising. It has continued to rise in the autumn. People can barely stand to hold cash in falling markets, as Klarman points out. They are no more eager to hold it–not to mention the scrawny yields–in rising markets. When investment opportunities are plentiful, Baupost and its president are busy investigating them. In the leisure afforded by the current spell of overvaluation, Klarman has written an essay on cash, “the globally despised investment alternative.” Why is it detested, this “most short duration and liquid of assets?”
Because investors are too impatient not to be fully invested. “Oddly,” writes Klarman, “investors choosing zero-duration cash as the lesser of available evils may well be employing a longer time horizon, demonstrated by their investment patience, than those who choose to speculate on overvalued long duration stocks and bonds, which they intend to trade out of at the first sign of trouble.” You would suppose, Klarman continues, that a three-year bear market would have weaned investors from their boom-time preoccupation with relative performance–that, by now, they “would have developed an appreciation for an absolute return focus consistent with capital preservation, but old habits and ingrained tendencies die hard. If keeping up with an overvalued stock market is your goal, cash is an unacceptable anchor to drag around.”
Cash, for Baupost, is a residual, Klarman reminded his investors. The amount held is determined not by a decree from on high, but by the presence, or absence, of “compelling opportunity.” “If an investment is sufficiently better than cash–offering a more than adequate return for the risk involved–then it should be made,” Klarman writes. “Note that the investment is made not because cash is bad, but because the investment is good. Exiting cash for any other reason involves dangerous thinking and eventual financial disaster. “Many investors,” the president goes on, “think only in two dimensions, and flawed ones at that. They compare the current yield on cash (lousy) to the current yield on a longer-term bond or [the] dividend yield (or historic long-term expected total return) from a stock.
Cash nearly always loses in this comparison, and investors feel quantitatively justified in doing what career and client pressures cause them to do anyway. It makes no difference how overvalued these alternatives may be in an absolute sense.” It isn’t just impatience that causes most investors to equate Treasury bills with intellectual bankruptcy. “One of the biggest challenges in investing,” Klarman continues, “is that the opportunity set available today is not the complete opportunity set that should be considered.
Indeed, for almost any time horizon, the opportunity set of tomorrow, which could be greater, narrower, or similar in scope but different in specifics from today’s, is a legitimate competitor for today’s investment dollars. It is hard, perhaps impossible, to accurately predict the volume and attractiveness of future opportunities; but it would be foolish to ignore them as if they will not exist.”
By deeds, if not words, even a value-oblivious, trend-following neophyte sometimes concedes the point. By averaging down, this individual tacitly admits that tomorrow’s prices might be lower than today’s. Still, as Klarman points out, most investors seem unwilling to be uninvested: “They are unwilling to bet that future opportunities will arise, although they acknowledge that existing names could become cheaper. Implicitly, investors intend to make room for any future bargains that do arise by selling other investments to make room at that time. This logic causes them to hold even significantly overvalued positions, preferring them to cash. Of course, the same forces that cause bargains to emerge in the future could easily drive the expensive securities they are already holding to much lower levels. For them, …
Klarman – Holding Cash in the Absence of Compelling Opportunity
(This section reiterates and expands on ideas previously discussed in our June 30, 2003 letter.)
Earlier we explained that cash and cash equivalents comprised approximately 57% of partnership assets at year-end. Perhaps some of you will soon be asking why you are paying us a management fee to hold so much cash. Let us preempt you by saying that we are not. You are paying us to decide when to hold onto cash and when to invest it, to determine when the expected return from a prospective investment justifies the risk involved and when it does not.
In a short-term, relative-performance-oriented world, earning next to nothing on cash creates a compulsion to invest, even when all investment alternatives appear overvalued. Choosing their position, most investors prefer to hope that something expensive becomes even more expensive, especially when it has recently been doing exactly that. Holding cash, which they find barely tolerable when markets are falling, is anathema when markets are rising.
The Japanese bond market is an extreme case. With Japanese overnight deposits paying literally nothing, investors moved out on the yield curve to pick up return. This past June, they accepted an annual yield of only 0.44% on the Japanese ten-year bond. By October, this bond had fallen from above par to below 90, yielding over 1.5%. Importantly, an investor lost (on a market to market basis) in four months more than twice the total return they would have earned if they had held onto that ludicrously mispriced bond for an entire decade. The summertime pricing of this bond can only be explained by the pressure of zero yield on cash, the globally despised investment alternative.
Today’s investors remain almost singlemindedly focused on relative performance, their results compared to the market’s. Their behavior is understandable in an environment where, for most professional investors, short-term underperformance is often rewarded with client redemptions. This is especially the case since “long-term oriented” looks a lot like “being wrong” until proven otherwise. Since no one can know if it is your long-term orientation or your incompetence that is causing poor performance results, it is hard for disappointed clients to stay the course. Career risk for individual managers adds to the pressure. To avoid underperforming in a rising market, many professional investors have a mandate to remain fully invested. After three years of a grueling bear market, one might have thought investors would have developed an appreciation for an absolute return focus consistent with capital preservation, but old habits and ingrained tendencies die hard. If keeping up with an overvalued and rising market is your goal, cash is an unacceptable anchor to drag around.
We have always believed that successful investing involved recognizing and correctly choosing among a series of tradeoffs. Cash (in the form of short-term U.S. treasury bills) is a way of safely doing nothing until compelling investment opportunity arises. It offers positive albeit very limited yield, complete safety of principal, and full and instant liquidity. A low positive return with virtually non-existent risk is not a bad proposition in the absence of better alternatives. Our
view is that investors should choose to hold cash in the absence of compelling opportunity, not because they are making a top-down asset allocation into cash, but based on the result of a bottom-up search for bargains. Baupost will make the decision to hold cash, even if it becomes a very large percentage of partnership assets, until better opportunities arise. Every investment must be compared to the alternative of holding cash. If an investment is sufficiently better than cash–offering a more than adequate return for the risk involved–then it should be made. Note that the investment is made not because cash is bad, but because the investment is good. Exiting cash for any other reason involves dangerous thinking and greatly heightened risk.
Many investors compare the current yield on cash (lousy) to the current yield on longer-term bonds or the dividend yield (or historic long-term expected total return) from stocks. Cash nearly always loses in this comparison, and investors feel quantitatively justified in doing what career and client pressures cause them to do anyway. It makes no difference how overvalued these alternatives may be in an absolute case.
Investors’ immediate problem is being too short-term oriented. One of the biggest challenges in investing is that the opportunity set available today is not the complete opportunity set that should be considered. Limiting your investment opportunity set to only the one immediately at hand would be like being required to choose your spouse from among the students you met in your high school homeroom. Indeed, for almost any time horizon, the opportunity set of tomorrow is a legitimate competitor for today’s investment dollars. It is hard, perhaps impossible, to accurately predict the volume and attractiveness of future opportunities; but it would be foolish to ignore them as if they will not exist.
It is one thing for a value investor to know that in the absence of opportunity you should hold cash. It is quite another to actually do it. It is particularly difficult to sit on your hands when others are probably speculating. We find that it is not a temptation to speculate that pulls at you, so much as a desire to be productive. Doing nothing is doing something, we have argued again and again; doing nothing means prospecting for potential investments and rejecting those that fail to meet one’s criteria. But emotionally, doing nothing seems exactly like doing nothing; it feels uncomfortable, unproductive, unimaginative, uninspired and, probably for a while, underperforming.
One’s internal strains can be compounded by external pressures from clients, brokers and peers. If you want to know what it is like to truly stand alone, try holding a lot of cash. No one does it. No one knows anyone who does it. No one can readily comprehend why anyone would do it.
Also, believing that better opportunities will arise in the future than exist today does not ensure that they will. Who can tell what investors will be willing to pay for securities tomorrow? Waiting for bargains to emerge may seem like a better strategy than overpaying for securities today, but tomorrow’s valuations may still be higher still. Standing apart from the fully invested crowd for significant periods of time can be a grueling, humbling and even demoralizing experience.