Grey Owl Capital on the Role of Cash in a Portfolio

Jeff Erber and Grey Owl Capital are out with their fourth quarter letter to investors.  In it, they highlight how they started to move more cash into equities in Q4 and have continued to do so in 2013.  This led to an interesting discussion about how they view cash as a component of their portfolio which we wanted to draw attention to.

Cash as a 'Hedge'

Grey Owl outlines the tradeoffs between holding cash and being invested:

"We have chosen to 'hedge' our exposure to these individual equities by holding cash.  If the broad equity market was overvalued and the economy was on artificial support, we wanted the cash available in order to take advantage of likely dislocations.  Today, our analysis says that the value of holding this cash is lower than in the past few years."

While they use the term 'hedge,' what they really mean is that they view cash as an opportunistic tool to take advantage of market sell-offs that might be unwarranted.

After all, Passport Capital's John Burbank once said, "cash is most valuable when others don't have it."  We've also posted how DoubeLine Capital's Jeff Gundlach said investors should hold cash.


Cash as a 'Call Option'

Given this discussion, it's important to also highlight how Berkshire Hathaway's Warren Buffett views cash.  Alice Schroeder (his biographer) highlighted that,

"He thinks of cash differently than conventional investors.  This is one of the most important things I learned from him: the optionality of cash.  He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price."

The Downside of Holding Cash

Turning back to Grey Owl's letter, they touch on the downside of holding cash: 

"We can hold a large-than-typical cash position (which we have), waiting for the monetary manipulation and fiscal imbalances to cause market dislocations (as they eventually will).  Alternatively, we can increase our exposure to the common stocks of great businesses ... They will certainly experience more market volatility than cash and we would typically like to make purchases with a wider 'margin of safety,' but the alternative of negative real returns in cash is worse."

The interesting decision here is that they've essentially determined that the adverse effects of negative real returns in cash is doing more harm than the benefits offered by having cash on hand as a 'hedge'  and as an opportunistic tool.  As such, they've decided to allocate more of this cash into equities.

This is a phenomenon we're seeing gain steam among investors.  Bridgewater's Ray Dalio highlighted this very concept of the negative real return on cash and said that cash will move into 'stuff' in 2013.  Appaloosa Management's David Tepper is also bullish on equities.  Contrafund's Will Danoff is also bullish for 2013.


Risk/Return

Normally, the investment environment dictates how much cash an investor will hold, i.e. if things are overvalued, they will hold cash and wait for better opportunities.  What's intriguing here is how Grey Owl's decision is less about deploying cash due to low price opportunities (after all, this isn't the financial crisis).  Instead, their decision was more-so focused on the perceived lack of risk in equities.

Investors are always focused on the risk and return of a potential investment.  Most of the time, value investors will wait for risk to abate via share price declines (providing a larger margin of safety).  In this scenario, it seems many investors are investing not because of an improved risk profile due to lower security prices, but instead because of the perceived lower risk environment as a whole, led by the Fed's backstop. 

So there are obviously a few different ways to view cash as a component of the portfolio.  Monetary policy has altered the way Grey Owl views cash.  They end their missive by saying, "At this point, too large an allocation to cash might prove to be a bet on Fed failure.  More likely, the performance of the underlying businesses will determine our results."

It will be interesting to see if even more investors follow this framework and shift their views, but as illustrated above, many already have (but for a myriad of reasons).


Grey Owl's Q4 Letter

Embedded below is Grey Owl's latest letter:

Jeff Gundlach: Investors Should Hold Cash

DoubleLine Capital's CEO Jeff Gundlach recently appeared on Bloomberg to talk about how to invest in this environment and claimed that "investors should be holding cash."  Below are some excerpts from his interview as well as the video.

He noted that risk assets have diminishing returns and that he didn't see much value in the US stock market and said to act cautiously in the US bond market.


On how to trade this environment:

"I think that investors should be looking for lower prices on most risk assets in these developed countries with the exception of Japan... investors should be looking for the potential inflationary consequences of all this money printing exercise and the place to look for that is Japan."


On whether investors should get more disciplined and look at fundamentals:

"The fundamentals are always important but it does get trumped by policy decisions when policy decisions are so radical as has been the case in recent years…There seems to be diminishing returns on the various rounds of quantitative easing. It's almost like a half-life of a radioactive particle. The first quantitative easing brought 50%, the second brought a little more than half of that, the third half again, the fourth less than half again. It just seems that the idea of a Pavlovian reaction when you see quantitative easing that you should go out and buy risk assets--it has worked four times, but it doesn't seem like you are getting much bang for your buck any more…I would point out that gold, for example, hasn't done much of anything in the last couple of rounds of quantitative easing. It seems that the fundamentals are starting to exert themselves more powerfully against the backdrop of endless quantitative easing, so it's possible that the market support is close to finding its limit. This is why I think that investors should be holding cash and buying risk assets at lower prices once the fundamentals assert themselves."


On where to put money now:

"You've got to survive with virtually no return if that's the way you look at things. I actually recommend that for many investors. I think the small amount of money that you might make by trying to push it here as we get closer and closer to the end game where this thing might tail out--the amount of money you might make will be dwarfed by the amount of money you might lose when things reprice lower. Put it another way, if you just stay in cash and earn a small return or stay in a low risk investment and earn a middling single digit return--the money you might be able to make as we move into late 2013 or early 2014 with repricing, the amount of money you might make if you are able to deploy the money at that point will make all the difference. People always want investments to go up like a line…That's just not reality. You make 80% of your money in 20% of the time in investing and you have to be patient…I see some values in some of these foreign markets. I don't see a lot of value in the U.S. stock market and I think you have to play it safe in the U.S. bond market with funds that are really dedicated to having low volatility." 


Embedded below is the video of Gundlach's interview with Bloomberg TV: