Kennon-Green & Co. Fiduciary Financial Advisor, Wealth Management, Global Value Investing

Using Cash to Increase as a Strategic Asset in a Value Investing Strategy Portfolio

One of the least discussed secrets of great practitioners of the value investing strategy is the use of cash, cash equivalents, and bonds to augment returns.  From Benjamin Graham and Warren Buffett to Wallace Weitz and Marty Whitman, intelligent use of excess funds has as much to do with growing your capital over the long run as does selecting individual common stocks.  We’re going to look at some of the techniques that have been used by value investors to manage their reserves, and the role played in the overall portfolio.

Why Value Investing Requires Large Amounts of Cash

The idea behind a successful value investing strategy is to buy assets worth $1 for less than $1, preferably 50 cents or less. The nature of the stock market is that this is not always possible.  Sometimes, stocks will present unbelievable, once-in-a-lifetime opportunity.  At other times, everything appears stupidly overvalued to the point that you can’t earn more than a few percentage points in earnings yield on any shares you own.  During times like this, some find it tempting to stray from value investing to at least feel like they are “doing something”.  In psychology, this is called the action bias.  It can be extremely dangerous for your portfolio.

There are two possible ways to counter this:

  1. Own a collection of other operating businesses (or, if you are an individual value investor and not a company, have a primary source of income) that generates large amounts of excess cash above and beyond what your company, or you, needs to conduct your daily operations or life.  If stocks fall in value, you can redeploy these earnings to take advantage of bargains.
  2. If you have a fixed portfolio value and can’t rely on adding fresh capital to your brokerage, retirement, or trading accounts, you need to keep large cash reserves on the side. These can be utilized when the market crashes, increasing your ownership of stocks at attractive prices.

Potential Places Value Investors Can Park Excess Cash During Dry Spells

There are several investments that may appeal to value investors who want to keep large cash reserves.  These include:

  • United States Treasury Bills, Bonds, and Notes: According to Poor Charlie’s Almanack, billionaire investor Charles T. Munger, Vice Chairman of Berkshire Hathaway, was known by his family to park tens of millions of dollars in family assets in Treasury securities until he found something intelligent that appeared to offer very good rates of return, sometimes buying nothing for years on end.  A classic value investor with a unique twist of only wanting to own excellent businesses, Charlie amassed an impressive record at the Munger Wheeler partnership.  You can read more about him in the article on Charlie Munger Value Investing. Treasurys are particularly attractive because they are free from state and local taxes, and backed by the full faith and credit of the United States Government.  They are generally considered the safest security in the world, making them perfect for value investors that want to sit out of the market until they can find cheap stocks.
  • Federal Agency Bills, Bonds, and Notes: There are a number of fixed income securities that are not technically issued by the United States Government, but they are backed by a guarantee.  The result is they often earn more than Treasury bills, bonds, and notes, making some value investors prefer them.  The Government National Mortgage Association, or GNMA (sometimes written as Ginnie Mae and pronounced “Jenny May”) is part of the United States Department of Housing and Urban Development.  This group buys mortgages from financial institutions such as banks and then gathers them into blocks of $1 million or more.  It then keeps some on its own books or sells them to investors, including individuals, insurance companies, banks, brokers, etc.  The Ginnie Mae bonds are useful for ordinary investors because they can be bought in amounts as small as $25,000 and the regular income you receive includes both income and principal, unlike most other bonds, which pay interest income throughout the life of the bond and then return the original principal at maturity.
  • Municipal Bonds: Municipal bonds are raised by local municipalities to do things such as build roads, bridges, schools, dams, hospitals, or sewers.  There are two types of municipal bonds: Revenue Bonds and General Obligation Bonds.  The former are backed by the specific revenue created from a project.  If the city of New York were to build a hospital and float revenue municipal bonds to do it, the money that investors received back in the form of interest income and principal repayment would come from cash generated by the hospital.  If the hospital fails and doesn’t turn a profit, the bondholders lose.  If the hospital was built with general obligation municipal bonds, however, the payments would be backed by the New York itself, including its taxing power and other sources of income.  Municipal bonds are attractive to value investors because if you invest in bonds of your home state, you may not have to pay any Federal, state, or local taxes.  I know one investor that keeps a portfolio of $1,000,000 parked in municipal bonds and lives off the $40,000 to $50,000 he receives each year without paying a single penny into the government.  As taxpayers, this shouldn’t concern us because he is providing the capital to build the nation’s infrastructure, quite literally!
  • Risk Arbitrage: Almost all great value investors use risk arbitrage as a form of excess cash.  Although returns are much harder to generate today due to market efficiency, 50 years ago, it was easy to generate 20%+ annual returns using this technique.  Discussing how to do it is far beyond the scope of this article.  Just realize that those using a value investing strategy on a professional basis most likely have some sort of arbitrage operation going on in the portfolios they manage.  Often, this centers around mergers and acquisitions.

The Goal of Cash Management for Value Investors

If you are a value investor, your primary goal when investing cash should be to avoid losing money.  That means you need to focus on only high credit quality securities.  Your secondary goal is to generate a return high enough to maintain your purchasing power in inflation-adjusted dollars.  Anything you can do above and beyond this is pure gravy.  Don’t lose sight of your goal and don’t be tempted to reach for too much yield.  The purpose of excess cash reserves in a value investing strategy is to provide a pool of liquidity that can be sold and used to buy stocks when the world falls apart.