When investors seek to beat the market, the discussion revolves around which stocks will comprise one’s portfolio. This is as it should be; however, allocation can be used as another tool to best the market. Allocation is simply the pieces that make up a portfolio. This could mean stocks, bonds, gold, REITs, etc. There has been a mind-numbing amount of research done around this subject, but I will solely be talking about the cash portion of a portfolio otherwise composed of equities. This article is somewhat of a philosophical approach to portfolio management revolving around the types of equities to hold and how to incorporate cash in order to beat the market averages.
Investors typically go through a lengthy process to research and select stocks. However, even stocks that appear attractive relative to their peers can result in substantial losses if the overall market declines shortly after shares are purchased. This is called systematic risk. It is risk that cannot be diversified away. Therefore investing in the greatest stock in the world likely won’t keep your shares from losing value if there is a downward revaluation of the entire system. Professional investors and retail investors are both susceptible to this risk. One would think that a professional would be able to determine if the overall market was overvalued and avoid investing on the brink of a market fall, but this has not proven to be the case time and time again. Ken Fisher, Warren Buffett, and countless other professional managers saw their holdings rapidly shrink after October 28, 2008. If the best minds in the investing world are not immune to broad based market moves, how can anyone else be expected to consistently determine when they will occur and time their investments accordingly?
It is impossible for an investor to purchase shares after a market fall, sell at a market peak, and repeat this cycle with any kind of regularity. Attempting to do so will almost certainly guarantee the investor underperforms market averages, and likely by a wide margin. To accommodate for the fact that nobody can see when exactly a downward market move will occur, it is wise to hold a large cash position. By fully investing in equities and taking your cash holding to zero percent, you are essentially handcuffing yourself. I like to say you are, “Holding and hoping.” Of course, if you have done your due diligence the stock will perform better than the market, but you could miss out on even greater outperformance because you are locked in. If you loved a stock at $25, wouldn’t you love it even more at $20? A large cash buffer gives investors the opportunity to be flexible and buy on market declines. Buying at these lower levels increases the probability of subsequent outperformance and can actually reduce risk.
Obviously this strategy seems tailored to investing in falling markets. The biggest risk is keeping a lot of cash on hand during a rapidly rising market because the investor is earning zero percent on the cash which can be a drag on the portfolio’s return. That takes us to the type of equities that make up the portfolio. In order to keep up with the market while also holding a large percentage of cash, it is important to hold stocks that are more volatile than the overall market. The most common metric used is a security’s beta. Beta is simply a regression analysis that compares a security’s returns to that of the S&P 500. However, beta is not always perfect. Just as past returns are not necessarily indicative of future returns, past volatility is not necessarily indicative of future volatility.
To determine a portfolio beta, merely multiply each stock’s beta by the portfolio allocation. (Assume that the beta of cash is zero.) Then sum this number to reach a portfolio beta. The portfolio beta should come out to around one to ensure that the portfolio will earn returns in line with the S&P 500 even if the investor gets caught in a rising market and cannot deploy cash at lower levels.
The goal of this strategy is to keep up with the S&P 500 if one finds himself in a rising market shortly after a purchase, but the big time outperformance comes from buying at depressed levels. I learned this lesson first hand. During the Financial Crisis, I began looking at blue chip companies that had precipitously fallen. I knew they did not have the same default risk as smaller firms, and the implied growth rates were far too pessimistic. One example of the strategy at work was first buying CAT at $43.10. Had I made a larger initial investment and handcuffed myself, I still would have earned a healthy profit. However, the heavy cash allocation allowed me to purchase CAT all the way down to $24.92. Over the lifetime of the investment (I sold at $87.51), the shares outperformed the S&P 500 by 279%. The same approach allowed me to get a better average price on BP shares. After the spill, I believed that the amount of market cap lost was far greater than that of the ultimate spill costs. I first tested the waters at $48.75—down almost 20% since the spill but actually higher than today’s price of $46.65. The flexibility afforded by my cash holding allowed me to make two more purchases—the lowest being at $29.11—and lower my average price to $36.39. I did not catch the absolute bottom, but the BP holding has outperformed the S&P 500 by 16.1%. Keep in mind that had I taken all funds ultimately invested and dedicated those to the first buy, I would be sitting on a 4.3% loss while underperforming by 16.3%. This strategy of holding a large proportion of cash offers an additional margin of safety to investors because all future prospects are not contingent upon one buy point.
As mentioned above, the strategy of buying on declines can actually reduce risk. There is a false belief that stocks that have performed poorly over a certain period are more risky than those that have performed well. Of course, there can be reasons a stock has fallen. Perhaps earnings are deteriorating, maybe the product line is becoming obsolete, or possibly there is a default risk. It is imperative to differentiate good value stocks from value traps. Assuming an investor is able to avoid value traps, buying after a decline greatly enhances the risk/reward characteristics of a stock. Here is an oversimplification with all things being equal: a stock that has declined and is now closer to zero does not have as far to fall as a soaring stock. The downside risk shrinks while upside return potential correspondingly rises. Holding a large cash position also mitigates risk in a falling market because as the market falls (allowing you to buy at more attractive levels) your cash has been “outperforming” the market and can be deployed at levels that will likely generate market beating returns.
I have avoided presenting any hard and fast trading rules such as buying after a pre-specified percentage drop, initially investing “x” percent of the portfolio in a stock, or allowing for “x” number of future buys. My goal was to make this a thought provoking article to allow investors to consider how utilizing cash in this manner might have changed his or her returns. For the sake of this article, stock selection was largely ignored to focus on allocation. By coupling excellent companies with a flexible allocation, investors can use systematic risk to their advantage in order to make outperformance far more likely.
Disclosure: I am long BP.