The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash. Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of forgone opportunities.
–Seth Klarman, Margin of Safety
I have a footnote scrawled in by this quote. ”I need more cash.”
Am I wishing I had more cash right now? Lord, yes I am. After ’08-’09, I became fully invested in companies I wanted to hold forever, and I still want to hold them well into my old age as they’ll still be kicking long after I’m gone. The problem is that we have another buying opportunity on our hands, albeit a smaller one, and I’m lacking in dry powder.
Outsize returns come from the ability to take advantage of the few opportunities you’re given. I am certain an institutional asset manager’s underperformance is caused primarily because asset managers are often fully invested at the wrong times, and on top of that, they lose cash through redemptions from investors at those exact wrong moments as well. (Note to self, never become an institutional asset manager or give them money.)
So what’s a value investor to do? My holdings weren’t throwing off much in the way of dividends nor did they reach fair value by the time this latest “looks like some hedgies had a massive margin call” fire sale. And, even if they had been at fair value, I probably wouldn’t have wanted to sell them unless they were grossly overvalued. Should I re-evaluate my cash balancing process? Many smart investors would say yes, but I still hear the raspy voice of Charlie Munger, saying that the best thing about buying something you can hold forever is that you get to earn returns on the money you owe Uncle Sam. I think there’s a different path.
Be Like USB
US Bank does something a little bit different than the other plain, vanilla banks. Their wealth management and merchant processing divisions add an enormous amount of extra income, so much so that it boosts their ROA to above 2% during good times. Now, many other gigantor banks offer services outside their core lending, but generally they’re smaller sections used to make customer switching a little harder as well as offset the costs of some of the perks they offer. Seldom do they raise their ROA to a level that US Bank achieves.
This extra income has allowed US Bank to plow right through the financial crises of today as they’re one of the few with the cash flow to take advantage of it. Good banking shares so many characteristics with good investing, and the past three years have been a beautiful display of careful, undervalued acquisition of assets. It would make Ben Graham proud if a zombie version of him suddenly rose from the grave and lumbered his way to Minneapolis for a closer look.
Normally, I find “diworsification” from a core business to be a bad idea. Every now and then though, you find places where a dual pronged approach produces something great. It’s exceedingly profitable to be amazing at one thing, but if you can be good at two and let them play off each other, you can achieve amazing results as well, and often that’s the more doable option.
Maybe Buffett Didn’t Have to be the Greatest Stock Picker
Do I think I can be an amazing stock picker who always has cash at the right times? Nope. Do I think that every few years or so, I can identify great companies trading at valuations with a significant margin of safety? Definitely.
I have no illusions that I’ll ever be able to summon Klarman/Berkowitz like abilities, but I can apply something else. An alternative asset class that I think more value investors should consider. Their own business.
Berkshire succeeded because it owned businesses that supplied it with cash to invest, whether it was float from insurance or cash cow small businesses with durable advantages. I’d argue that this was the primary source of Buffett and Munger’s success. If you have ready cash and no investors that can cause redemptions at inopportune times, you don’t have to be the greatest stock picker, just a good one. The genius was in picking businesses that supported more investing, predictable businesses that readily supplied cash. And, if you owned them wholy, you would not be taxed twice. That was the key part in Berkshire’s outsized returns. It was not just some magical research ability, it’s that they had more cash at the ready than most folks.
It’s a point I think many value investors don’t ask themselves when they’re busy looking at the value of companies. Does this investment help me make the next investment? Sure, you can own a lot of undervalued property in north-western Florida. But, is it going to reach fair value or return you more cash to invest any time soon, or be able to do so for a lifetime in a predictable manner?
Most of us don’t exactly have the funds to buy businesses outright and place them in a holding company. However, we do have another ability, and that’s to start one. We spend years studying businesses, and even though theory is a great deal different than practice, I have to imagine investing gives us some intuition on principles for running a good business. The difficulty of starting a new business, especially if you have some capital, continues to get easier and easier. Given the services available over the internet, one and two man shops are more of a possibility than ever before. Sure, it’s difficult and requires a great deal of time, and I’m presently figuring out how best to build ours, but the ultimate goal is to build a cash cow that acts as a great alternative investment class to just publicly traded companies. Nothing teaches how to analyze a business better than trying to run one. Investing and running a business are very much skills that play off each other. In future posts, I’m looking forward to showing some of the surprising places where value investing can be applied when running a business and showing just how important and achievable a business can be at earning outsized returns. At the end of the day, the goal is the same, to buy and build things that are of substantially greater value than initial costs.
So, perhaps if I was solely focussed on stock picking, I might need to re-evaluate my process, and have some means of selling parts of the things that support me to make sure I have enough capital on hand, which strikes me as a very Citibank-esque thing to do. Or maybe I can build a business that will help me earn through every crisis and act on the few great opportunities we’re offered. I think I have a better chance of building a decent company than I do of being a fantastic stock picker. My only mistake is I didn’t have it in place before I started investing.
Full Disclosure: I own USB. If I had more cash, I’d likely buy more.
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