Cash and its Place in a Portfolio

Reflections #6

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Today, we’re diving into a topic that’s often overlooked but is of great importance for long-term investors: the strategic role of cash in a portfolio. While many view cash as a performance drag, we believe it's a crucial asset for managing risk and seizing opportunities, especially when running a concentrated portfolio.

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The Power of Cash

Some of the most successful investors in history, including Warren Buffett and Seth Klarman, have demonstrated the strategic importance of maintaining significant cash reserves. Let's explore how these legends have leveraged cash to their advantage and what lessons we can draw for our own portfolios.

Warren Buffett's Cash Strategy

Warren Buffett, is renowned for his value investing approach, but what's less discussed is his strategic use of cash and cash flows. As of June 30, 2024, Berkshire Hathaway's cash and cash equivalents totalled $276.94 billion. This might seem counterintuitive for a man who once said, "Cash is always a bad investment".

However, Buffett views cash not merely as an investment, but as dry powder - ammunition to be deployed when opportunities arise. This approach has allowed Berkshire Hathaway to capitalise on market downturns and make significant acquisitions when other investors are fearful. During the 2008 financial crisis, for instance, Buffett's cash reserves enabled him to make highly profitable investments in companies like Goldman Sachs and Bank of America.

“Be fearful when others are greedy, and be greedy when others are fearful.”

—Warren Buffett

But Buffett's cash strategy goes beyond just holding reserves. He has masterfully engineered Berkshire Hathaway to generate consistent cash flows, creating a effective cycle of investment opportunities:

1. Insurance Float: Berkshire's insurance operations provide a significant source of cash flow. The "float" - money collected in premiums but not yet paid out in claims - serves as a form of interest-free loan that Buffett can invest.

2. Cash-Generating Businesses: Buffett has consistently acquired businesses that generate strong, predictable cash flows. These range from utilities to railroads to consumer goods companies.

3. Dividend-Paying Stocks: Many of Berkshire's stock holdings pay substantial dividends, providing another steady stream of cash.

4. Capital-Light Businesses: Buffett favours businesses that require minimal reinvestment, allowing more cash to flow back to Berkshire for redeployment.

The predictability of Buffett's constant cash inflows allows him to make opportunistic investments without needing to sell existing holdings, and enables more precise financial planning. This therefore reduces the need for excessive cash reserves as a safety net all the time.

However, its important to note that Buffett does view excessive amounts of cash as “unnecessary and bothersome”. In a 2009 interview with Charlie Rose, Buffett likened cash to oxygen — essential in sufficient amounts for security but unproductive and depreciative when stockpiled.

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Seth Klarman's Cash Philosophy

Seth Klarman, founder of the Baupost Group, shares a similar perspective on cash. Klarman views cash as both a risk buffer and as "dry powder" for seizing market opportunities. Unlike many growth investors who aim to stay fully invested, Klarman is comfortable holding substantial cash positions when valuations are high.

"Cash is the ultimate risk aversion. But clients are uncomfortable about it. Why people should pay a money manager to hold cash? They are paying the manager to wait for the opportunity to invest."
—Seth Klarman

Klarman's strategy emphasizes long-term returns, underlining the importance of conviction and adaptability in value investing. He believes that holding cash in the absence of opportunity makes sense, as it preserves capital while awaiting better value.

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The Way We View Cash

Our view on cash takes a lot of inspiration from both Buffett and Klarman. When our cash pile grows too large, it can feel like a burden, especially when our portfolio is experiencing significant inflows. However, we'd rather have too much cash than rush into investments for the sake of being fully invested.

Having dry powder ready to deploy when opportunities arise is far preferable to owning lower-conviction positions or overpaying for assets. This approach requires discipline, but it aligns perfectly with our strategy of running a concentrated portfolio. We invest only in our best ideas, and when we find them, we bet big.

We've also noticed that our cash position often serves as a useful barometer for market valuations. When cash accumulates, it's usually a sign that we're struggling to find great values. Conversely, when we're deploying cash rapidly, it often indicates an abundance of attractive opportunities.

This approach echoes the principles of a barbell strategy, which typically balances low-risk assets with high-risk, high-reward investments. Although not a textbook barbell strategy, holding a significant portion of cash alongside a concentrated portfolio captures the essence of blending safety with opportunity, avoiding the middle ground of mediocrity. We don’t view our concentrated investments as inherently risky—quite the opposite. With our deep understanding and selective positioning, we mitigate much of the risk typically associated with volatility. While traditional barbell strategies focus on managing risk by splitting between extremes, our adaptation allows for lower volatility and flexibility, particularly in portfolios that might otherwise experience sharp fluctuations. It’s a useful mental model for appreciating the balance between being opportunistic with cash and fully invested in high-conviction ideas.

As a general rule, we aim for a cash allocation of around 5-15% when inflows are steady. This percentage may rise if inflows slow or if we're struggling to find value in the market. Regardless, we always strive to maintain at least a 5% cash position, even when inflows are strong, to ensure we're prepared to capitalise on any unexpected opportunities.

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Conclusion

In conclusion, cash isn’t just a passive part of the portfolio—it’s a strategic tool. By adopting a thoughtful approach, inspired by investors like Warren Buffett and Seth Klarman, we can use cash to manage risk and seize opportunities.

Remember, the stock market is a no-called-strike game. There's no penalty for waiting for the right pitch. Our job is simple: watch the game carefully, wait for a fat pitch, and swing hard when it comes. As Nassim Nicholas Taleb wisely noted,

"Optionality is simply the right to take an action, with no obligation to do so—hence you can only benefit from it and never lose."

—Nassim Nicholas Taleb

By holding cash, we maintain the optionality to seize opportunities as they arise, while protecting ourselves from unnecessary risk. It’s as simple as that.

We hope this post has been insightful. If you found it valuable, feel free to share it, and stay tuned for our next edition!

Have a great rest of your week,
The S.C. Team

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Disclaimer: The content provided in this newsletter is for informational purposes only and does not constitute financial, investment, or other professional advice. The opinions expressed here are those of the author and do not necessarily reflect the views of Schwar Capital. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. The author may or may not hold positions in the stocks or other financial instruments mentioned. Always do your own research or consult with a qualified financial advisor before making any investment decisions.