Investing The Cash Portion Of An Investment Portfolio

Since about November, I have received a significant amount of e-mail correspondence from readers asking how to approach oil stock investment against the overall desire to maintain adequate cash reserves that act as “dry powder” for attractive opportunities. I haven’t responded to any of those e-mails, but I want to address the question in its broadest form right now: How should the zeal of picking up attractively priced assets be balanced against the desire to maintain proper cash balances for the next opportunity?

First, I think people should avoid fear-of-missing-out syndrome. Benjamin Graham wrote in The Intelligent Investor that “there is always something intelligent to do.” Sure, some environments are easier for finding stocks that will produce outsized future wealth than others, but even the most bubbly of stock markets contain opportunities that deliver attractive returns.

Take the summer of 1999, for example. The P/E ratios of most stocks at the time have been fairly recorded by history as a time of irrational exuberance and general unattractiveness for those wishing to make value-based long-term purchases.

And yet, if you had a broad enough knowledge base of common stocks, there were many intelligent things you could have done. The most attractive industry at the time was tobacco, as the P/E ratio of the leading players fell to the single digits in response to the very expensive terms of the Tobacco Master Settlement Agreement (MSA) between Philip Morris, R.J. Reynolds, Brown & Williamson, Lorillard and 46 U.S. States.

A summer of 1999 investment in Philip Morris, Inc. would give you 19% compounding across companies that are now: Altria, Philip Morris International, Mondelez, and Kraft-Heinz. An investment in Reynolds America would have been one of the best investments you could have that summer, as it went on to compound at 24% annually and turn $10,000 into $339,000.

If the uncertainty of the final toll from the tobacco litigation or ethical principles deterred you from considering the stock, there were still plenty of other opportunities to outperform. Brown Forman, a Dividend Aristocrat and excellent builder of alcohol brands, compounded at over 13% from the highs of 1999. Lowe’s home repair went on to compound at 11%, Hershey did its historical thing and returned 10% per year, Church & Dwight would have been a real good pick that went on to deliver 17.5% annual returns, the utility Southern Company returned 11.5%, my favorite water utility Aqua America returned almost 13%, Airgas gave you almost 18% annual returns, the Union Pacific Railroad returned 12.5%, and T. Rowe Price as well as Nestle returned over 11%.

By contrast, the S&P 500 (including dividends) returned 4.1% during this same time period. The “classic” dividend stocks, like Clorox, PepsiCo, Colgate-Palmolive, Abbott Labs, Kellogg, General Mills, and Johnson & Johnson all returned between 7% and 9%. They were all trading at P/E ratios that none of them had ever seen since becoming large-caps, and they still went on to compound satisfactorily as the core earnings power eventually burned off the grotesque valuation (others, like Coca-Cola and Pfizer, had such ridiculous valuations that time still hasn’t healed the wounds). My favorite statistic from this time is that Wells Fargo, a mega-cap bank that endured the destruction of the financial crisis, still went on to outperform Colgate-Palmolive and Johnson & Johnson over the 1999 stretch. Wells Fargo shareholders got 8.18% annualized, Colgate got 8.17%, and Johnson & Johnson got 7.49%.

Performing this type of analysis during any other period would be considerably easier. My point is that, even in environments that are blatantly inhospitable for value investing, there are still things to beat the market. You could have found a food giant, utility, mutual fund firm, home improvement store, chocolate company, alcohol giant, bicarbonate producer, an old railroad, or the legacy tobacco industry and still done well. That’s a wide range of industries that could have helped an enterprising investor get rich.

I mention this to say that there is no necessity to spread yourself too thin. I can’t think of a worst year to invest large sums of money than 1999, and you still could have made intelligent investments that consisted solely of large firms that are well-known to those with a basic familiarity of investing.

Applying that abstract principle to the specific, sure, it is possible and even likely that the oil stocks of today will go on to reinvest when you compare Chevron, Shell, and Exxon with dividends reinvested 2015-2030 to the S&P 500 in general. But from that observation, you should not extrapolate and conclude that those stocks must be purchased right now at any costs. Oil, or Tiffany, or Diageo, or Hershey, or whatever, may be attractive investments today, but there will be 75 MPH fastballs coming over the middle of the plate in 2017, 2018, 2019, and 2020.

When you are first starting out, the point is to get your hands on some initial cash generators through the public markets. There’s no real point to holding cash yet as the priority should be placed on things that are producing cash. You try to find the most attractive thing you can at the time, and then add to a collection of things that generate cash for you to deploy later. It doesn’t matter what you thought about the future of the markets back in 2012–it was obvious that Johnson & Johnson at $61 per share was a good deal. Even assuming no dividend reinvestment, that 2012 allocation in JNJ stock will be paying out 5% in a few months after the annual dividend hike. You’ll be collecting $500 on every $10,000 deployed in 2012.

I call it the “You don’t have to get GE at $6 to make good investments principle.” You could have paid $10, $15, $20 per share and still earned double-digit returns. For someone starting from nothing and trying to build wealth, I don’t see the element of holding cash–the point is acquiring the initial assets that throw off the cash in the first place. Once you have a passive income engine that is generating $1,000+ per month, then you can start turning towards the question of holding dry powder and thinking about how to deploy it (the whole premise of this post assumes that someone has an adequate “emergency fund” that is separate from investing. If not, that should be tended to at first, as it would be incredibly suboptimal to risk having to sell cash-generating assets to meet the needs of life).
This is more art than science, but I think that once you are in the dry powder stage, it would be wise to try and save enough cash so that you can make establish five “normal sized” positions during periods when the S&P 500 falls by 20% or more. That’s enough to enable you to seize the moment while also limiting the cash drag of cash during extended bull markets like we saw from 1982-2000 with only very short windows in 1987 and 1990-1991 to be seized.

The reason why I call it more art than science is because you can never weigh with certainty the opportunity costs that lay ahead. If Coca-Cola were available at $25 per share a year from now, or Hershey available at $55 per share a year from now, it would affect the relative attractiveness of today’s offerings. You also need to come up with a game plan that lends itself to psychological stability–you don’t want to bang yourself up over whether a stock gets cheaper after you bought it because the arrival of that opportunity was at least partially (or perhaps fully unknowable).

That’s why my writings encourage you to ask yourself the question: “Is stock X at price Y a good deal?” rather than “Is stock x at price y the best deal ever?” That’s my incorporation of behavioral analysis. You can analyze whether something is objectively attractive, but you can never know before the fact whether that was the best deal possible. With Chevron, a day will come when the purchasers at $100 and even $110 will be vindicated. The intelligence of that purchase needn’t be undermined because a $70 or $80 price tag came along shortly thereafter. Otherwise, you might be claiming to be a long-term investor when you really have the characteristics of a trader that cares about the stock price six, twelve, eighteen months later.

Broadly speaking, I don’t think storing cash is something to focus on in the early days. The objective is to find cash generators at attractive prices, and you should be able to make do based on what the market currently offers (even 1999 had some great opportunities). As the cash generators start to produce meaningful income, then the dry powder position should be built up so as to allow “meaningful participation” in the event of a 20% S&P 500 correction. I try to put some meat on the bones of that term by defining it as the ability to make five full-sized investments during a recession beyond what you can generate passively during the crisis.