U.S. Markets closed

When Should You Hold More Cash?

Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) reported a record $122 billion in cash on its balance sheet at the end of the second quarter.

This is a tremendous amount of cash to have, and it's a level even Buffett himself is uncomfortable with. In his most recent letter to shareholders, the Oracle of Omaha said Berkshire's liquidity is "far beyond" the level he would like to have.

He went on to add the conglomerate would like to deploy some of this "excess liquidity" into businesses that the group will "permanently own." However, the prospects for that "are not good" at the current time because prices for companies with attractive long-term prospects are "sky-high."

Deploying cash

Until recently, Buffett had been redeploying some of this capital into equities, particularly stocks like Bank of America (BOA) and some of the airlines.

But he stopped buying equities in the second quarter, only adding modest sums to Bank of America, US Bankcorp (NYSE:USB) and Amazon (NASDAQ:AMZN) (the latter was actioned by one of his investing lieutenants).

Buffett's decision to stay out of the market has attracted some criticism, mainly because equity markets have been so strong over the past decade.

1124623228.png

At the Berkshire 2019 annual meeting of shareholders, one investor put it to Buffett that if the group had invested its $122 billion in cash and cash equivalents in an index fund, after the equity market rally over the past 15 years, the position would be worth $155 billion.

Responding to the question, Buffett said he "wouldn't quarrel" with the numbers presented and he would rather "own an index fund than carry treasury bills." That being said, he cautioned that this approach would have tied his hands in 2007-08 and Berkshire's returns might have suffered in the years after the result. The best chances to deploy capital, he summarized, come when "other people don't want to allocate capital."

Thinking like a business owner

Holding cash versus investing is one of those age-old questions. Some investors prefer to hold a lot of cash and have generated fantastic results even while doing so, while others like to be fully invested.

One of the best discussions on the cash verses stocks debate is Seth Klarman (Trades, Portfolio)'s 2004 year-end letter to investors of The Baupost Group. In the letter, Klarman outlined his "painful decision to hold cash," and explained why it was important to do so even if it meant giving up on some investment gains.

He summarized the section with this particularly relevant quote:


"Investors expect corporate managements to make carefully reasoned decisions, such as whether or not to commit their capital to build new factories, hire additional staff or acquire a competitor. A corporate management that invested capital at low expected returns just because they had the funds at their disposal and nothing immediately better to do would inevitably arouse investor ire. Why, then, should any investor (hedge fund, mutual fund or individual) always deploy 100% of their capital into marketable securities, applying none of the analytical rigor or intellectual honesty they would demand of the underlying corporate managements? As we said last year, why should the immediate opportunity set be the only one considered, when tomorrow's may well be considerably more fertile than today's."



Investing is like a business

For so many investors, buying and selling stocks is all about trying to beat the market. But at its core, investing is a business as well. Good businesses make sensible capital allocation decisions and do not waste shareholders' funds.

The same must be true for investment funds and investors; in fact, it is relevant to every single investor. For example, I like to invest in cash-rich businesses with little debt and attractive levels of free cash flow. It would be downright foolish to ignore this and run my own finances differently.

So even though Klarman penned this advice a decade and a half ago, it is still extremely relevant today. The next time you are thinking about whether or not you hold too much cash in your portfolio (or if you should be earning better returns), thinking like a businessman and asking yourself if you can generate attractive returns on that capital if invested, might give you a definite answer.

Disclosure: The author owns shares of Berkshire Hathaway.

Read more here:



Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.