For the past several years, Seth Klarman (Trades, Portfolio) has ended the year with an inordinately high cash position in his hedge fund, The Baupost Group. Many institutional investors seem perplexed as to why the guru has steadfastly refused to partake in the upward movement of the market, a posture that puts him at odds with the conventional wisdom.
The same question has been asked repeatedly of Warren Buffett (Trades, Portfolio), who has maintained a massive cash position for Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) for the better part of the last decade. Since Klarman and Buffett both are steadfast disciples of Benjamin Graham, their response to critics is the same: stocks will be purchased on a timely basis only when appropriate opportunities for investing in an undervalued business arise. Should prevailing market conditions be at odds with this strategy, Buffett and Klarman are both unabashedly content to hold cash.
Klarman articulated this fundamental principle in his 1997 letter to investors, within the context of an environment of market turbulence. He posed the question, what should value investors do to guard against risks in a sudden and precipitous market downturn?
The guru discounted the utility of traditional hedges, as well as short positions, as the cost of premiums for such strategies has increased appreciably over the years, in lockstep with market surges as well as during periods of acute volatility. Though Klarman was referring to market conditions in 1997, the same reasoning applies today because of similar market indicia.
Though Klarman contends that cash may be appropriate, he is nonetheless careful to note the tradeoff between foregoing opportunity costs and maintaining sufficient cash to avail oneself of selective bargains during market downturns.
“Cash provides protection in a storm and ammunition to take advantage of newly created opportunities, but holding cash involves the considerable opportunity cost of foregoing presently attractive investments. Given the choice between holding mostly cash awaiting the periodic market tumble or finding compelling investments which earn good returns over time but fluctuate to a certain extent with the market amidst turbulence, we choose the latter. Obviously, we could not have earned the returns we have from investing, without investing.”
Another reason to maintain a relatively sizeable cash position is that it allows astute investors with long-term horizons to reap the rewards for those who abide by one of the fundamental principles of value investing that remains as pertinent today as it was when first enunciated by Graham & Dodd long ago. Klarman restates this important tenet:
“I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone, with any investment strategy or none at all, can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk.”
In 1997, Klarman maintained a 25.5% cash position in his hedge fund, in part, because it allowed him to implement his unwavering fundamental value investment strategy, which was appropriate for the turbulent market environment at the time.
“In a stormy market, the value investing discipline becomes crucial, because it helps you find your bearings when reassuring landmarks are no longer visible,” he wrote. Having sufficient cash available allows an investor to maximize the advantages of a value investing approach because it provides a sufficient margin of safety.
Klarman noted that during downturns or prolonged and unpredictable periods of market tergiversations, while growth or momentum investors may flounder:
“…the value investing discipline tells you exactly what to analyze, price versus value, and then what to do, buy at a considerable discount and sell near full value. And, because you cannot tell what the market is going to do, a value investment discipline is important because it is the only approach that produces consistently good investment results over a complete market cycle.”
Klarman refuses to pay up for growth, nor will he buy businesses that may soon be obsolete. His fund’s relatively high cash position allows him to take advantage of short-term market volatility that may present investment opportunities for stocks whose prices abruptly drop because they have suddenly fallen out of favor with Mr. Market.
For Klarman — as well as for Buffett — if scrupulously following value investing principles in an uncertain market environment requires an inordinate cash position, then so be it. Going against the conventional wisdom has never been for Klarman an occasion for abandoning his long-term value investment program.