Sitting on the sidelines - patiently

Times are tough for investors, especially those of the value discipline. It is hard for a genuine value investor to get too excited about the usual asset classes.

Sure, there are always gems among the rocks but, on the whole, stocks and bonds are not priced to offer any compelling reason to buy. Similarly, most other assets, from emerging markets to real estate investment trusts, are priced to the gills and require a leap of faith bordering on a fairy tale.

I have included a sizable dose of cash holdings in my portfolios for some time now. In normal times, a given portfolio might only have 2 to 3 percent in cash. In these not-so-normal times, I have been holding around 20 percent, even for long-term risk-seeking investors.

I do my valuation analysis, I find the valuation wanting, and I move money into cash. Cash is the default hiding place. It’s where we go with our money while we are waiting for something better to come along.

However, cash isn’t really cash. Strictly speaking, cash means money: nominal dollars, the proverbial cache stuffed under a mattress. In real life, we actually buy things with our cash. We buy very short-term, very secure investments that we refer to as cash equivalents.

The usual candidates are savings accounts, money market funds and certificates of deposit. I would also consider short-term bonds such as 13-week Treasury bills as cash investments. While some certificates of deposit are deemed to be cash-equivalents, any CD maturing in more than a year is not a true cash investment.

Cash is our safe harbor. Yet there is another aspect to cash equivalent investments. Just as we perform valuation analysis on stocks and bonds, we can also perform valuation analysis on cash. If cash investments are cheap, we might want to over-weight them on their own merits rather than as simply a hiding place from riskier investments.

Valuation analysis starts with asking the question: What is a fair rate of return for this asset? We then determine whether the asset is currently priced to provide that rate of return. If the expected rate of return is above our fair-return threshold, the asset can be considered cheap.

Cash and cash-equivalent investments are the refuge of the risk-avoiding investor. One can venture out to sea and brave the storms in pursuit of riches, or one can stay safely in port. If I choose to stay in port, do I really deserve much in the way of investment returns?

No, not really. I would make the case that the risk-avoiding investor should only expect to break even over time. In our modern economy, breaking even means after taxes and after inflation.

Economists and other policy wonks have argued that the appropriate target for the Federal Reserve’s short-term interest rate is a rate that provides investors with the bare minimum to pay taxes and keep up with inflation. In other words, if you stay in port, do not expect to profit from the entrepreneurial economy.

The invisible hand of market economics will help to ensure that this is the case.

With short-term, high-quality cash-equivalent investments paying around 5 percent right now, it so happens that after-tax returns are very close to the reported rate of inflation.

While there exists some disagreement over whether the reported rate of inflation is accurate or not, we at least know that it is in the ballpark. As such, I consider cash investments to be smack in the middle of the fair value range at present.

Some investors are not satisfied with these low yields at the moment. When cash is only providing a break-even real return, investors are tempted to move into riskier investments with the potential to earn more. I encourage caution here.

The only way any investment pays more than cash is if it entails one form of risk or another. There is no free lunch. You can get a higher yield on a two-year CD than on a money market fund. The CD pays more because it is riskier; your money is locked up for two years.

Similarly, do not be tempted to buy stocks simply because cash doesn’t provide a high yield. You would be moving from an asset class that is priced in a fair-value range to one that is priced far into the over-valued range. That has never been a good strategy.