Hold Cash: Wait till You Get Offered 65 Cents on the Dollar
A Focused Compounding member who fears the stock market is expensive posted this comment:
“Hi Geoff,
S&P today is expensive based on TTM PE of 24 and CAPE of about 30. An investor whose holdings consist entirely of stocks outside S&P500, will still see a drop in the prices of her equities if the S&P falls even if she has bought her holdings significantly below their estimated fair values. In your opinion, what’s the best way to position oneself going forward with the goal of course being total portfolio returns outpacing market returns in the long run?
change to 100% cash position (to take maximum advantage of potential future price drop)
2. 20% or so equities and about 80% cash (so as to take advantage of potential price drop)
3. Ignore the market completely and keep current balance of about 80% equities, 20% cash
4. Any other thought besides the above three.”
The option that comes closest to what I’d suggest is #3 (“Ignore the market completely and keep current balance of about 80% equites, 20% cash”).
But, let’s walk through why that is.
First, do I think the market is expensive?
Yes.
In an August 29th post, entitled “The Market is Overpriced: These 3 Stocks Aren’t” I wrote:
“I’ve never seen a time when it’s as difficult to find a good stock to buy without overpaying as what I see right now.
But, I don’t think that means you should be 100% in cash. I think it means you should be in stocks like:
Cheesecake Factory (at $41 as I write this)
Omnicom (at $73 as I write this)
And Howden Joinery (at 412 pence as I write this)
If the market as a whole is overpriced, it will fall. And when it does fall: it will take stocks like Cheesecake, Omnicom, and Howden with it.
In time, they will recover.
And you will be able to look back – 5 years or more down the road – and say that buying stocks like these at today’s ‘not overprice’ levels and holding them wasn’t a mistake.
You don’t need to get out of the market.
But, you do need to be more selective than ever now that the market is more expensive than ever.”
The second question is: how have I positioned my own portfolio?
My account has 30% in cash right now. I expect that to rise to 35% sometime soon (when I sell a small position).
My 30% to 35% cash position is not a market call. I’m going to spend the rest of this article explaining what it really means when you see me holding cash.
With most investors, a 30% to 35% cash levels means they have thought about portfolio allocation and decided that 30% to 35% in cash is a good level to be at right now because of the risk level in the overall market.
For me, that’s not true.
The truth is that I like two stocks – and only two stocks – enough right now to keep holding them. Those two stocks are: Frost (CFR) and BWX Technologies (BWXT). As of August 1st, 2017 these stocks accounted for 42% and 23% of my account. Frost has dropped since then, so those percentages are not up to date anymore. But, the rough idea that I have about 20% of my portfolio in my second favorite stock (BWX Technologies) and 40% of my portfolio in my favorite stock (Frost) is true.
The fact I am so concentrated in my approach to stock picking makes understanding my cash levels in terms of portfolio positioning difficult. I’ve been at around 35% in cash before. The fact I have 35% of my account in cash doesn’t mean I’m especially bearish about the market. I am, actually, especially bearish about the market in the sense I think it is overpriced and will perform badly in the years ahead. But, that’s not why I have 35% of my portfolio in cash. I have 35% of my portfolio in cash, because I can’t find anything to do with that money.
What do I mean by “anything to do?”
Let’s look at the two stocks I own as examples.
I am holding my shares of BWX Technologies (my second favorite stock) even at $54 a share. This does not mean I would buy more shares of the stock. My cost basis in BWXT (this figure is adjusted for a spin-off, because I bought pre-spinoff and then sold my shares of B&W Enterprises) is $19.32 a share. So, BWXT is now about 2.7 times more expensive than when I bought the stock. That’s also why the position is near 25% of my portfolio. This was actually a smaller than normal position for me initially. I put about 20% of my account into Babcock pre-spinoff and then I didn’t buy more shares of BWXT after the spin-off. In fact, I sold shares of the spin-off (B&W Enterprises). So, my investment is similar to if I had put 10% to 15% of my portfolio into just BWXT right after the spin-off happened.
Usually, a new position for me is closer to 20% to 25%. So, I think I made a mistake here by not buying more BWXT after the spin-off to make it a 20%+ initial position for me. It’s at that level now, because BWXT has outperformed other stocks since the spin-off. Since the spin-off, I think BWXT is up something like 119% and the S&P 500 is up something like 19%.
Would I buy more BWXT shares now?
No.
And I don’t recommend you do either.
BWXT trades at a P/E very close to 30 right now. I think the stock should, perhaps, sometimes trade at a P/E very close to 30. It’s a wide moat business. The company’s key source of profit is supplying nuclear reactors for the U.S. Navy’s aircraft carriers and submarines. I don’t expect other companies to compete in this area. So, I expect BWX Technologies will continue to be the monopoly supplier of nuclear components for the U.S. Navy. The company has guided for annual EPS growth in the “low single digits” for the next “3-5 years”. If achieved, that might be enough to keep the P/E multiple from contracting – but it’s certainly not enough to justify a higher P/E ratio.
In a more normal interest rate environment, I think BWXT shares should have a P/E of between 20 and 30. If the company grows EPS by 10% a year over the next 5 years while the P/E contracts from today’s level of 28 to a future level of 20, you’d only get about a 2.5% annual gain in the share price. There’s a 1% dividend yield right now too. But, overall, we are talking about a likely future where you could be making not much better than 3% a year over the next 5 years. Of course, the stock’s P/E could fall even further. If it did, I’d recommend buying the stock. I don’t think BWX Technologies should ever have a P/E below 20.
If you’re asking what my appraisal value is rather than where the market could value the stock in the future, you’d get a different annual return expectation. I think the stock will be worth about 25 times earnings even 5 years from now. So, if you got a 10% annual growth rate in EPS for the next 5 years, you’d get about a 7% annual gain in the share price (for it to end up at a P/E of 25 in 2022) and then you’d have that dividend I mentioned. It works out to around 8% a year. If you put a gun to my head and demanded to know what I thought your annual total return in BWX Technologies would be over the next 5 years, I’d say 8%. That’s better than what I expect the S&P 500 to do. I like BWX Technologies better than the market overall (I think it’s safer). And so, that’s why I continue to hold it.
Would I sell BWX Technologies?
Yes.
But, if and only if I had something better to buy.
Since I have more than 30% of my portfolio in cash right now and a new position for me is usually 20%, I know I don’t need to sell anything yet. There’s certainly no reason to sell a business I like (BWX Technologies) till I need the cash from that sale to buy something else. So, regardless of what BWXT’s stock price does, I expect to hold the stock till I find something better to buy.
What about Frost?
Frost is my favorite stock. My cost basis in the stock is $49.83 a share. It now trades at $83.47. So, that’s 68% more expensive than when I bought the stock. You might think that means that – like BWX Technologies – I think of Frost as a good stock to hold, but I’d never consider buying more.
You’d be wrong.
When I wrote my report on Frost I put the appraisal value at $141.36 a share. The company has grown over the last two years. So, I’d probably raise my estimate of intrinsic value by about 5% (which is about the increase in deposits per share). Let’s call that $148 a share. Take today’s stock price of $83.47 and divide by my appraisal value of $148 a share. You get 56%. Frost is now trading at about a 44% discount to what I think it’s worth. Normally, I buy shares of a stock I like when the discount to my appraisal value is 35% or more. So, here, the stock price is telling me I should add to Frost.
There’s one problem.
Frost is already over 35% of my account.
I have enough cash to put 15% into Frost (and bring the position up to 50% of my account) and then still have enough cash left over for a new 20% position in the future. But, I’m not sure I want to do that. I’m a very concentrated investor. But, I have very, very rarely ever thought about putting 50% of my account into just one stock. I prefer to start by putting 20% to 25% into 4-5 stocks and then just letting the winners get bigger in percentage terms as they outgrow the losers. But, I don’t normally add more to a position. And I don’t normally aim for concentrations as high as 50% in one position.
So, now we know why I have about 35% of my portfolio in cash. There are two stocks I like. One is BWX Technologies. But, at $54 a share (and a P/E in the 25-30 range) it’s too expensive for me to add to. The other stock I like is Frost. I think (at $84 a share) it’s still quite cheap. Definitely cheap enough for me to buy more. But, I already have more than 35% of my account in Frost. Do I really want to add more?
No.
That leaves me with about 35% of my portfolio in cash. Since I don’t want to add to the stocks I already own, the only place to put that cash is in a new stock idea.
I mentioned three stocks I like right now:
- Omnicom (now $72 a share)
- Howden Joinery (now 424 pence)
- And Cheesecake Factory (now $40 a share)
All are reasonably priced. The P/E ratio isn’t my favorite metric. But, it works well enough for these 3 stocks right now and it’s the metric you’re most used to seeing quoted. So, I’ll use it here.
Omnicom has a P/E of 15. Howden has a P/E of 15. And Cheesecake has a P/E of 14.
All of those sound wrong to me.
These are above average businesses with far above average predictability. They should have above average P/E ratios. The market is more expensive than normal right now. These 3 stocks are a bit cheaper than normal right now.
So, why aren’t I buying these stocks right now? Why keep 30% to 35% of my portfolio in cash when these 3 opportunities are available?
I said I tend to buy stocks when a business I know I really like trades at about a 35% discount to my appraisal of its intrinsic value. I did a report on Omnicom. So, I have an exact appraisal value to quote for you on that one.
In my report, I appraised Omnicom at $95.20 a share. However, I made that appraisal some time ago. Omnicom’s revenue is now higher than when I wrote my report. And – because the company constantly buys back its own shares – Omnicom’s shares outstanding are lower. The value in an ad agency comes from the level of sales per share. So, we have to adjust my old appraisal value for the increase in Omnicom’s sales per share. The increase has been about 5% in sales per share. So, my appraisal value should now be roughly $100 instead of $95.20. A $100 appraisal value makes determining my normal “buy point” very easy here. I normally buy businesses I like when they trade at a 35% discount to my appraisal of their intrinsic value. Here, that’s $65 a share. So, I should buy Omnicom when it hits $65 a share. That would require a 10% drop in the stock price from here. If that happens, I expect I’ll buy shares of Omnicom.
My normal new position size is 20%. And my current cash level is 30% to 35%. So, if Omnicom’s stock price drops just 10%, I’ll put 20% of my account into OMC and suddenly my cash levels will go from between 30% and 35% all the way down to between 10% and 15%. That’ll sound like I suddenly got a lot more bullish on the overall market. All that will have really happened is a stock I liked dropped a bit in price.
I don’t have exact appraisal levels for Howden Joinery or Cheesecake. A negotiated purchase of a good restaurant chain like Cheesecake Factory (that is maybe only two-thirds of the way to saturating the U.S. market) rarely happens much below 10 times EBITDA. So, my “buy point” for Cheesecake would probably be somewhere very close to 6.5 times EBITDA.
Personally, I’d use sales rather than EBITDA. But, I can tell you now that we are probably already very close to the level at which Cheesecake would be trading at a 35% discount to my appraisal value.
So, I can imagine my cash levels going from 30% to 35% right now down to 0% by year end. All it would take is something like a 10% drop in the price of both OMC and CAKE.
There’s one reason why I think my cash levels won’t go to 0% this year.
I have this rule.
I try to buy only one new stock a year.
I violate that rule all the time. But, it’s there. And I will definitely try to stick to it this year. If I get several bargains I like all at once – for example, if Howden and Omnicom and Cheesecake were all to drop 10% to 25% in the next 4 months – I’d probably violate this rule.
It’s worth noting that all these decisions are arbitrary in terms of the levels you set. If I plan to hold Omnicom stock for let’s say 5 years a difference of 10% in the initial purchase price level isn’t going to make more than a 2% difference in my annual rate of return. Imagine you like a stock and feel certain it can return 15% a year if bought at that magic 35% discount to appraisal value. Well, it’ll still return 13% a year for 5 years if you pull the trigger early and buy at about a 28% discount to appraisal value instead of a 35% discount to appraisal value.
How much does that 2% a year really matter to you?
Most people I talk to would be more bothered by missing out on the opportunity to buy a business they like than they would be bothered by paying 10% more for the stock at the start. Most people I talk to about Omnicom say that – if I like the stock that much – I should just buy it now.
But, that’s just not my approach.
I’m selective both on the quality of the business (I’ve only mentioned 3 business I like and yet don’t own in this article) and I’m selective on the price. I don’t like paying more than 65 cents to the intrinsic value dollar even when I like the business a lot.
That’s why I’m holding a lot of cash. If I wanted to buy thing at 75 cents or 80 cents to the intrinsic value dollar – I could fill up a portfolio of 10 stocks easily. But, if I only want to buy things at 65 cents to the intrinsic value dollar – right now, I can’t even fill up a 5-stock portfolio.