Andrew Kuhn April 2, 2020

Question: Why Are You 40% in Cash?

Someone sent Geoff this email:
I’m curious why the SMAs are 40% cash. Did that happen once you learned about the potential impact of the virus? Or was that the case beforehand? I know you were fully invested at some point last year, and I would have assumed your strategy was to stay fully invested. So you either sold things last year and never reinvested, or you went cash this year. I’m interested in anything you’d share.
Part of the reason I ask is I am curious how you are framing portfolio management during this turbulent time. I was fully invested coming into the year and didn’t go cash, so my portfolio, which has a decent amount of small-cap and a mid-cap financials that has gotten hit very hard, is down a lot. I’ve written down intrinsic value for some of these businesses, but they are still cheap. I’ve done just a little bit of “value trading”, either moving money to something the same quality but much cheaper, or similarly cheap but much more quality. And I first started seriously investing in stocks in 2015. So this is my first bear market. Psychologically I am doing fine – I’m not stressed or bothered. As I said, I’ve marked down some of my holdings in value but think the price declines have exceeded them. But my questions above are more aimed at understanding how you are thinking about structuring the portfolio in this sort of environment – I don’t have personal experience with this. Perhaps this is simplistic, but my basic strategy has not changed at all. I’ve always aimed to hold durable businesses, so I don’t feel any of my holdings face bankruptcy risk. So, the process is the same: keep holding businesses who offer attractive long-term returns and shift around when prices warrant doing so. But I haven’t gone cash or done a lot of trading yet. Would appreciate any thoughts you have on how to think about this environment.
Geoff’s answer: I’m A Lot More Concerned About Business Performance in 2020 and 2021 Than Most Other Investors and Experts Are
The decision to be 40% in cash was mainly NOT a decision made because of the virus. I had decided earlier this year – after making several mistakes in the past couple years – that I would stop trying to force myself to be 100% invested and only be invested if I liked the stock and the price. This is how I had run things when managing money for myself and others before. However, clients tend to prefer being 100% invested – or, at least, they tend to have strong opinions about how invested you are or aren’t. I’ve just bought so many stocks over the years that haven’t worked out well when I had more cash than ideas. If I was managing my own money – I might put 33% in each of 3 stocks and thus be 100% invested. But, for clients, we don’t do more than 20% (at cost). So, we are 40% or so in cash, because clients generally hold only 3 positions right now.
The virus did increase cash in one way. I sold a stock called “Points International”. This was the marginal stock in my portfolio anyway. I’m not necessarily a fan of management. I wouldn’t say I dislike them. But, I certainly wouldn’t say I like them. They don’t own a lot of stock. I don’t think they communicate clearly about the business model. And I think they spend way too much time providing detailed guidance for the current year. It’s also not necessarily an overlooked stock. That point is debatable. But, anyway, the company is tied to airlines. And it has some real financial risk if it can’t sell enough airline miles as it promised to. I sold out of the stock before they reported earnings. The timing wasn’t necessarily to avoid being in it when earnings came out (the stock actually rose as they reiterated full year guidance). It was more that I thought there’d be enough volume for us to get out of the stock quicker than during normal days. Of course, with the volatility in recent times – it’s probably been very easy to get into or out of any stock you want (volume isn’t the issue – what price you get is the more random part now). So, I definitely did sell Points International because of the virus. And, honestly, when management reiterated guidance – that really turned me off of them and the stock. By that point, many airlines (like Southwest, who I assume may be one of their biggest customers) had already withdrawn guidance or said the declines they were seeing were worse than 2001 and 2008 and so on. The company had a very easy opportunity to remove guidance – and should have. They didn’t. I’m not sure I’d want to buy back into a stock where management reiterated guidance on an airline miles based business after it was so clear what the virus was doing to air traffic.
Generally, why am I not buying?
I just don’t see bargains.
Stocks started this year out pretty expensive.
They only briefly got down below levels I could’ve bought at within the last couple years.
And then the outlook for businesses is just generally a lot worse. I mean, if I could get Hilton Food at a terrifically low price – I would. But, if I could get Vertu (VTU)?
I haven’t sold Vertu. And I have no plans to sell Vertu.
But, I don’t know – except at a very, very low price (which to be fair, VTU did actually get to unlike many stocks) – I’m not sure that I’d want to just be shoveling unlimited amounts of cash into a U.K. car dealer. I mean, car dealers are potentially going to be very, very harmed by this. When their local economy is shutdown, no one will come to the lots to buy cars. When their suppliers’ economies are shutdown, they’ll have an interruption of supply. And then when an economy isn’t shutdown but consumers have just been through a shutdown or are in fear of another shutdown happening soon – households will want to husband cash. A car is probably the second easiest purchase to put off (next to a house). Now, Vertu gets a lot of money from servicing cars. And a decline in new car sales can often be an increase in used car sales. Obviously, during an actual shutdown – there’s a decline in hours driven per week and less need to service cars. But, I’d expect that most of the time they’ll be operating in an economy that isn’t shutdown – maybe just a bit fearful about what they’ve just been through and about whether it will happen again and when. Still, Vertu was one of the most attractive stocks I saw this week.
I need to point two things out.
One, I may value cash more highly than most investors in the sense cash in an option on future lower stock prices. So, I may be more hesitant to buy things now – not just in this moment, but generally – than other investors would be. Before starting the managed accounts, it wasn’t unusual for me to have 30% in cash in some years. Then, I’d find something good to buy and be 100% in stocks. Eventually, something would get bought out or I’d sell it or whatever and I’d be back to 30% cash. It happens. That was a bull market though. You’d expect that I’d be less in cash during a bear market.
Point #2 is just that I’m much, much, much more pessimistic than everyone else about the longer-term harm done to an economy by shutting down for a short period of time. I am way out of line with all consensus, expert opinion, etc. here. I just see this on a company by company basis when analyzing risks as the biggest risk I’ve ever seen across companies. I have seen declining stock markets before around 2001 and 2008. What’s going on in the market might be comparable. But, what I am worrying about when looking at each company and how it might function as a business in 2020 and 2021 is so much worse. So, I think that I have just crossed out so many more stocks as having serious solvency risks or marked down the intrinsic value of so many financially solid firms by so much – that this decline doesn’t seem to change the market value to intrinsic value ratio that much to me.
Like I said, my concerns are completely out of line with what other people are expecting. However, because those are my expectations – I can’t buy stocks when other people would be comfortable buying them. Because other people see less risk to business performance (and business survival) in 2020 and 2021 – they can buy confidently at only 30% (or whatever) off prices. Whereas if I am looking at a lot more risk to business performance (and business survival) in 2020 and 2021 – I can’t. That, I think, is the main difference. We see the same market values. But, others are more confident in higher intrinsic value estimates weighted for risks of insolvency and so on than I am. I’m not buying – in large part – because my estimates for intrinsic values of some companies (and particularly my estimates adjusted for risks to common shareholder dilution) are a lot lower than other people’s.
I don’t intend this to be a macro call. And, if it is a macro call, it’s obviously completely out of step with all crowd opinion, expert opinion, etc. However, I do analyze risks on a company by company basis before investing. And, in many companies I would invest in – the risks have changed dramatically in a way I’ve never seen before for financially solid and even sometimes non-cyclical companies. This is very unlike 2008-2009 for me. It’s completely unlike 2001. I have never before changed the price at which I’d be willing to buy individual stocks so greatly and so rapidly. I’ve also never before moved so many stocks from the “yes, they have obligations – but they’re fine credit risks” to the “credit analysis is a meaningful part of analyzing this stock” category. Huge clumps of businesses where I wasn’t particularly focused on credit risk have now moved into categories where I would be hesitant to invest in the stock.
So, for me, this is unlike anything I’ve ever seen before in terms of risks to actual businesses I would invest in. I wasn’t – in 2008 – looking to invest in businesses where I saw a lot of risk to those companies. There were things like Omnicom having some convertible bonds put to them that no one would’ve expected and their float from clients plummeting in a dramatic way for a couple quarters – but, that’s so slight compared to what I’m seeing today.
Again, this is different from what other people see.
Other people don’t see as high a risk to business performance as I do. But, I’m just looking at these things on a case by case basis – and I’m seeing a lot of harm caused by shutdowns of economies and thinking about the harm that will follow that for these firms.
Because I am so out of step with other investors in how high I think risks to business performance (particularly solvency of individual businesses) is in 2020 and 2021 – I’m probably sitting on the sidelines when others would be eager to invest. If I shared their beliefs about the future, I might be eager to invest too.
So, I think that’s the difference. I just have an outlook that’s way out of step with other people.
It’s important to note – I don’t make macroeconomic predictions. So, I’m not concerned with correctly determining what WILL happen. If I see a 70% chance of an outcome that leaves things looking just like they did before the virus and a 30% chance of an outcome that is devastating for the company I’m looking at – I don’t use the 70% chance outcome as my base case and invest. Generally, if I see a 30% chance of a devastating outcome, I’m just not going to invest. I mean, a 30% decline in price doesn’t more than offset a 30% chance of a terrible outcome financially for a firm.
So, I’m not making predictions. I’m saying that there are risks that are now within the range of possible outcomes that are of a magnitude that never appears in the range of possible outcomes I consider for stocks. It’s not that I am assuming a base case that’s bad at all. It’s just that I’m looking at the “worst case scenario” for a lot of stocks that is much, much worse than the worst case scenario I would’ve included in any 10 years or so looking forward normally.
It’s very important for me to stress that my choice to pass on many stocks in the past week or so is based in large part about risks I am looking at and thinking about that most people would consider illusory or extremely unlikely. So, my individual stock picking has certainly been infected by my concerns about wider, really global issues of business performance under conditions of shutting in large parts of the populace. These are not consensus views. Most people do not share my concerns about this. Experts included.
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