Monday, February 24, 2014

Buffett on Cash

Warren Buffett on CNBC back in 2009:

"The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing...Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don't want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it."

That's certainly no invitation to speculate on stocks but does help make the point that risk comes in many forms. 

Having some extra cash on hand certainly creates options in the near term, but the clock is always ticking. This ends up being in direct conflict with the need to be patient then decisive as Charlie Munger explained during the 2004 Wesco shareholder meeting:*

It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor.

So having a comfortable amount of cash around makes lots of sense. This means knowing when to resist the inherent pressure to put money to work until the right opportunity presents itself. With the benefit of hindsight that might seem easy to do.

It surely is not.

In the CNBC interview Buffett continued by saying...

"We always keep enough cash around so I feel very comfortable and don't worry about sleeping at night. But it's not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially."

The problem is that the environment has changed substantially since Buffett said that back in 2009. Many stocks were quite cheap back then, in part, because we were so close in time to the financial crisis. The world seemed much more risky and uncertain at that time. (Even if, in reality, the world always is uncertain no matter how it might seem at any point in time.) The scary recent events were fresh in the minds of market participants and prices reflected it. At that time it would have felt more uncomfortable to buy stocks, but that's often when it's time to be buying.

Easier said than done.

Today, cash remains a lousy investment over the long haul, but attractive investment alternatives are harder to come by. Well, at least those can be purchased with a sufficient margin of safety. In the current environment, that sort of thing has become a whole lot more challenging to find. As always, what's not very risky at one price can become quite risky at some higher price. In other words, risk necessarily does not just come down to the intrinsic characteristics of the investment itself. What is paid upfront can regulate some of the risks involved but, unfortunately, only up to a point.
(i.e. Sometimes no price is low enough because the risks are just too hard to understand.)

Most risks just do not lend themselves to being easily quantified. This can tempt some to focus on what's more easily quantified and, as a result, is easier to analyze but just happens to matter a whole lot less than what can't be reliably quantified.

That's a mistake worth avoiding.

Unfortunately, in the near-term and even longer, none of this gives an indication what stock prices might do (as always, I never have an opinion on market price action). Market prices, at times, can go to extremes on the both high side and low side while the intrinsic values of good businesses mostly do not change so quickly. If nothing else, the past 15 years has provided us with many examples of this. What's already expensive becomes more so; what's clearly cheap goes on to get much cheaper. Some inevitably try to profit from the price action thinking they'll get in or out at the right time. Good luck to those who try to do this but, chances are, it won't end well for most who do.**

Instead, how price compares to well understood underlying value should dictate behavior.

The discipline to see market price action as being entirely there to serve you as a long-term investor isn't a bad one at all.

A successful investment outcome should never depend upon selling at an expensive price. Naturally, the more elevated current price environment doesn't mean certain individual investments aren't attractive. What it likely does mean is that, on average, more risk is being taken for less reward, and the risk of permanent capital loss has increased. Eventually, market participants in increasing numbers end up letting their guard down. They'll justify, sometimes rather creatively, paying way too much for future prospects. Well, at least that's what an extended period of rising prices inevitably tends to do.

Those that ignore this will likely end up only appreciating the full extent of their mistake after the fact.

Expensive.

Figuring out how price compares to likely value may not be easy, but is doable with some work.

Timing things well mostly is not.

Short run risks are very different than long run risks. Holding cash is risky over the long haul but less so in the short-term (and maybe even medium-term).

Having enough cash on hand provides the necessary flexibility to act, for example, as decisively as Buffett and Munger did during the financial crisis.

Holding onto plenty of cash while knowing it's not a great investment is not at all inconsistent. A natural tension between the need to find more lucrative, attractively priced, investment opportunities and holding enough cash in order to remain flexible necessarily exists.

Many forms of risk are out there, but they're rarely easy to quantify in any kind of precise manner (if at all). This is where the importance of quality -- those businesses that tend to have persistently attractive core economics in lots of different environments -- and buying at the right price comes in. The merits of this, in what is a vastly unpredictable world, seems not often fully appreciated when it comes to managing risk and reward.
(Those who primarily bet on what are essentially "lottery ticket" stocks will no doubt find this to be of little interest. Many of the high-flyers will turn out to be fine businesses; that doesn't mean the investor will be compensated sufficiently for the risk even if some of those who speculated on the price action happen to do just fine.)

Buying high quality all but eliminates the need to consistently make correct predictions and forecasts -- a fool's game -- in an uncertain world.

It's the inherent uncertainty -- the futility of making investment decision based upon on forecasting -- that increases the importance of a flexible approach.

So the idea that cash is safe and stocks are risky depends heavily on time horizon. The investor with a sufficiently long time horizon, who buys shares of a business that has durable and attractive economics (judged well, of course), may be taking on less risk than someone who decides to hold mostly cash (that nearly inevitably will have diminished purchasing power over time).

Cash feels safe but, again, the clock is ticking.

Paying near full value (or, worse yet, paying a premium in the hope that the investment will grow into its value someday) exposes the investor to the unforeseen and unforeseeable. Bad things inevitably happen. Sometimes, it's specific to the business itself, other times, it's something more external. Eventually, these things are pretty much a given. Even the best businesses get into trouble. Unexpected macro events occur. It's a fallacy to think one can consistently maneuver around these kind of unpredictable changing tides.

The price paid should provide a meaningful buffer against misjudgments and surprises.

Many will still unwisely feel compelled to make, or listen too much to, prognostications about the future. Well, just consider the findings of professor Philip Tetlock.***

The following excerpt from Susan Cain's book Quiet summarizes it well:

"A well-known study out of UC Berkeley by organizational behavior professor Philip Tetlock found that television pundits—that is, people who earn their livings by holding forth confidently on the basis of limited information—make worse predictions about political and economic trends than they would by random chance. And the very worst prognosticators tend to be the most famous and the most confident..."

Morgan Housel explained it the following way:

"...one reason people take too much risk is because they believe in their delusional forecasts, and aren't prepared to react to events." 

Housel then adds "most people can improve their financial lives by distancing themselves from as many forecasts as possible.

Sure, we'd do better if we could anticipate the paths our lives go down. But we can't. You would not wish upon your worst enemy the track record of professional economists predicting the financial events that really mattered throughout history."

Here's how Henry Singleton once explained it:

"...we're subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible."

The risks will always be there. Instead of trying to predict the future, better to try and be, however imperfectly, in a position to handle all but the worst things that might occur. Singleton's track record didn't come about because of some sixth sense about the future; ditto for Buffett and Munger.

Those who realistically assess their own limits and avoid trying to figure out when to jump in or out based on how the world looks on any given day can do just fine; those who do the opposite are just inviting mistakes. It requires some discipline, sound judgment, respect for some of the psychological factors that hurt results, and the right habits. The importance of eliminating error, where possible, is underestimated.

"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin

Ultimately, instead of attempting to manage risks via prescient predictions (bold or otherwise), manage risks, at least in part, using an appropriate margin of safety considering the specifics of each individual investment; manage risks additionally by sticking to what one really knows.

Unlike trying to consistently figure out what is often an unknowable set of future outcomes, paying a reasonable (or better than reasonable) price is something well within the investors control.

The same goes for buying only what one truly understands.

When you've made a judgment that a particular business is likely to do well long term, it isn't about making a definitive prediction; it is about a combination of patience, decisiveness, while also understanding the business characteristics that make it more likely for good things to happen -- even as the world, or the business itself, inevitably throws out a curve or two -- over the long haul.

Buy quality at an attractive price then have the discipline to, as Buffett says, "stick with it."

One final thing that's at least worth mentioning: the biggest potential gains -- those things that truly capture the imagination and, often, the biggest headlines as well -- usually exist not far from where big potential permanent losses of capital can happen.

Telling the big winners and losers apart without making errors that wreck returns sounds easier than it is.

In other words, the big wins must more than compensate for the losses. More excitement, maybe, but as far as risk and reward goes, seems likely to be far less than optimal. The difficulty of getting good overall results (i.e. not just the wins that look good in a vacuum) in the long run shouldn't be underestimated.

Besides, some of the very best investors have done just fine while generally avoiding such things.

"...Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer

The plainly more aggressive approach (and, yes, almost certainly a wilder ride) contrasts greatly with the elimination -- or, at least, nearly so -- of losses, wherever possible, by always buying with a meaningful margin of safety, and sticking to those well understood things that have a narrower range of outcomes.

With the bigger misjudgments mostly eliminated, the returns of the more reliable if less exciting winners tend to take care of the rest.

Adam

* Munger also said: "Success means being very patient, but aggressive when it's time." He certainly has, to say the very least, put this way of thinking to good use in recent years.
** Those interested in trading near-term price action -- even if based upon certain fundamental characteristics of a stock -- will likely find not much of use here. To me, investment involves a 5-10 year holding period and longer. Those attempting to profit from price action over shorter time horizons, even if the holding period involves a few years, is more or less involved in speculation and, in some cases, even pure gambling. There's certainly nothing wrong with making bets on such short-term moves. No doubt some are actually good at that sort of thing. Still, it has little in common with investment -- the primary focus of this site. Investment has as it's emphasis the "weighing machine" -- the value of what a productive asset itself can produce (farms, businesses, real estate etc.) for owners over longer time frames. Speculation and gambling, in contrast, more or less have as their emphasis the "voting machine" -- how the psychology of markets will impact the price of something (marketable securities, commodities, currencies, etc.) near-term and even somewhat longer.
*** Professor Tetlock puts it this way: "Hedgehogs are big-idea thinkers in love with grand theories" while "foxes are better at curbing their ideological enthusiasms."

He goes on to say foxes tend to not over-simplify and are more aware of the limits to their arguments. As a result, they become less prone to mistakes.

Philip Tetlock books:

Expert Political Judgment: How Good Is It? How Can We Know?
Why Foxes Are Better Forecasters Than Hedgehogs
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