When cash is also an investment

With the market starting to get a bit wild and silly, its time for a good contrarian piece on the virtue of cash, and how investors should look at it as an investment option in its own right.

Not as a long-term investment, of course. Everyone knows that cash is trash when measured against the market over a span of three to five years or more.

But every now and then, cash is king. I’m not sure I would go so far as to say that’s the case now, but it’s not a bad short-term ‘investment’ that should produce market-beating returns in the long term.

Let me explain…

Cash is a guaranteed return. You know what you’re going to get. More importantly, you know your capital is not at risk of short-term loss.

The ‘value’ of cash is more than that, though. It gives you options when market volatility hits.

This gives you an advantage over most professional fund managers. Their investment mandates mean they have to be nearly fully invested at all times. So when market volatility does hit, they usually have to sell something to buy something else.

But this requirement also prevents them trying to engage in market timing. That is, thinking that a correction is likely and increasing cash ahead of this expectation.

It sounds like a smart thing to do. But market timing is all but impossible. You can get lucky occasionally, but you can’t replicate luck.

In advocating for cash as an investment, I’m not talking about market timing or expecting a correction to unfold in the near term (although it wouldn’t surprise me).

I’m saying to think about it in relative terms. The market roughly trades on a P/E multiple of 20 times. That represents an earnings yield of 5%. As a proxy for cash, I’ll use the RBA’s cash rate. It’s currently at 3.85%, not far off the market’s earnings yield.

Adjusted for the risk of investing in equities, the cash looks reasonable. Add in its option value in an increasingly speculative market, and it looks even better.

I run a model portfolio for clients. It’s not your normal model portfolio. It doesn’t hold banks, any of the iron ore majors, or ‘safe’ large companies. It’s completely benchmark-unaware. It takes concentrated positions in companies that have good risk/reward profiles.

My long-term annual return target is 12%. In order to achieve that, I need to buy businesses at a price that gives me a good opportunity of achieving that long-term outcome.

I can tell you that as an investor in businesses (not ‘stocks’), there are not many that fit the bill these days. 12 months ago, it was a lot different.

If I can’t find good businesses to buy that have the potential to achieve that long-term return, I’m happy to sit in cash.

On the other side of the coin, when stocks in the portfolio rise sharply in price relative to their potential earnings, I look to reduce or sell out completely.

You should always look at your potential future return from an investment based on the prevailing price. When the share price rises well ahead of a reasonable expectation of a rise in earnings, it means your long-term return potential is lower than it was previously.

A sharply rising share price (more prevalent in wild speculative markets) effectively brings forward the return you would have expected to receive in the years to come.

Five years of returns in one year

A good example of this is CSL Ltd (ASX:CSL). In early 2019, the share price surged from $180 to $340 in early 2020. In that one year, it priced in many years of future growth.

Today, the share price is around $270. It’s gone from an 80% return in one year (2019) to a roughly 6.4% return over six and a half years (not including meagre dividends).

As good as CSL may have looked in early 2020, such a high price skewed the long-term risk/reward equation. If you bought in at the tail end of that rally you’re still underwater. And everyone agrees CSL is a quality company!

It’s going to be the same over the next 5-10 years for Commonwealth Bank (ASX:CBA) investors. It either goes nowhere or falls considerably to re-establish a favourable risk/reward profile.

A potential example I can share from my existing portfolio is Lynas Rare Earths (ASX:LYC). Clients bought in when it was unloved during 2023 and 2024. I thought the market was underestimating its strategic value, given its position as the Western world’s only integrated rare earths producer.

Now, the market is well aware of that value. Rare earths and critical minerals are in the headlines every other day. When it’s in the news, it’s in the price. So we’ve gone from a very large position down to a very small one.

Again, it’s all about risk/reward. Having taken profits on a few other positions and with nothing compelling to add to the portfolio, the cash position in the portfolio is now around 25%.

To be clear, this is not a bet on the market falling and hoping to time my way back in. It’s about being disciplined with capital and only investing when you’re getting adequate potential reward for the risk you’re taking.

It’s an investment mindset. A speculative mindset, on the other hand, is to not want to hold any cash because it ‘does nothing’ while the market’s going up.

That’s a game some people play well. But in my view, it’s a low-probability game. 

It’s also a game some investors play unwittingly. 

As bull markets mature, more and more people move from the investor camp into the speculator camp.

There’s no such drift for the master of temperament, Warren Buffett. Berkshire Hathaway recently released second quarter results. It revealed he was a net seller of equities for the 11^th straight quarter. His cash levels are around 30% of total assets.

Buffett is famous for claiming he can’t time markets. Yet in every bear market, he is always flush with cash and ready to buy what everyone else wants to dump.

That is the power of patience and a true long-term mindset. Being prepared to sit it out when the value isn’t there can hurt you in the short-term (see GQG Partners’ (ASX:GQG) update today). 

But over a longer-term timeframe, the ‘investment’ in cash today, when deployed with discipline, should produce above-average returns.