Top Investors Reveal The Importance Of Cash

(MENAFN- ValueWalk)

This is part five of a new ten-part series from ValueWalk on value investing. Throughout this series, I'm looking back at some of the lessons learned from our historic ValueWalk interview series. You can find all the previous parts of the series at the links below:

If you're looking for more up-to-date interviews and stock ideas, you should take a look at ValueWalk's exclusive quarterly magazine, . Each issue contains four stock ideas and a detailed Q & A session on each idea. .

According to a recent interview you gave to Value Investor Insight, Centaur's current cash allocation is more than 35%. Does this mean you're preparing for a market crash?

We are always preparing for a market crash, whether we are 10% in cash or 50% in cash, at least mentally. Nobody can predict the timing of market corrections or crashes with perfect accuracy, but a professional investor always has to be prepared to wake up in the morning to a vastly different market than the one prevailing when he or she went to bed. Also, being mentally prepared for a crash and being positioned for a crash are two completely different things. There have been times in the past where we'd been prepared for a crash (or at least further declines) but positioned for a recovery. If a crash happened tomorrow, we'd be both mentally prepared and reasonably well (but not ideally) positioned.

I've been responsible for managing other people's money in one vehicle or another since late 1998, and I have learned that the scoreboard changes very quickly in the stock market. Very few people in March of 2000 would have believed that the NASDAQ index would fall 80% from its peak to the trough in early 2003, but it did. That is a major index, by the way, not some small corner of the stock market. I can assure you that in mid-2007 very few people saw a 50% decline in the S & P500 coming, or at least very few were positioned for it.

All that said we don't use some kind of crash probability generator to determine how much cash we hold. The amount of cash we hold in our funds is almost 100% correlated to our ability to find really compelling long ideas that meet our criteria for value, safety, and liquidity. Right now, the pickings amongst the ideas we feel that we can evaluate are pretty slim.

The U.S. stock market today is probably more uniformly overvalued than it was prior to either of the two prior bear markets. Total debt outstanding in the world is far higher now than it was prior to the credit crisis of 2008. So yes, we are prepared for a correction, though I am not predicting a crash. I am also prepared for a multi-year period where the market bounces around a lot and doesn't go anywhere, or a period where the market doesn't crash or correct, but just loses ground for an extended period of time. But mostly we are just trying to exercise patience until we see the next compelling bargain security that we can buy.

How do you weight your portfolio: do you tend to run a concentrated or highly diversified portfolio of equities?

We are definitely considered focused managers. Of course, it varies between each client's account but generally, we have between 10 and 20 equities per portfolio.

We feel it is difficult to exceed 20 holdings due to the level of research we put in to each of our holdings. We don't think you can reasonably know more than 20 different holdings at a given time, considering the amount of research and analysis that needs to go into each holding.

In terms of a weighting among the three categories mentioned above; we don't have a set allocation, we let the market dictate what sort of allocations we should hold. For example, coming out of the 2008/2009 financial crisis we were more overweight the 'higher quality great business' category.

I should make clear that with our investments what we are usually looking for is a certain return over a given period. With the 'good businesses trading at fair prices', we are looking to get a return of around 7% per annum over a five-year period.

In the middle category, 'good businesses trading at great prices', we are looking for an expected return of 15% per annum over a five-year holding period.

And with special situations, given the risk involved we are looking for a return of 25% per annum at least over a five-year holding period. We won't take a position unless these return targets are available. We take a similar approach to cash, we will let the investment environment dictate what level of cash we should be holding at any given time.

Are all your positions equally weighted in the portfolio or do you tend to direct more cash towards your higher conviction ideas?

That's an interesting question. You know you hear a lot about these famous investors that say you should concentrate your bets on your best ideas, but you never really hear the other side of the story. Many people have tried it and haven't been successful?

I know some people personally who have tried it and failed. There was no reason to believe that they wouldn't have been successful to start with, but a concentrated portfolio cost them a substantial amount of money. That's the side you don't hear about. You only hear the success stories. So we tend to use equal weightings

In some cases, we will underweight positions if they are a bit more risky or if there are questions about the business. I'll admit this is a bit strange for a value investor, most tend to rebalance but I've had success using this method, so I'm going to stick with it. I think it also helps enforce buy and sell decisions. Because I'm fully invested if I want to add a stock I have to sell something first. I need to be sure that I want to make the trade-off, so its helps with discipline.

That said, we do own multiple stocks in the same industry, which could be considered a form of overweighting, other than that it's equal weighting.

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