When I was just starting out managing money almost 30 years ago, I asked the head of our investment department what his worst experience was and when it occurred. Without batting an eye, he said, “1974.” I asked him what happened to make this such a special year. This is what he told me.
The markets had been moving steadily upwards for several years to its peak in early 1973. But in 1974, the U.S. market (Dow Jones industrial average) crashed, dropping about 45 per cent from peak to trough. And the reason it was such a miserable year for this portfolio manager? Well, as he described it, pre-1974, he said he received one sheet of paper (pre-electronic delivery) from the fund’s accounting department with his portfolio printed on it. In 1974, as the market crashed, he would get a second sheet of paper – instructing him to meet incoming liquidations from the fund’s clients. If he didn’t do so, the mutual fund company would make the sales in his place. He had no choice and thus sold – day after day, month after month, for well over a year.
The point I want to make is that with a fully invested fund (no cash on hand) and clients demanding their money, this manager had lost control of the fund. The clients had hijacked the management of the fund and he was just there to obey orders. Taking orders from the unknowing, emotional clients. Clients irrationally taking less by redeeming as they, along with millions of other sellers, were forcing the prices of the very stocks they owned to lower and lower prices.
Today, we find ourselves in a situation not unlike that before markets fell apart in 1974. Stocks were expensive then as we find them today. The biggest difference now is the presence of index funds and their cousins, ETFs, which didn’t even exist for a few more decades. Today, ETFs alone total $2.5-trillion (U.S.) under management and comprise 13 per cent of all U.S. registered investment company assets. Because equity indexes and ETFs are meant to be mirror images of these theoretical index vehicles, they have little or no cash reserves. Average June cash levels were at 5 per cent versus the 10-year average of 4.5 per cent, according to Bank of America’s recent global fund manager survey.
Most investors today continue to pour large sums of money into the market (with large chunks going into passive investments such as ETFs and indexes). This all works well as markets continue to appreciate. What happens when investors start to sell? What transpires if a large percentage of investors head for the door at the same time?
I’m not predicting this will happen again soon. Just don’t be surprised if one day you wake up in a major market collapse where that 5 per cent cash in actively managed funds evaporates in a nanosecond and ETFs with little or no cash are crushed by sellers as emotionally-motivated, adrenalin-driven “investors” stampede for the exits. Then what ensues? I leave it to your imagination.
Warren Buffett said in his 2014 letter to Berkshire Hathaway shareholders: “At a healthy business, cash is sometimes thought of as something to be minimized – as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.”
Mr. Buffett, in managing money has held large amounts of cash in the past, especially in the early ‘70s when he exited the market completely because of the overvalued market he perceived in the late ‘60s.
At Sarbit, we have a history of holding a large percentage of liquid assets when equity valuations, in our mind become excessively overvalued. Today, we find ourselves in this situation once again. We think that liquidity will give us two essential advantages: first, we will be able to meet any redemptions we will face from emotionally motivated clients and second, we will be able to take advantage of bargain prices for the wonderful businesses we would love to own. ETFs and mutual funds with 5 per cent cash won’t have that opportunity.
What’s required is the commodity most lacking in the world of investing: Patience.
Larry Sarbit is the chief executive and chief investment officer at Winnipeg-based Sarbit Advisory Services. Mr. Sarbit is a sub adviser on three funds for IA Clarington.
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