In the Kennox Strategic Value Fund, we tell investors that we will have up to 20% cash. The Fund is primarily an equity fund but we feel that the flexibility to hold some cash benefits investors, and we feel this is one reason why we tend to hold up better in falling markets. It helps us to protect capital.
One point to emphasize is that the decision to hold cash comes from our stock process, and is not a forecast as to what we feel the returns from stock markets are likely to be. Our cash levels are driven almost entirely by bottom-up factors.
Primarily, cash is used to separate our sell discipline from our buy discipline. If we think a stock should be trimmed or sold, we are able to act immediately, and are not paralysed into doing nothing as we can’t find the corresponding buy. Why would good ideas always appear in opposing pairs? Surely one idea would be better than another, and why be forced to take them both when you can simply pick the best one. When you have a strong inclination to do something, the fewer restraints holding you back the better.
Our cash reflects the level of excellent, but sufficiently diverse, opportunities available in the market. When bargains are abundant, we use up cash; when bargains are few, we tend to be increasing cash. Thus our cash level does not reflect our view of the global economy and stock market (we admit to frequently having a bleak outlook), but the availability of excellent investment ideas. If the idea is worthwhile (even if we are pessimistic), then we feel that we will have the best odds of being pleasantly surprised.
Bargains come most often when prices are low. This sounds self-evident but we are always surprised at how happy people are to buy when prices are high. One instance of this was when we remember hearing of the ISA savings season in the UK – four times more money was invested in 1999 than it was in 2002, despite the FTSE 100 index having halved over the period. It is more comfortable to buy when the outlook is sunny, but the stock market doesn’t pay for comfort and this strategy is rarely the most profitable.
Mr Market offers us great opportunities only infrequently, and low prices are how we identify those opportunities. It is not because we are trying to have a better crystal ball than the next investor. We wait for low prices, where there are the best chances to make excellent returns. Therefore, as a rule, our cash holdings increase in rising markets, and we use up cash when the markets have fallen. We invested 10% of the Fund into equities in June 2010 (markets were off 12% in 2Q 2010), and another 7% in August 2011 (the sharp drawback on euro worries). On the other hand, cash increased as we sold through the rising markets of late 2010 and early 2011.
Cash is useful for us as value investors. It allows us to keep our dry powder for the best opportunities, and to avoid being too heavily invested at the tops of markets. How much cash we have depends on the prices in the market – the higher the prices, the bigger our cash pile tends to be. And this helps us to deliver our primary objective – to protect and to grow our clients’ wealth.