A comparison of two investors

23 Oct 2011 by Jim Fickett.

Holding cash until clearly better opportunities come along can be a very successful strategy.

Recently I've spent time reading two books. One, “The long and the short of it”, by John Kay, is erudite, amusing, well-written, and full of interesting observations that may or may not be relevant to real-world investing. The other, “Margin of safety” by Seth Klarman, is somewhat disorganized, a bit plodding, and full of very useful investing advice.

I mentioned before one of John Kay's ideas – that an unsophisticated investor might do well to imitate institutional pension funds, via a portfolio of ETFs (A low cost, low maintenance, professional portfolio). I still find this idea intriguing, but the book did not give any evidence that it would really work. The lack of evidence turned out to be a theme, and some of the ideas presented seem quite dangerous. For example, Kay is of the opinion that intelligent investors should never hold cash or bonds, at all, and instead depend entirely on diversification of higher-return assets to limit volatility.

Buffett, on the other hand, often states that he is willing to hold cash as long as necessary, waiting to find true values worth buying. This contrast on the cash position was further brought home as I read Klarman, who states,

Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. …

How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.) By replacing current holdings as better bargains come along. By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available. …

The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines. …

when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive.

How should one evaluate the Kay philosophy on cash – never hold it because returns are poor – versus the Klarman philosophy on cash – stick with cash unless the alternative is very surely better? One way is to look at the logic each author presents. The argument for not holding cash is that you can achieve stability without it: a portfolio of sufficiently diverse assets has lower volatility than any one individual asset (see for example the capital asset pricing model). But of course the real world does not always cooperate, and correlation among the prices of formerly uncorrelated assets was very high in the last four years, so this argument is not very strong.

One might also compare the investing performance of the two authors. The jacket of Kay's book says, “For more than twenty years he has been Investment Officer of Oxford's wealthiest college.” It is easy to verify that St. John's College is the wealthiest. None of the colleges provides easily accessible performance data on their endowment portfolios. However law students have managed to get their hands on some performance data, and it would appear that Kay was achieving returns of about 5%/year through 2007.

On Klarman, CFA and blogger Wade Slome writes:

I did some digging regarding Klarman’s performance, and given the range of markets experienced over the last 25+ years, the results are nothing short of spectacular. Here is what I dug up from the Outstanding Investor Digest:

Since its February 1, 1983 [2008] inception through December 31st, his Baupost Limited Partnership Class A-1 has provided its limited partners an average annual return of 16.5% net of fees and incentives, versus 10.1% for the S&P 500. During the “lost decade”, Baupost obliterated the averages, returning 14.8% and 15.9% for the 5 and 10-year periods ending December 31st versus -2.2% and -1.4%, respectively, for the S&P.

Here is some additional color from Market Folly on Klarman’s incredible feats:

Despite Klarman’s typically high levels of cash [sometimes in excess of 50%], Baupost has still generated astonishing performance. It was up 22% in 2006, 54% in 2007, and around 27% in 2009. During the crisis in 2008, Klarman’s funds lost “between 7% and the low teens.” Still though, he certainly outperformed the market indices and much of his investment management brethren in a time of panic.

The record speaks for itself. Don't feel bad about it if you have a hard time finding good opportunities to put cash to work.