Thumb twiddling

The biggest mistake any investor can do is just invest cash for the purpose of investing it in something instead of investing it in something proper.

Hence, I am still twiddling my thumbs.

Curiously I do notice Encana (TSX: ECA) is up about 6% despite the fact that natural gas futures are still depressed. Might be a sign of short covering?

I’ve also been doing some research on R.R. Donnelley & Sons Company (NYSE: RRD) – I have owned their corporate debt in the past so I have not had to do much additional work. They are facing the same issues that Yellow Media had, mainly a good chunk of their business (catalogs and cheque printing) is getting enveloped by the online world. Still, the company is hugely cash flow positive and doesn’t even have the debt albatross that Yellow Media has. If it wasn’t for the fact that they are a well-known case, I might dip my toes in.

There are a couple other smallish-cap companies ($100M-$250M range) that I am reluctant to mention here that seem to have very compelling valuations, plus almost no financial pundits are paying any attention to them.

The great thing about having a large cash position is that it feels like I am working with a blank canvass. Despite earning almost nothing in yield for cash, I also do not feel pressured to make any portfolio decisions. If I have to wait out an entire year without hitting any candidates, so be it.

7 thoughts on “Thumb twiddling”

  1. Why cash? By my computations, cash will earn something like -1% to -3% real return over the next couple of years. With TIPS, you can lock in a real loss for a ten-year period.

    Contrast this to a diversified global stock index. Smoothing the earnings over past three years and assuming a low long-term future ROE and 50% reinvestment rate gets me to over 4-7% expected long-term real return on stocks. Call the point estimate 5.5% or something.

    Isn’t 5.5% real enough to keep the portfolio in a liquid, diversified index fund waiting for better ideas?

  2. -1 to -3% real returns? Sounds about right.

    Here’s the problem with your comment – your analysis is not secret information. The S&P 500, for example, will have a projected P/E of about 13, depending on which analyst estimates you use. Why not dump cash there and claim a 7-8% earnings yield? 10-year bonds are yielding about 2% or so, quite the spread between “risk-free” and equity.

    Makes sense? It does. Why does the market give it to us?

  3. I think that the market gives it to us for a number of reasons:

    First, only a minority of individual investors can do the simple present value computation to evaluate forward looking expected real returns on the market. Most people simply look at historical returns over some period, be that 100 years in the best case and 10 years at the worst case. Bonds look great and stocks look bad based on that method, so people buy bonds (or bond mutual funds) and leave equities alone.

    Second, a lot of institutional investors globally are moving to asset-liability matching and moving their assets to bonds. Some voluntarily, some because of regulatory pressures. I like the idea in principle, but hate the timing. They are also heading to hills and buying bonds.

    Third, the opportunity is not fat enough for hedge fund managers and other professional speculators. If the expected equity premium is about 5.5% – (-1.5%) = 7% and volatility is 21%, that implies an annualized Sharpe ratio of 1/3 with basically unhedgeable risk. Sharpe ratio of 1/3 and a lot of beta with it is not something that interests most professional speculators. So they are not buying the market up.

    This leaves just people like you and me. We are not enough to be the catalyst to drive the price up and earn oversized capital gains. However, I think we can just sit on the position and earn that expected return of 5.5% real and beat cash by about 7%.

  4. I don’t think individual investors matter, the bulk of the capital will always be moved around pension and institutional investors (yes, some of that capital is through mutual funds and such that are funded by individuals, but the decision-makers in the markets will be the institutions).

    With respect to asset-liability matching, there is no way that pension fund managers can make their expected rates of returns with bond rates at existing levels without taking disproportionate risk – so wading into BBB bonds, or increasing the equity allocation. With existing rates, why have they not already shifted more into equity?

    I also find the relatively low implied volatility of the S&P to be puzzling.

    I agree with you “on paper” that you can just sit in a happy index and probably outperform cash, but what is the “catch”? You’re basically saying there is none, while I am more suspicious. Going back to the micro world, it would make firms like Dell seem like an absolute bargain. What’s the catch?

    Too many questions.

  5. Why does there have to be a catch with the market? Nobody knows substantially more about the market valuation and long-term expected returns on the broad market than an individual with a spreadsheet, internet connection, and 30 minutes of time. You could argue that someone might have some inside information about monetary policy at some points, but right now even that’s not an issue. The Fed is fully committed to keeping the monetary policy loose as far as the eye can see. There’s no catch, or conspiracy.

    Contrast this with sector, industry, and individual company. As we go to more disaggregated level, the likelihood of there being a catch increases dramatically. There can be some insider information out there about an industry and definitely about an individual company. The growth prospects and how well the management takes advantage of those prospects can also vary dramatically between individual companies,

    The question “where’s the catch” is the right one to ask at industry or individual company level. It’s not the right question to ask at the whole stock market level.

  6. The logical conclusion, especially with short-term rates as they are, then would be to leverage on equity?

  7. In general, that depends on your risk aversion. For most people, rationally or irrationally, a Sharpe ratio of 1/3 is not high enough to prescribe a high leverage.

    There’s a specific feature of the current market pricing that does suggest buying equities with leverage, though. You mentioned that the implied volatility on index options is lower than what you think it should be. If so, why not take levered equity exposure via long-term index call options? This will protect almost all of your cash from the downside. If you furthermore end up being correct that volatility will be higher than the current implied volatility, you ended up getting that leverage cheaply. Usually index calls are a bit expensive, but if you think they are cheap now, why not buy them?

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