Cash – your silent portfolio partner

Too often ignored until it is too late.

The role of cash in one’s share portfolio is often underestimated. So much so, that many even consider cash a drag on a portfolio, particularly when markets go up. The return from cash on an inflation adjusted basis is effectively zero, and if you believe as I do that over the long-term markets go up, then I too agree that holding cash can act as a limiter to long-term performance.

But if respected and harnessed correctly within a disciplined investment strategy, your cash holding can be a powerful weapon that contributes positively to overall portfolio performance.

Tactically, managing cash is what differentiates someone who manages their portfolio versus a simple stock picker. And while we all understand that cash is required to buy stocks and seize opportunities, what are the ways we as managers of our portfolios can harness the power of cash within a share portfolio?

As an investor

Cash as an Insurance policy

When markets are volatile, like they are currently, investors can react in different ways. Some see volatility as an opportunity, others become worried that things will get worse. As the old saying goes, markets go up the stairs but come down the elevator.

There are several complex investment products and strategies open to investors that can provide downside protection. But at the end of the day there is no cheaper, easier or better insurance than to hold funds in cash.

I’m often reminded of BBUS, the BetaShares US Equities Strong Bear Hedge ETF, a suitably complicated instrument which has futures contracts to deliver an over 250% exposure to downside protection against the S&P500 falling. (So the price of the ETF would go up if the US market crashed).

Since inception on 24 August 2015, it has been a massive capital killer providing very little in the way of capital protection making the product a true oxymoron. Even the COVID correction was a mere blip of success over the long term woe. In fact in Mid 2021 when the ETF consolidated 10 units into 1 effectively raising the price by reducing the amount of units on issue, cynics would have seen this as a necessary move to give the price of the ETF more room to fall.

Whereas holding good ol’ cash in volatile times is a form of insurance as it protects an investor from things getting worse than they currently are. Investors that are momentum sensitive often decide on this course of action to avoid any potential future catastrophic declines in a stock they are holding.

However, anyone who sells based on sentiment must be prepared to re-enter a quality business, even if the price is higher than what they sold it at, to benefit from any rebound.

But if you use cash as insurance don’t beat yourself up if your insurance doesn’t pay off.

Ultimately we take insurance to protect our interests IF something bad happens. No individual complains when they can’t claim on their life insurance policy because they’re not dead yet, so you should not complain if a stock you sold didn’t fall.

Use bull runs to build your cash pool

As mentioned briefly earlier, cash is required to seize on future opportunities. However, when you are fully invested how do you free up the cash required to buy a new inclusion? Particularly if you're happy with your other holdings?

When markets are on a tear, there is a propensity for investors to overcommit to the market. At this point however, it is important to remember that markets never move in a straight line north-east and investors should be prepared to see even the greatest of companies have a pullback in price at some stage. Therefore, a prudent measure within any investing plan is to have a disciplined profit taking strategy, particularly if a stock’s recent run has been steep.

This has the benefit of first, ensuring your portfolio does not become a victim of over concentration where the direction of one stock would have a disproportionate impact on the overall portfolio.

And second, it also helps you build a war-chest to seize future opportunities that will stare you in the face, without the need to commit any extra funds to the portfolio from other sources.

In effect, taking profits is good portfolio hygiene, ensuring that you are well positioned for anything the market throws at you.

Cash as an investment?

In Australia we have had eight consecutive rate rises. In New Zealand, the Reserve Bank delivered a record rate increase and remains quite hawkish in its stance against inflation.

Despite the lag between rate rises and deposit rates, with subsequent rate rises, cash style investments are becoming more of a consideration for investors who can look at total risk adjusted portfolio performance.

What is meant by risk adjusted returns? Without discussing the mathematics, the concept is that if I can achieve 5% in a term deposit versus 5% in the share market, I would prefer the term deposit because on a ‘risk-adjusted’ basis my return is more stable and predictable than that offered by the share market.

At the minute cash rates are still not enough to see a sizable coming together of risk adjusted returns. However remember, much of the market's lure in the past decade has come from the significant migration from term deposit refugees in search of a better dividend, despite the increased risk they were taking. More years like 2022, coupled with a continuing rate rise cycle, may see some investors returning home to cash style products. And in a rising rate environment, it would be remiss of us as custodians of our money to not consider its overall place within a holistic portfolio..

As a company

But your business needs cash too. - It’s the life blood of their health

While to this point we have talked about cash from the management perspective, it is equally as important to understand the role of cash within the businesses you are investing in.

As anyone who has run their own business will tell you, cash is indeed king, and this is no different for a listed company.

Cash flow is critical for long-term success. Put simply, if you can’t generate positive cash flow, particularly operating flows, doing what you do everyday, then that is not sustainable long-term.

From a financial health assessment perspective, profit figures generated by a business can be heavily impacted by significant events, timing issues and ‘interpretations.’ However, a dollar in the bank is a dollar, no matter how you cut it. In Stockopedia we use the Beneish M-Score to measure whether a company has managed / manipulated its earnings figures. What we want to identify is whether a company’s earnings are driven by real operational factors, or financial engineering.

From a funding perspective, cash generated via retained profits is the cheapest source of financing a business has access to. Growth companies rely on cash to keep growing, reducing the need for higher-risk bank debt, or more expensive shareholder capital.

Finally, income seeking investors will focus on cash flows because it is from these that a company pays dividends to shareholders. Should this cash pool dry up, then the likelihood of future dividends, let alone any increases, comes into question. Savvy income investors will also seek those companies with excessive cash balances in anticipation of a capital return or special dividend.

Where can you find cash numbers in Stockopedia?

Great question! (Even if I do say so myself)

Starting with the StockReport™ there is a great little section towards the middle of the screen where you can see the current level and trend of the following elements of cash flow

• Operating cash flow per share - the lifeblood. What the company generates in cash doing what it does everyday on a per share basis

• Capital Expenditure (Capex) per share - the amount of expenditure spent on maintaining or developing operating assets

• Free cashflow per share - This is the cash that is left once capex is removed from operating cash flows.

What I also like about Stockopedia is that when you hover over a number a nice little histogram appears to provide context to what you are looking at.

And if you ever need a reminder as to what something means, simply click on the measure.

For all you Stock Nerds (like me) out there. If you want to get down and dirty with Cash Flow, Then you can simply click on accounts >> cashflow statement.

*Tip: Once the February reporting season is done, be sure to select “Interim”. That way the latest cash flows for the first 6 months of the new financial year will appear allowing you to do comparisons against the previous corresponding period.

Conclusion

The net outcome of this contribution is that you neglect cash and its role within our portfolios, and in our companies, at your own peril.

While it has been out of sight, out of mind for some time, a rising rate cycle and the subsequent rising costs of financing means that we need to start rediscovering cash’s important role in our portfolios once again. How we, and our companies, harness it will play a big role in our investing success.

_________

Important Information: Stockopedia Ltd ABN 39 757 874 670 UK business registration number 0637267 (“Stockopedia”) is an Authorised Representative of Daylight Financial Group Pty Ltd ABN 77 633 984 773 (“DFGPL”) which is the holder of an Australian Financial Services Licence (AFS Licence No. 521404).

Information in this commentary is current as at date prepared unless otherwise stated. However, please bear in mind that investments can go up or down in value, and that past performance is not a reliable indicator of future performance. For more Important Information please refer to the Disclaimer section of this website.

This communication may contain general financial product advice. It has been prepared without taking into account your personal circumstances, and you should therefore consider its appropriateness in light of your objectives, financial circumstances and needs before acting on it.

If our advice relates to the acquisition or possible acquisition of a particular financial product, you should obtain a copy of and consider the Product Disclosure Statement (PDS) before making any decision.