One of the realities that makes value investing possible and profitable is that market prices vary more – sometimes much more – than underlying business values. Joel Greenblatt is fond of illustrating this point by getting out the newspaper and showing his students the huge variances in prices between 52 week highs and lows. This, of course, is also the lesson of Graham’s famous Mr. Market parable.
To take advantage of these opportunities requires cash.
You not only need to have cash on hand to provide reasonable buying power when the market goes into a funk, but also you need to have enough cash on hand to never be in a position of needing to raise cash in a down market by selling your undervalued holdings. If you don’t have any cash, you won’t be able to profit from Mr. Market’s gifts. If you need to sell your holdings in a severe market decline, you turn your primary advantage as a value investor on its head and make it work against you.
There is no precise formula on how to do this but a few common sense principles should go a long way.
1. Have sufficient liquidity from income and savings that you can go three to five years without needing to tap into your equity holdings.
2. If one of your holdings becomes materially overvalued – thereby discounting years of the most optimistic expectations for progress in the underlying business – sell it to restock your cash position.
3. Maintain a meaningful portion of your portfolio in liquid form so you have buying power when opportunity presents itself. This is not to say that you should never be fully invested, but the bar should be set pretty high for you to part with that last 20% of your portfolio held in cash. The prospective investment should be screaming at you, and you should be fully cognizant of the opportunity costs of committing these funds.
4. As a compliment to point 2, consider a meaningful investment in companies such as Berkshire Hathaway that have the ability to buy opportunistically on your behalf. For example, Berkshire has a huge cash stock pile of around $40 billion, annual earnings power of approximately $12 billion, ready access to funding, and – most importantly – the skills and attitude to put it to work when opportunity presents itself.