Cash Equals Options

Bombs away. Iran continues to struggle economically, and you can hear it in the language coming out of the leadership, which is now calling openly for a resolution to the war. The number one concern for authoritarian regimes like Iran is social unrest, and with a declining economy, high inflation and crushing sanctions, the pressure on the government and military is mounting.

Closer to the economic picture, the two "Is" continue to dominate: inflation and immigration. They are more connected than most commentary allows. Businesses use imported labour to hold down wages and increase their profit margins, which flows through to higher shareholder returns and executive pay. At some point, wages will have to rise in order to keep the economy going as debt levels fall and borrowing demand weakens. An alternative would be a boom in business lending, driven by a commodities upswing or larger government deficits creating local demand, but that would likely push labour costs and inflation higher. That may not be a bad thing, depending on how it is managed.

And then property. House prices keep falling. Every capital except Darwin posted a negative monthly result for August, and the quarterly picture is worse.

Property prospects are looking gloomy, and a lot of commentators are now calling for falls of 10%. Whether it is a slow grind or something sharper, the direction of the numbers is clear.

One of the secrets of Warren Buffett's investing process, and ours, is maintaining a portion of cash. Most investors feel like they are "losing" by holding cash, but that is not the case. Cash equals options.

This is exactly how Buffett was able to extract a 10% preferred dividend from Bank of America during the GFC, along with warrants at a strike price of around $8. He made roughly $500 million on the dividends alone. That deal was only available because he had the cash when everybody else was desperate. The opportunity went to the patient capital, not the fully invested.

While it does not feel like it in a rising market, cash is beneficial precisely when markets decline or desperate asset holders want to sell. It is those with dry powder who benefit. We are all investing over a long period of time, so holding cash is rational because you do not know when the next opportunity will present itself.

One example will do. From 1982 to 2000 the secular bull market delivered 666% over 18 years. But the next 9 years to March 2009 saw a loss of 59%. That is 59% of 666%. Add dividends and they can be largely neutralised by inflation. Add in taxes and fees and the damage a long bear market does to your portfolio becomes very clear. Buy and hold is not the best approach.

This is one of the reasons we think stocks are a better long-term investment than property. You cannot rebalance a property. If the price falls 20%, you have to hope the market rebounds 25% just to get back to where you started. That can take a very long time and it grinds down your compound return. Think about the difference between making 30% over 5 years or 30% over 15 years.

With stocks, the act of rebalancing between uncorrelated assets, say stocks and gold, creates a positive return even when neither asset goes anywhere over a period of time. This is one of the advantages of the Permanent Portfolio approach: the constant rebalancing between uncorrelated assets gives the investor a smoother, less volatile flow of returns over the long term. You harvest the winners and add to the losers.

Property, especially since it is a large, concentrated purchase, is difficult to offset with an uncorrelated asset of the same magnitude. You cannot trim a bedroom and add to gold.

When you think about stocks, think in terms of the whole portfolio. Very few investors hold a portfolio of individual stocks that all rise at the same time. The advantage is precisely that they do not, because the divergence between holdings is what makes rebalancing work. This is why we think stocks are the better long-term vehicle. Property and other assets will have their day in the sun, but over time stocks can be rebalanced, leading to higher compound returns.

Cash is not dead weight. It is the option to act when everyone else is forced to react. Property is falling and cannot be rebalanced. Stocks can be, and the maths of rebalancing turn flat markets into positive ones. Returns measured across a full cycle, from low to low, look nothing like the headline averages the industry promotes. The investors who do well from here will be the ones who understand all three of those ideas.

As always, this is general information about how we read markets and portfolio construction, not personal advice tailored to your circumstances.