An Equity Investor's Most Potent Weapon: Cash - The 5 Minute WrapUp by Equitymaster
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An Equity Investor's Most Potent Weapon: Cash

Apr 23, 2016
In this issue:
» The rally in metal stocks: Is it sustainable?
» US market close to all time high once again
» And more....
0.00
Rahul Shah, Co-Head of Research

In the world of equity investing, cash is frowned upon.

Note: I'm not talking about the black money. In investing parlance, cash connotes investments in debt instruments like bonds, fixed deposits, etc.

So when it comes to investing in stocks, cash is a dirty word. Any portion of money reserved for stocks but lying in cash is thought of as underutilised. A waste of capital even.

So you'll never see equity fund managers or equity mutual funds sit on too much cash. They even have laws against it! If a fund wants to be counted as an 'equity' fund, it cannot have cash of more than a certain percentage.

But here's the thing: Cash can be an equity investor's best friend...and most potent weapon. If used correctly, it not only makes his equity investing safer, but gives an adrenaline shot to his returns.

Most investors out there - even the professionals - don't understand this. Many are afraid to sit on cash.

'What if the markets keep rising?'

'What if they don't come down at all?'

'Won't I look like a fool in that case?'

Such fears have another side effect. They prevent investors from selling stocks, even if they know the market is high. If the sale means sitting on cash because they don't know what else to buy, they end up just holding on to expensive stocks.

More astute investors realise the power of cash. They know it's usually just a matter of time before the stock market throws a tantrum. And when that happens, stock prices go out the window.

At such moments, the cash portion of your portfolio does two things for you. One, it doesn't let your overall capital value go down as much as the markets. Two, when the market's tantrum is at its fiercest and stock prices are in the dumps, it lets you scoop up stocks at terrific prices.

But just how often does the market throw tantrums? Let me lay down some facts for you:

Date when market's tantrum was at its fiercest BSE Sensex' decline from high Time taken for the decline after market hit a high (years)
28-Mar-88 -41% 2.1
25-Jan-91 -39% 0.3
26-Apr-93 -54% 1.0
25-Jan-96 -39% 1.4
20-Oct-98 -39% 1.2
21-Sep-01 -56% 1.6
17-May-04 -27% 0.3
14-Jun-06 -29% 0.1
09-Mar-09 -61% 1.2
20-Dec-11 -28% 1.1
11-Feb-16 -23% 1.0
  Average 1.0

Source: Equitymaster, Ace Equity

As you can see, over the last 30 years, the average time the BSE Sensex has taken to fall from a high down to its knees has been just one year. It's a habitual tantrum thrower...and can't keep from it for long.

So, never be afraid of selling expensive stocks, even if you can't seem to find a replacement at the time. Never be afraid to have a portion of your capital meant for stocks in cash.

At the end of the day, having gunpowder is just as important as having a gun.

Do you think that, at times, sitting on cash as part of your equity portfolio could be a good idea? Let us know your comments or share your views in the Equitymaster Club.

2.35 Chart of the day

After a prolonged weakness in commodity prices, metals stocks have been on fire in the last three months. The BSE Metal index is almost up by 27% since mid-February. Does this mean turnaround time for metal stocks?

Is the rally in metal stocks sustainable?

The recovery in the prices globally can be attributed to the lower production and capacity curtailment. Similarly, the increase in domestic steel prices is backed by an imposition of MIP. To have sustainability in steel prices, China needs to cut more capacity to adjust to the falling demand. China accounts for half the world's steel output. Any improvement in global steel outlook, therefore, hinges on a revival in Chinese demand and supply-side reforms. However, it is important to note that the current rally is not driven by a fundamental improvement in demand. Temporary price rally may increase steel mill's profitability, but it could also stimulate more output.

We have also seen a rally in non-ferrous metal stocks since Mid-February. Although the underlying fundamentals remain unchanged, in Budget 2016-17, the government has increased custom duty marginally on primary aluminum products to 7.5% from 5% and custom duty on other aluminum product increased from 7.5% to 10%. In the current weak pricing environment, companies from this space have been focusing on increasing volumes and improving the percentage of value-added products (VAP) in the overall metal production.

To have a sustainable rally in metal stocks, it is essential to minimise the demand-supply mismatch. Excess supply from the market should dry out. With improved demand, the metal sector can bounce back. But it all depends upon China. If China continues to slow more than the markets currently anticipate, there could be further downside risks for commodity prices.

3.15

The US markets have been testing their all-time high levels constantly over the past fifteen months. There were two small concern phases which led to sharp corrections in this period. As The Economist points out, the concerns were largely to do with the slowing earnings of the corporate sector, the declining oil prices, stabilization of China and not so frequent rate hikes by the Fed.

However, the markets seem to have overcome those. As of today, the S&P trades levels of around 2,100, close to its all-time high level.

From what we can gauge, it's seems to be a situation of seeing the glass half empty or half full. Market participants are looking at things from the latter point of view as per us. The rate hikes will be slower than what was earlier expected. Or for that matter, the corporate sector earnings are falling lesser than anticipated. Oil prices have stopped falling as sharply.

All said and done, market valuations of the S&P 500 are at their highest since 2009. Going by the Shiller PE methodology too, this holds true. As per marketwatch.com:

  • The Shiller PE basically compares the price to inflation-adjusted earnings over the previous 10 years. The higher the Shiller PE, the lower long-term returns. The Shiller PE stood at 26.24 on Thursday, according to multipl.com, versus its long-term average of 16.67.

In a recent article, Bill Bonner shared his views on why it makes sense to prep for worse times ahead given that the Fed is unlikely to go about making improvements to its balance sheet anytime soon. Here is a quote from Charlie Munger that he used in his recent write up:

  • I remember coffee for 5 cents and brand new automobiles for $600. The value of money will continue to go down. Over the past 50 years, we lived through the best time of human history. It is likely to get worse. I recommend you prepare for worse because pleasant surprises are easy to handle.
4.05

It was a good week for stock markets around the world. The surge in crude prices has boosted sentiment. Despite the failure of the talks between members of OPEC to cap global oil supply, the commodity has continued to rally.

The US market (DJIA) was up 0.6% for the week. However, there is apprehension about the earnings season in the US. Expectation are quite low and many large corporations could report disappointing numbers. The US Fed will meet on 26th - 27th this week. The Fed is expected to keep interest rates unchanged.

The European markets did well this week as the ECB vowed to maintain its accommodative monetary policy. Except the British FTSE, most European indices ended the week in the green. However, fears of Britain leaving the EU are growing bigger every week.

The Indian markets also continued their rally. The BSE Sensex was up 0.8% this week.

Performance During the Week Ended 9th April, 2016

4.50 Weekend investment mantra

"If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring." - George Soros

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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1 Responses to "An Equity Investor's Most Potent Weapon: Cash"

Ravi shah

Apr 23, 2016

Yes, it is very true to have cash with you when market throws tantrums.This is very helpful insight for us.I m delighted to read this research.thnks a lot Dear Rahul shah

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