Cash on Hand...An Investors' Best Friend

Warren Buffett’s annual letter to shareholders came out recently. This is probably one of the most anticipated shareholder letters in the financial world. Everyone wants to know what the Oracle’s take on the world is. Also, because Berkshire is so large and spread across so many sectors – it owns 80-plus businesses now – his thoughts may give some insight into how the economy is doing.

His letter was the most optimistic letter we’ve seen in awhile – and maybe ever. Buffett said things such as “There is an abundance of [opportunity] in America” and its “best days lie ahead.”

Looking at his businesses, you can see from where that optimism might spring. Iscar, which makes metal tools, enjoyed a 41% increase in sales from a year ago. TTI, an electronics distributor, saw sales jump 45%. Burlington Northern, the railroad, reported a 43% jump in profits. And on and on it goes.

Forced to pick one indicator to judge the health of the economy, Buffett said it’d be rail car loadings. In 2010, rail car loadings were up 7.3% over 2009, which was the largest percentage increase since we have data (1988).

He also offered up the prediction that the housing market would recover within a year. A few of his businesses, such as carpet maker Shaw, are still way below where they were a few years ago.

So there you go. The Oracle is optimistic.

Now, I’ve learned a lot from Warren Buffett over the years. Studying his career is a must for investors. After all, he may be the greatest investor of all time. But this cheerfulness doesn’t sit well with me. I’m seeing too much of it everywhere. Perhaps Buffett will be right when looked at over a period of years. But in the near term, I see a lot of things that give me pause.

Some of these are just unassembled fragments, but consider…

The IPO market is off to its best start ever, according to Dealogic. So far, there has been $26 billion raised in new listings. And there is a backlog of $48 billion. So essentially, insiders are selling stock to public shareholders, who, so far, have lapped it up like hungry dogs.

Insiders are also selling stock of already public companies at a brisk rate. Insider selling itself is not a profitable signal to follow. In fact, academic studies have shown time and again that insider selling is not a worthy predictive signal. That makes sense because insiders can sell for all kinds of reasons. (This is in contrast to insider buying, which is a profitable signal to follow.) And we did get a very bearish level of insider sales last November, which did not materialize into a market correction of any kind. But it is unsettling, nonetheless. Insider sales outnumber insider buys by a ratio of nearly 40-to-1. Bad.

If things were so rosy, would that ratio be so high?

Then, there is the surging price of grains and oil. The high price of food is a major destabilizing force in emerging markets, where there are large pools of poor people who spend a great deal of their income on food. When food prices rise 25% in India over a few months, that’s going to have an outsized effect.

This matters for investors because the market so far has floated on a sea of good earnings. And if you dig into those earnings, you can’t help but notice how many companies are reporting wonderful results because of booming business in Brazil or Russia or China or some such place. Emerging markets helped drive earnings. By contrast, the results from the US and Europe and Japan have enjoyed more muted recoveries.

I worry that the rising cost of food and raw materials will dampen those results in the coming quarters. So that’s bad.

So I think it’s a good time to be careful. In fact, Buffett had some very good advice in his letter when he started to talk about the effects of borrowed money.

“The fundamental principle of auto racing is that to finish first, you must first finish,” he writes. Using lots of debt makes finishing iffy. The Oracle continues:

“Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

Of course, this math applies to investing in stocks, which is why it is important to look at financial strength and balance sheets, as we do. Maybe we haven’t made as much money as we might have in the past two years if we had bet on more speculative, less ably financed companies. But over the long haul, we’re following a surer path. (And we’ve done pretty darn well as it is.)

Buffett also writes about a letter he found written by his grandfather to his son in 1939. “Ernest never went to business school – he never, in fact, finished high school – but he understood the importance of liquidity as a condition for assured survival,” Buffett writes.

Old Ernest gave his son Fred very good advice. He writes: “Over a period of a good many years I have known a great many people who at some time or another have suffered in various ways simply because they did not have ready cash… Thus, I feel that everyone should have a reserve.”

Buffett says Berkshire customarily keeps at least $20 billion on hand, “so that we can both withstand unprecedented insurance losses…and quickly seize acquisition or investment opportunities, even during times of financial turmoil.”

It’s a good way to run a business. It’s a good way to run your personal finances. And it’s a good way to run a portfolio.

So my advice to you is to keep a cash reserve.

As a long-term investor, I might share some of Buffett’s optimism. When I look over our names, I see a lot of people doing great things that could create substantial wealth this year and in the years to come.

At the same time, I think this market has a little air under it. I would never advocate selling simply because of a guess about the market’s direction. Calling tops and bottoms is a fool’s errand. But I do know that finding bargains is getting harder. Many valuations are full. Keep a cash reserve so that you are ready to take advantage of new opportunities when we get the inevitable dip in the market.


Chris Mayer,
for The Daily Reckoning

The Daily Reckoning