I debated this topic with some people today and found it interesting so I decided to jot down some of my thoughts on the process of being a long term investor who has the goal of outperforming “the Market” over a full business cycle.
The question was posed “why hold so much cash right now?” to which my answer was “the opportunity set has shrunk and I’m not finding many attractive investment opportunities”. Waiting for attractive investment opportunities was deemed to be “trying to time the market”.
In my, likely ill informed, opinion I believe that market timing and waiting for fat pitches are completely different animals. The market and underlying businesses are in a constant state of pulling forward or push out future expected performance. This push/pull effect a direct result of recent performance, valuation and growth. Theoretically if assets price are high (low) its a result of 1) high (poor) recent performance and 2) high (low) valuation, thus forward expectation of returns is lower (higher).
The term “attractive investment opportunities” has unique definitions to each investor, but there are two basic forms of attractiveness. An investment can either look attractive on a relative or an absolute basis. How much you want to be invested all depends on you define your hurdle rate and whether that hurdle rate is absolute or relative. If its a relative rate then all you’re looking to do is beat the index by X% per annum. When you find investments that look attractive when analyzed using that hurdle rate then you own them, if you can’t find any then you hold cash (or some alternate liquid short term investment). Same goes for an absolute hurdle rate. If your mandate is to only own things with an expected return of 20% then you hold cash until you find something with an expected return of more than 20%.
As a part of my process I seek investments with an expected return of 15% because I think that provides me with an adequate “margin of safety” over the long term expected return for the market of 7-9%. If I’m modestly wrong on my assessment of value then I should still end up with a decent result, if I’m very wrong then I’m not very good at my job. That said, if the risk of loss is lower (recurring revenue or stable business model, cheaper valuations) I’m willing to reduce that minimum required return. Needless to say, in today’s environment it is difficult to find investments with an expected return of 15%.
Anyways, I welcome any and all thoughts on the matter.