How Value Investors Choose Cash Holdings?

Chen Jiahe

As of the end of the third quarter in 2024, Berkshire Hathaway's cash reserve ratio reached a historic high under Warren Buffett. According to the quarterly report, the company held a total of $3252 billion in cash and equivalents, accounting for 28.3% of its total assets.

This ratio is much higher than previous levels. In 2021, 2022, and 2023, this ratio averaged only 14.8%. Some investors are worried about the direction of the US stock market. How do value investors like Buffett choose their cash holdings?

In traditional investment methods, investors often believe that cash holdings can effectively reduce the volatility of a portfolio, thereby achieving risk reduction. For example, when the market drops 10%, a portfolio with a 30% cash holding will only drop 7%, thereby achieving market volatility avoidance. This is discussed in financial textbooks.

However, for long-term investors, this approach actually makes a mistake: it treats market fluctuations as risk. Instead of saying that this approach avoids portfolio risk, it actually avoids portfolio fluctuations. In fact, price fluctuations may look scary, but they do not equal risk.

If the fluctuation of a portfolio is equivalent to risk, then the US stock market in 1987 was extremely risky: from October 14th to October 19th, the S&P 500 index plummeted by 28.5% over just four trading days. However, this massive market fluctuation did not equal risk; the index continued to rise and walked out one of the largest bull markets in US history.

As Howard Marks repeatedly emphasizes in his book "What I Learned About Investing": (without short-term leverage) portfolio fluctuations do not equal risk. Portfolio fluctuations may make inexperienced investors feel more comfortable, but they provide no help for long-term profits.

After investing for 20-30 years or longer, the final numbers on your statement are all that matters. Looking back, you might even forget about the time you lost 20% of your portfolio in a single month, despite this short-term fluctuation seeming terrifying at the time.

So, from the perspective of choosing cash holdings, if investors take "increasing cash holdings can effectively reduce portfolio volatility" as their principle for selecting cash holdings, they will make an error. If portfolio fluctuations should not be a target for managing cash holdings, how do value investors like Buffett choose their cash holdings?

Simply put, value investors should only consider one reason: that cash-type assets are more valuable than other assets. Investors should forget about the fact that cash values will fluctuate while publicly traded securities' values will fluctuate, and instead focus on the relative value relationship between cash and other assets, making a choice based solely on value.

How can we compare the relative values of cash and other assets? Investors need to put them under the same consideration framework. For example, when cash yields 2%, it is actually an ROE (return on equity) of 2% with a PB (price-to-book ratio) of 1x, PE (price-to-earnings ratio) of 50x, and a dividend yield of 100%, with no change in annual profits.

If we think about cash from the value perspective rather than market fluctuations, investors can easily compare the relative values of cash and other assets. In the above calculations, cash has a PE of 50x and its profit does not grow or decline; if the stock's PE is 8x with profits growing, but the dividend yield is only one-third, then it can be determined that investors do not need any cash holdings. If real estate's PE (price-to-net rental income ratio) is 70x, then cash still has a relative value compared to real estate.

Returning to Buffett's example, as of the end of the third quarter in 2024, the target range for the Federal Reserve's federal funds rate was between 4.75% and 5%, corresponding to a PE of 20x. The 10-year US Treasury yield was around 4%, corresponding to a PE of 25x. At the same time, according to Choice financial terminal data, Buffett reduced his holding in Apple Inc., with a market capitalization-to-earnings ratio reaching 34x, and Bank of America's market capitalization-to-earnings ratio reaching 12x.

Clearly, when facing cash assets with a PE of 20-25x and no risk of profit decline, Buffett said "no" or at least a "conditional no" (he still held some stock holdings). This approach to selecting cash holdings through value comparison is undoubtedly simpler, more relaxed, and more effective than trying to catch and manage those ephemeral market fluctuations.

Set your mind at ease, do nothing. For investors, since long-term returns come entirely from value growth, when considering how to choose cash holdings, investors should start from a value comparison perspective, choosing cash when it has relative value and giving up on cash when it does not have relative value, rather than considering the fact that cash values will fluctuate.

Thus, investors can avoid being troubled by market fluctuations in long-term investing and achieve excellent value growth to obtain the best investment returns.