Many years ago, I asked a fund manager about why did not take cash calls – why he not exit a lot of his portfolio and keep cash, since it was obvious that stock valuations were rather high. His response was that the investor has given him money to invest in equities, which made up his or her ‘equity’ allocation and therefore he was duty bound to keep it invested fully. Then he said that even his offer document says that he will not hold more than ten percent in cash. I then pointed out to him that there is also a provision that under some circumstances, up to half of his assets could be held in cash.
My personal portfolio has no such rules. What I do goes. There are times when I like to preserve the gains already made. Or think that the valuations are overboard, like the last few weeks when we are faced with spectacular earnings and spectacular valuations.
Whether we can or should go in to cash is also a function of our life stage and risk appetite. As a very late-stage investor, I generally prefer to keep a lot of cash. A young investor may have a higher allocation of his disposable income to equities and manage with a lower level of cash than I do. My approach to investments is very simple and does not involve excel sheets. Being fearful by nature, my first line of defense has been fixed income and real estate. I have modest investments in equities that have done extremely well as a portfolio, since I have not sold most of my holdings in over twenty-five years. Some of the shares give me current dividend that is greater than my original rupee cost of investment. I am sure that these shares also went through their periods of undervaluation and overvaluation. Obviously, I am a beneficiary of the buy-and-hold style. Frankly, I do not know if the shares I’ve owned are the best compounders. But they’ve delivered close to 20% annualized returns in my estimation and that’s good. Yes, some of the stocks have not done well and some I have sold off.
So why, how and on what should one take a cash call on an equity portfolio?
Why a cash call?
My simple answer to the why question is – to preserve my gains or lock into my good fortune. Maybe a stock I own is not at the top, but the stock price has far exceeded my expectations. That’s a good enough reason to take profits. The other is a sense of euphoria in the markets, which can last one day or for a very long time but keeps me awake at nights. Prices and valuation will keep crossing each other in opposite directions. When the price exceeds my own valuation at a portfolio level or at market level, I find it useful to convert some of my stock holdings to cash. I do this with reasonable confidence that I can buy the same quality at a better price. In technical parlance, I am trying to create a ‘higher’ prospective return.
To me cash is also an essential asset. The only loss to principal I will face in a cash call is the adverse difference between my rate of return and inflation. You may choose to tell me that things are different this time. There is a new breed of investors for whom conventional valuation rules do not apply and stock prices only move north. I remember in 1991, we used to have a ‘minimum trading lot’ size of 50 shares. As prices went higher, your minimum outlay had to compulsorily rise in rupee terms. Clients would call up their broker and ask him to please recommend some share priced below Rs.20 and so on.
How to take cash calls
On the how part, I have found it useful to divide my stock portfolio into two categories. One that is based on ‘earnings’ and one that is based on ‘balance sheet’. My long-term portfolio has shares only of the first kind. These would be services, information technology, BFSI, FMCG etc. The rest are generally for trading. My trade could be sometimes as short as a week or as long as a couple of years.
Today I group all commodity companies in to the second (trading) bucket. I like to buy them when the Price to Book Value number is close to the historical lows. I do not look at the earnings. The P/BV is typically low when the commodity price cycle is in the doldrums, earnings tend to be in the brackets and the PE multiples are either absent due to losses or very high. I buy them and wait. Wait for good times in the cycle to surface like now when I sell them.
These are ‘extra’ investments I have made with a clear objective that in a year or three, I will cash out. Today commodity prices are rising. Today the market is busy valuing these stocks based on earnings. That is showing on the share prices of the smokestack companies. Even PSU stocks are joining the party, because they look ‘cheaper’ in comparison. Will commodity prices keep going up and staying there forever? Will they come back? In my view, gravity works and only the time lag will differ from cycle to cycle. I say, leave me out as I am happy to forgo this leg of the journey. My first leg has given me excellent returns. This approach has worked at least five times in my investment journey since the mid 1980s.
The other tactic I follow is to have a dedicated corpus for ‘speculative trading’, though people may not use the word ‘speculative’. Here I tend to play the momentum game, chasing and anticipating the trend and using stop-losses very strictly. This just keeps me busy and hopefully gives me a return better than a bank deposit.
What should I sell?
Even if you are clear when to take a cash call, what to sell can paralyze you into inaction. Here, rules help. It is best to have a single method and follow it. In my case, I like to see the historical high and low P/E and also look at the ROE trend of a stock before making a sell call. Unless there is going to be a secular change in ROE, a long-term re-rating in valuations is unjustified. Looking at our economy, it is unlikely that interest rates will head south for good. For example, if one can say that long term interest rates will settle at two percent and companies will grow earnings at fifteen to thirty percent, there is a strong case for a higher P/E across the board. For a ‘no-growth’ company, the P/E can be 15 to 16 times (an inverse of the long term interest rates) without considering the equity risk discount. Anything above this, is a payment for growth and superior ROEs.
So, when I have to sell something from my portfolio to go in to cash, my first rule is to see where the valuations are. Let us say I have ten stocks in my portfolio. And let us say they are in a range of between five and fifty percent below their long-term high P/E. I will prepare a sell list putting at number one, the stock which is closest to the long-term high P/E.
The next thing I do is to ‘kick the tyres’. Has the company’s latest earnings been impacted abnormally (down or up) and hence the current P/E is not reflective of the valuation? Is there any reason to believe that the next ten years of the company is going to be significantly better than the last ten? If yes, will it mean a higher ROE? Once I answer these questions, I will prepare my ‘sell’ list. In some cases, I may err. For example, about a year ago, I exited an investment in HUL as I believed that it had run its course, its returns were falling and the P/E was far above its long-term averages. That call didn’t work well, but it’s a call on long-term potential not short term.
Is this a good time?
So that brings us to the most contentious question on whether this is a good time to raise cash. In my view, it is. There is a lot of optimism that is totally hinged on a Goldilocks scenario of great economic recovery, high commodity prices, low inflation, falling interest rates and sustained earnings growth. Every piece of news is seen as bullish for stock prices. Have a look at this wonderful data.
Clearly, earnings have a long way to go to catch up with the valuations. I will be raising cash in the hope that the cash I raise will help me buy equities at better value tomorrow.
More from R Balakrishnan about maintaining a stock portfolio: