Guest Post: Holding vs Deploying Cash

A great article by DividendMantra on the pros and cons of holding versus deploying cash. Do you agree with his take?

I’m just another young guy, at 30 years and counting, trying to achieve
financial independence at a young age. My main mission with this
blog is to chronicle my journey from a negative
net worth to retirement in 12
years. As such, this being my real life, it’s of the utmost importance to me
that I do everything in my power to maximize the possibility of this goal
actually being achieved. As many of you already know, my strategy is to invest
fresh capital on a monthly basis in attractively priced high quality dividend
growth stocks and to keep most of my net worth there, eventually living off the
dividend income my portfolio will provide.

One concept that dividend
growth investors, including yours truly, often talk about is the right time to
deploy cash. When’s the right time to invest? If the Dow Jones Industrial
Average just moved up 300 points over the last two weeks, is it better to wait
for it to come down? I just got my paycheck yesterday, but I should hold it for
at least a few weeks before I inject fresh capital into my portfolio right? The
Shiller PE is above 20 right now…maybe we should wait for a correction,
right?

This article is going to lay out my exact thoughts on this
issue. The answer is – there is no right answer. Unfortunately, as many things
in life, it depends. It depends a lot on how much capital you have to invest
with, how long your investing horizon is and where individual equities are at in
terms of valuations. Ultimately, opportunity cost is at the heart of this
matter.

Per Investopedia,
the definition of opportunity cost is as follows:

“The cost of an
alternative that must be forgone in order to pursue a certain action. Put
another way, the benefits you could have received by taking an alternative
action.”

So, by holding cash you’re forgoing the opportunity to earn
a potential return on your capital. By holding cash, you’re going to
consistently lose purchasing power as the invisible tax known as inflation eats
away at the true value of your principle. On the other hand, you could also
invest in an asset that loses value. Investing in dividend growth stocks (or any
asset for that matter) that are significantly overvalued will lead you to
conclusion #2.

Benjamin Graham, the oft-cited forefather of modern value
investing wrote a bit about this phenomenon in his seminal work “The
Intelligent Investor“:

“We are convinced that the intelligent
investor can derive satisfactory results from pricing of either type. We are
equally sure that if he places his emphasis on timing, in the sense of
forecasting, he will end up as a speculator and with a speculator’s financial
results. This distinction may seem rather tenuous to the layman, and it is not
commonly accepted on Wall Street. As a matter of business practice, or perhaps
of thoroughgoing conviction, the stock brokers and the investment services seem
wedded to the principle that both investors and speculators in common stocks
should devote careful attention to market forecasts.”

“There is
one aspect of the “timing” philosophy which seems to have escaped everyone’s
notice. Timing is of great psychological importance to the speculator because he
wants to make his profit in a hurry. The idea of waiting a year before his stock
moves up is repugnant to him. But a waiting period, as such, is of no
consequence to the investor. What advantage is there to him in having his money
uninvested until he receives some (presumably) trustworthy signal that the time
has come to buy? He enjoys an advantage only if by waiting he succeeds in buying
later at a sufficiently lower price to offset his loss of dividend income. What
this means is that timing is of no real value to the investor unless it
coincides with pricing—that is, unless it enables him to repurchase his shares
at substantially under his previous selling price.”

“By pricing we
mean the endeavor to buy stocks when they are quoted below their fair value and
to sell them when they rise above such value. A less ambitious form of pricing
is the simple effort to make sure that when you buy you do not pay too much for
your stocks. This may suffice for the defensive investor, whose emphasis is on
long-pull holding; but as such it represents an essential minimum of attention
to market levels.”

Graham, a true genius when it came to investing,
starts this off by talking about profiting from both timing and pricing.
Timing would be trying to profit from what one perceives as upward or
downward market trends and investor sentiment. You would hence sell when the
market is likely to dip or dive, and conversely buy when the market is trending
upwards. Profiting from timing is of no concern to me, and I pretend it doesn’t
even exist. I don’t trade on trends, and I don’t time the market. Profiting from
timing is extremely consequential to traders and speculators,
however.

So, we move to pricing. With pricing, and the arbitrage
of such, a long-term (or long-pull as Graham calls it) investor is
looking to purchase stocks sufficiently and significantly, if possible, below
their intrinsic value which would allow you a margin of safety. The investor
would then continue to hold this asset as long as it remains attractively priced
on an ongoing basis (as profits continue to rise and allows for price expansion)
or sell when the stock rises sufficiently above intrinsic value. Graham, it
should be noted, was not a dividend growth investor and was not shy about
selling stocks when he thought they were fully priced.

Graham, however,
explicitly refers to dividends above when talking about pricing. He explains
that an investor would only do well to wait on a better price (that may or may
not come) if the lower price (if achieved) makes up for the lost dividend income
(as opportunity cost) that the investor would have laid claim to had he invested
in the stock at an earlier date.

For example, let’s say you think
Philip Morris International (PM) is expensive right now. At a price of
$84.65 currently, you determine intrinsic value (through DCF analysis or other)
of this stock at $83. Let’s say PM misses analyst expectations in the third
quarter of 2013 and it falls to $82.80 and you decide to pull the trigger. Would
you be better off? Well, at a quarterly dividend rate of $0.85 per share you
would have accumulated three quarters of dividends between now and then
(ex-dividend dates in 12/12, 3/12 and 6/12) totaling up to $2.55 per share. So,
$84.65 (today’s price) minus $2.55 (the accumulated dividends) is $82.10. In
this example, you would not be better off. Of course, this is just cherry
picking an example and using hypothetical future numbers. It does, however, give
you some framework on which to quantitatively base a pricing decision. And, on
the other hand, that $82.80 share price may never come in which case you really
lose out. PM may instead rise to $100 per share, and a pullback to $90 (well
above the numbers referenced above) now represents a good entry point.

Let’s instead use some real numbers from our past. In a recent
article I said:

“However, what I really tend to look at is future
expectations. If you buy shares in McDonald’s for $86.08 a piece, as I did recently, or if
you buy them for today’s closing price of 84.05 will it really matter all that
much 20 years from now when MCD shares are available on the market for $700
each? Probably not. That’s not to say that I don’t believe that purchasing
stocks on a strong value basis isn’t important. Quite the contrary, as I believe
valuation is paramount to a dividend growth investor’s long-term success and
total returns.”

Let’s continue with the McDonald’s Corporation
(MCD) example. You could have purchased MCD shares back in 1992 (a timeframe
I referenced in the article above) at many different prices. On January 17, 1992
a share of MCD would have been available at a split-adjusted price of $10.06.
Later that year, on September 17, 1992 a share of MCD would have been trading at
a split-adjusted price of $11.19 per share. That’s a difference of over 11%! So,
that means the investor that waited eight months to make up his mind on MCD
shares paid a full 11.2% more for his shares. What a ripoff, right? Well, seeing
as how MCD shares currently trade for $89.71 I think any dividend growth
investor with a brain that is fully operational would be plenty happy with a
cost basis of either price. This brings the point I made in the above article
full-circle. When you’ve investing for the long-term, price swings of 3-5% today
or tomorrow or the next day will have negligible effects on the values of your
holdings decades from now. The key, as I’ve always said, is to buy high quality
at an attractive price. The investor trying to catch the absolute bottom dirt
cheap price on a high quality stock, or otherwise time the market, may get his
reward, but may also miss out on dividend income that is compounding itself, or
wait for a price that never arrives. If you’re investing for the next 40 years,
your future self will most certainly thank the present-day you for making such
wise choices as buying high quality dividend growth stocks; your future self
will not, however, chastise you for not buying your $700 MCD shares for $85
instead of $90 per share.

I often say that I believe valuation is
paramount to the long-term dividend growth investor. While I treasure
qualitative properties over quantitative analysis, buying even the highest
quality stock with excellent future prospects at too high of a price will lead
an investor to sub-par returns over the near to medium-term until the stock
catches up to the market’s pricing. Time heals all wounds, and it can certainly
fix investing mistakes, but how much time you have is an individualistic
question. So, while I practice a strategy that compels me to buy quality
dividend growth stocks for the very long-term on a monthly scale, I do not
recommend buying stocks if they’re trading at prices significantly higher than
fair value (intrinsic value). If one truly cannot find anything attractively
priced in the universe of high quality dividend growth stocks (a universe of no
less than 100 stocks, and much more), then I actively encourage sitting on
capital and waiting for opportunities to come to the investor. I haven’t
experienced this yet in my still-short (3 years) investment career, but I may in
the future. As I pointed
out recently, the market, as an aggregate, is somewhat pricey and probably
on the higher side of fairly valued. Again, I don’t buy the market – but an
extremely overpriced market makes it very difficult to find attractively priced
individual opportunities.

I’ve talked about valuation of equities and
I’ve talked about investment horizons regarding the question at hand, but one
other variable that’s important is how much capital you have to invest. As any
blog readers know, I typically invest anywhere from $2,000 – $4,000 per month.
This is up significantly from when I started this blog due to increased earnings
at my day job, as well as rising dividends. This much capital allows me to make
monthly purchases and quickly rebuild my capital base for sizable purchases the
following month. If you have significantly more available capital than this then
I can’t imagine how sitting on massive amounts of cash (that’s building quickly)
will benefit you. However, if you have much less to invest with ($500 per month
or so), then building up capital for a few months at a time would be best as you
want to maximize your available capital to reduce possible friction costs. Also,
if you make a purchase and the market quickly turns south it will be quite some
time before you have enough capital to make the most of that opportunity. So,
the amount of capital you have to work with will definitely affect the frequency
of one’s purchases.

Another approach, which I might actively pursue, is
to continue making monthly purchases but to also build a cash position/buffer
slowly with which you can use if equities quickly move south and opportunities
become extremely bountiful. This kind of approach would only be available to me
if my income remains strong and I’m able to continue investing thousands of
dollars per month while also funneling a few hundred dollars into cash each
month. This way, if we get an annual significant dip in the market, like we did
this summer or in the fall of 2011, there is a little “juice” in the form of
spare capital above the usual monthly contributions, available to me to take
advantage of the Mr. Market’s moodiness to whatever headlines win the day.
Mispricing, in this way, would be most welcome.

As I mentioned earlier, I
feel that qualitative analysis outweighs quantitative analysis. Qualitative
properties, like management quality, the products and reputation of those
products, brand names, historical operations, the economic moat of a business,
R&D and scale of operations are all extremely important. Quantitative
numbers, like the P/E ratio, P/B ratio, debt numbers, earnings and dividends are
all used, of course, in evaluating a company, but I really like to look at where
I think the company will be 50 years from now. A cheap stock with no future
prospects is not cheap at all. I’d rather pay fair price for a company’s stock
that has excellent chances for future success. After all, a company cannot
continue paying rising dividends if there is no future growth for its earnings
and cashflow.

It should be noted that I am actively adding capital to my
portfolio for only 12 years, after which I plan to live off that dividend income
and pursue opportunities other than paid full-time work. If you’re actively
adding capital for decades and decades you can certainly be less aggressive with
your purchasing frequency and the amount with which you add to your portfolio on
a consistent basis.

I hope this article answered some questions on
whether or not you should continue holding cash, waiting for the next market
correction (that may come tomorrow or next year), or continue to use fresh
capital to invest in long-term attractively priced opportunities and let that
investment start compounding. I truly believe in most circumstances you should
aim to invest as much and as often as realistically possible for your situation.
On the other hand, I also think having a little capital on the side to take
advantage of extreme opportunities would also be wise. If you have little
capital it’s wise to limit commission fees and other transaction/friction costs
and try to invest only when the transaction costs less than 0.5%. This may take
a few months to build up the capital necessary to make the numbers work. But, as
your portfolio builds the dividends will add up and your purchasing frequency
can be increased. If you have large amounts of capital (on the order of multiple
thousands per month), I strongly encourage a habit of regularly investing the
money as any lost opportunity of a market correction can be quickly reversed
with the fresh capital you’re regularly receiving, as well as using any cash
position you have set aside for such circumstances.

In the end, however,
I also believe that your savings
rate will far outpace your investment returns. All this talk of investing in
a stock today or waiting for an unknown price tomorrow is relatively moot if
you’re only saving paltry portions of your net income. I truly believe that if
you’re saving high amounts (50%+) of your net income and investing in high
quality dividend growth stocks that are attractively priced for the long-term
with great qualitative qualities you’re going to do quite well. Intelligent
wealth building strategies, like saving a high amount of your net income,
avoiding debt, investing regularly, minimizing unnecessary consumption and
maximizing your income and are far more important than trying to nail down the
absolutely perfect stock price.

So stop fretting over that $0.50 share
price fluctuation and get busy being a part-owner of a high quality company.
That company will make you back that $0.50 many, many times over if you stick
with them for the next few decades or so.

Source: http://www.dividendmantra.com/2012/12/holding-vs-deploying-cash.html