Solidarity is a multi-family investment office. We are often asked (by clients with high ability and willingness to take risk) why we recommend they should hold at least 10 -15% of their Investible Assets in Bonds/Liquid funds and not be fully invested in Equities; especially if clients don’t need the capital for at least 3 years. Many push back saying bonds offer lower yield and are tax inefficient and whether holding cash for redeployment later is akin to trying to “time the market”.
To explain why we recommend holding Bonds, one must appreciate that the cornerstone of our investment process is capital preservation and growth. The sequence of this is important.
Secondly, every investment hypothesis is associated with a probability. While we remain optimistic about India’s long term prospects, we need to balance our confidence/optimism with a fair respect for the unexpected. Even in normal market conditions, we will be wrong on multiple occasions or enter too early. While stock prices are slaves to earnings in the long term, in the short term, sentiment has far more influence on market direction. And sentiment can change on a dime. In June 2014, with the euphoria around the BJPs election win, how many of us would have thought that the NIFTY would be at these levels 20 months hence? Hence, even as the NIFTY trades at long term average multiples today, adverse sentiment could push markets even lower.
This is where Bonds play a significant role. While the “relatively” low returns of Bonds in a rising equity market do cause heart burn, they come with a decent coupon and the Optionality of being able to sell them and re-deploy proceeds into Equities when valuations turn even more favourable for equities. The Option value they provide is often not considered by investors. Cash combined with courage of conviction during times when sentiment is downbeat, such as at present, can result in exponential returns, which in turn can help balance losses or poorer returns on other portfolio constituents.
Consider the analysis below for the time period 2001 till date.
• That markets have mainly stayed between a trailing PE of 16 to 20; entry at these levels have provided an IRR over 3 years of about 13.2%. At this zone, investors should deploy money as markets are fairly valued
• However, if the market sentiment slips and Capital is invested when the market trades at a trailing PE between 12-16, the IRR obtained almost doubles to 28%… and on occasions of entry at points of extreme bearishness (e.g. summer of 2008), the IRR trebles to 39.5%
• The data also shows that a trailing PE band of 12-16 is not very infrequent and markets trade in that band almost a fourth of the time
Note: Trailing PE is not our preferred metric to ascertain valuation; however, it has been used to illustrate the point
How does one ensure one is not “timing the market” or freeze up when such opportunities present themselves. We follow a systematic plan of decreasing cash allocation when stocks in which we have conviction decline by certain percentage points from initial purchase price. Similarly, when markets or individual stock valuations get heady, we have found that it is prudent to trim the position a bit and move it to cash/bonds or rotate it to a position with better perceived pay offs. This does not mean not allowing our winners to run but recognizing that valuation ratios are mean reverting.
Holding cash can be uncomfortable when others around you are making money. However, one should recognize that the race is long and is only with oneself. Life moves in cycles and cash provides significant strategic value during uncertain times