“I think the [Berkshire Hathaway’s] record shows the advantage of a peculiar mind-set – not seeking action for its own sake, but instead combining extreme patience with extreme decisiveness. It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”
─ Charlie Munger

As of the end of last month, our mutual fund—The Cook & Bynum Fund—had about 40% of its portfolio in cash and equivalents. Unsurprisingly, a question we get frequently from prospective investors is “Why are you holding so much cash right now?” Our answer can be found in one of our core investing tenets: the optimal, long-term compounding of wealth requires the avoidance of permanent impairments of capital along the way. 

The math is oft-cited: portfolios hampered by losses require more than proportional returns to recover, and this gets geometrically worse the larger a loss is. A 10% loss requires slightly more than an 11% return to get back to even, while a 50% loss necessitates a 100% return to reach its previous levels.

Our approach to avoiding permanent capital losses takes multiple forms, although two are most prominent in our investment process. First, we are careful to only invest in businesses that are squarely within our circle of competence. An investor should only put capital to work when information is adequate and where an edge is present. 

Second, we subscribe to what Ben Graham called the central concept of investment: we demand that an investment trade at a healthy discount to its underlying intrinsic value before we buy. No matter how well an analyst understands and underwrites a business, he will still be prone to make both analytical and psychological mistakes. By paying a discounted price, an investor can be wrong and hopefully not lose money (or even eke out a profit), while simultaneously increasing the possibility of outsized returns when correct.

So how do these core pieces of our framework relate to holding significant levels of cash in our portfolio? We are focused on realizing absolute, as opposed to relative, returns. We begin building our minimum “absolute” hurdle rate for an investment with the idea that humans inherently have a positive time preference—that is, in general people would rather consume today than in the future. 

As a discipline, investing can therefore be fundamentally defined as deferring consumption today in exchange for the expectation of increased consumption later. For example, if a farmer invests in a tractor to improve the efficiency of his production, he is deferring some current consumption (the purchase price of the tractor can no longer be immediately used for consumption) for the anticipated higher crop yields he will receive over the useful life of this piece of capital. The same concept applies to the corporate executive who funds his 401(k) in expectation of better-funded retirement years in lieu of taking a Caribbean vacation now. 

The point at which someone is indifferent between consuming today or tomorrow is called the marginal rate of substitution, and this rate varies based on personality, age, income, wealth, culture, etc. 

For an entire economy, this marginal rate of substitution for consumption deferral is the real interest rate. Various studies have attempted to estimate this rate during human history, and we would probably settle on 3 percent to 4 percent as the correct long-run figure. So humans, on average and over time, are indifferent between consuming today versus next year if they have a reasonable expectation to consume 3 percent to 4 percent “more” at that time.  Adding inflation expectations of 2 percent to 3 percent to this figure yields our belief that long-term nominal rates of returns on assets are adequate in the 5 percent to 7 percent range.

Applying our required discount to intrinsic value, an investment with a prospective return in the 10 percent to 14 percent range has been our minimum satisfactory expected annual rate of return before we will put capital at risk. In the absence of opportunities that do not meet our core criteria and this hurdle rate, we are unwilling to compromise our long-term standards and are quite comfortable holding cash until appropriately attractive investments come along.

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