Cash: It's More Valuable Than You May Think

I'm privileged and honored to be a part of The Motley Fool's Real-Money Stock Picks program. Each month, The Fool contributes $1,000 into an investment portfolio that I affectionately refer to as Tier 1 (to signify my focus on elite businesses), and I'm tasked with allocating that capital to the best of my ability. We give our readers an opportunity to invest ahead of us if they so choose, and in that way it's a wonderful opportunity for me to help fulfill The Fool's mission: to help the world invest -- better.

Rather than allocate that capital in small increments or at regular intervals, I typically let my funds accumulate until I find an idea I'm excited about -- and then I invest aggressively in that idea. Usually it's an equity investment in a Tier 1 enterprise -- a straight-up purchase of stock that I intend to hold for years. But sometimes it's an option position, mostly written puts, that either help me generate income or allow me to purchase shares of outstanding businesses at prices that I otherwise could not.

Skating to where the puck is goingDue to the nature of the regular cash infusions in the Real-Money Stock Picks program, I'm always trying to invest according to where my portfolio will be in the months and even years ahead. By that I mean that I may take a large position in a business that I believe is especially attractively priced -- larger than I otherwise would have if the portfolio was static -- knowing that the portion of my portfolio that is allocated to that business will decrease over time as more capital is added, all other things held equal. It also means that I sometimes write puts that are not secured by cash currently in the portfolio, but that I know will be contributed by the time the puts are set to expire (or soon after). In this way, I'm able to generate leveraged returns with less of the risk generally associated with a portfolio that isn't regularly adding cash.

Yet one of the questions I often ask myself is "What is the best level of cash to keep in the portfolio?" There's no right or wrong answer, and the "best" level for me is constantly changing based on the opportunities I'm currently seeing in the market.

Recently, I've been intrigued by my Foolish colleague Morgan Housel's outstanding work on the value that cash can serve in a portfolio. Specifically, the option value cash creates by allowing an investor to act when favorable opportunities present themselves in the market.

A changing situation This has been less of an issue in Tier 1, as The Fool's monthly cash contributions supply a regular stream of capital to allocate to new (or existing) investments. I've also amplified my ability to profit from opportunities via my written put strategies. However, above a certain level, the leverage supplied by noncash secured written puts becomes too dangerous, so there's a limit to the amount of puts that I'm comfortable writing at any given time.

In addition, while the monthly $1,000 cash contributions are still a sizable portion of my overall portfolio (currently valued at about $78,000), each individual contribution will soon be less than 1% of the total portfolio value and will continue to decline on a percentage basis over time (barring a substantial long-term decline in the value of Tier 1's investments -- a situation I find unlikely due to the quality of businesses in which I invest). The point is, it will soon be difficult to take a meaningful position in a new investment idea when each new capital contribution will be 1% or less of the portfolio. That is, unless I'm willing to sell an existing holding -- something I rarely do unless I find a far more attractive investment in which to invest that capital.

Worst still is that if I were to remain fully invested, and even somewhat leveraged via written put positions, I will be unable to take advantage of favorable opportunities presented by future market declines.

The strategyThe solution, I believe, is to allow The Fool's cash contributions to accumulate until I find a high conviction investment idea. And by high conviction, I mean one that I'm willing to take a significant position in.

I won't set hard and arbitrary rules in terms of what percentage of my portfolio qualifies as "significant," and as with most rules, there will likely be exceptions. But in a general sense, this will be my philosophy in terms of how I allocate Tier 1's capital.

In fact, I've already been executing this strategy pretty much since Tier 1's inception on Sept. 1, 2011. Combined with other strategies and techniques, such as time arbitrage, it's helped Tier 1 achieve a 128.93% return since inception, compared to the S&P 500's return of 87.23% during that time. More importantly, I believe preserving cash until a highly attractive investment is available gives Tier 1 the best opportunity to continue to outperform the market in the years ahead.

The risks The main risk to this strategy is that the market tends to rise over time, and usually at a rate well above the returns generated by cash. In this manner, cash is typically a drag on a portfolio's overall return. But as Morgan Housel and Fool Co-Founder Tom Gardner have explained in Fool One, the true value of cash is found by the returns it allows you to generate when that cash is invested. In that sense, cash can help an investor generate outstanding returns if it's prudently allocated to quality businesses at bargain prices, say during a market downturn.

Still, cash drag can dramatically lower returns in a prolonged bull market, and it's particularly painful during times when inflation is steadily reducing the purchasing power of that cash. Therefore, I will remain vigilant in monitoring Tier 1's cash position, and I strive to not be too conservative in allowing my cash balance to grow too large. It's a constant balancing act, but it's a challenge all portfolio managers must embrace and one that I look forward to.

Why now?If you're asking yourself why, if I've already been using this strategy for years, I am writing about it in this article, it's because all Real-Money Stock Picks participants are tasked with making three investments per quarter. My first investment for this quarter was a short position in the iShares 20+ Year Treasury Bond ETF, which I then increased as my second investment. But for my third investment, I had a special request. I asked The Fool's CFO if I could make cash my investment. And the answer was yes. This article is my attempt at explaining my reasoning for that request.

There are always opportunities in the market, but I already have large stakes in my best ideas, such as Facebook , Google , and Amazon . And while there are other companies I would like to buy or add to, many of them are trading at lofty valuations. I don't want to allocate The Fool's capital to a lesser idea, and even more importantly, I don't want any Fools following me and investing their hard-earned money based on an idea for which I don't have strong conviction. I'm always cognizant -- and humbled -- by the knowledge that our readers factor what we write here into their investment decisions. Decisions that can determine if they purchase a home, or send their children to college, or if and when they can retire. That's a huge responsibility -- one that I will never take lightly.

And so, in the absence of a high conviction investment idea, Tier 1 will be allowing The Fool's capital contribution to accumulate in our brokerage account for the time being. The return will be basically nil (0.01% annually at last check), but I expect the ultimate returns this cash allows the portfolio to generate -- by investing in a high conviction idea in the near future -- will be quite satisfactory.

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Joe Tenebruso isportfolio manager ofTier 1 Investments, a Motley FoolReal-Money Portfolio.You can connect with him on Twitter@Tier1Investor. Joehas the following options: long January 2017 $65 calls on Facebook. The Motley Fool recommends, Facebook, Google (A shares), and Google (C shares). The Motley Fool owns shares of, Facebook, Google (A shares), and Google (C shares). The Motley Fool is shortiShares 20+ Year Treasury Bond ETF.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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