Investing through the lens of a balance sheet...

Almost "cash", Maybe "Receivables", Maybe "not"

The game of long term investing is often a balance sheet exercise.

Instead of generating an income, investors should be looking to profit from the increase in the valuation of wonderful companies purchased at fair value.

The chance to generate adequate in-depth understanding, to have the conviction to own wonderful companies at position size that matter and holding them through various testing time period is the most rewarding form of investing in term of effort and reward.

If it is treated as an income statement exercise, the temptation to sell early would overwhelm this investment exercise.

Portfolio construction is the key here.

There is a need to ensure that there is sufficient liquidity at all time to allow an investor to channel their “cash” into the most promising idea during the worst of time.

Keeping high level of cash while remaining on the sideline often looks like a practice to build the virtue of extreme patience… until the stock market continues to power higher without your presence. Succumbing to pressure, one usually lose all sense of patience when more is required and demanded.

Keeping “fully” invested also meant that one has to contend with a lack of cash when the market is challenging.

Understanding what is “cash” is critical here?

Is a stock position which can be easily liquidated considered “cash”?

We may just need to dwell deeper into the spectrum of cash and receivables in a stock portfolio.

For the professional world, the seemingly easiest way is to possibly run a market neutral long-short equity strategies. But the risk is often compounded when both the long and short book collaborate to go against the portfolio which usually spell the demise of the fund and the asset manager.

Our thought process is to keep a segment of the portfolio which can be almost considered “cash”.

Understanding what is “cash” allow one to leverage conservatively to ensure that some part of the portfolio is always free to be liquidated at minimal losses.

A manager of a fundamental long only fund who can meaningfully take advantage of a downturn is often assuring for both the fund, the asset manager and the investors.

By classifying each investment into groups with different duration and market liquidity profile, one can effectively map out the spectrum of what is possibly almost cash and the possibility on the collection of the receivables.

The thought process below relate to our Special and Statistical Strategy where majority of the positions are assembled with some specific duration in mind.

Along the spectrum of cash:

Let’s determine what is cash.

There is real cash, almost cash and somewhat cash.

  • Real cash could refer to cash in the bank (which needs no introduction).

  • Almost cash could be like money market account which could be withdrawn in a few days but may not be available at short notice.

  • Somewhat cash could be investment which is highly liquid and is in the money.

There is really no need to talk about real cash or almost cash but there is a need to dwell a tad further on the third.

When a position of any size is in the money, the decision to exit or stay is largely dependent on the expected return after that large run versus the liquidity of that position.

  • If the future expected return is adequate and the stock is illiquid, there may be a need to protect profits by lowering the stake in the company.

  • If the future expected return is adequate and the stock is liquid, then the bet may be to ride the stock higher.

  • If the future expected return is inadequate, no matter if the stock is liquid/illiquid, exiting to cash in your profit is logical.

By being very clear on your position, one can decide clearly on how to position your “somewhat cash” position which may become critical when you have the opportunity to divert cash into the wonderful companies.

Along the spectrum of receivables:

Let’s determine what is receivable.

There is receivable which is like hedging position, highly liquid high market capitalisation companies and special situation

  • Hedging position will most likely be an instrument which is likely to be in the money when the market tank.

  • Parking excess cash into highly liquid high market capitalisation companies with ample liquidity at some margin of safety may not produce fantastic return but will most of the time be a good place to generate some excess return during normal times. Highly liquid high market capitalisation companies allow one to exit a position with minimal loss just at the start of the carnage. Anything later, it will be the same…

  • Special situation allow us to plan for regular infuse of cash to keep the cash position adequate.

The determining factors on collecting back your capital include

  • What is the size of your position in relative to the

    • Market capitalisation of the instrument?

    • Trading liquidity of the instrument in normal time?

  • Which ultimately result in how long it will take to unwind the position without affecting the share price?

By dividing up your stock position into their various receivable timeline, you will get

  • a good gauge on the amount of cash coming back in the short term/medium term,

  • how long it will take to move into cash,

  • how much you can move into cash

  • and at what cost to your portfolio.

When it is considered as fixed asset:

If there is plan to hold a a substantial shareholder position or a position which cannot be closed in a measured manner, the stock holding cannot be seen as a receivable.

The position expected return must be huge otherwise the cost of illiquidity can often be a bane both in a good and bad cycle.

A good mental exercise would be to imagine the scenario where you had been offered a block of low liquidity, high value stock which you may become the ultimate bag holder.

The questions you need to ask yourself is

  • Can you hold that for an indefinite period?

  • Can you bear to see it losing 90% of its value?

If your answer is both no, then what makes you think that you should invest in an illiquid stock or a private investment?

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