Who’s The Sucker?
Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”
I was sitting at my desk early last week listening to CNBC – I rarely watch but listen to it most of the day – and another fund manager being interviewed brought up the idea that there was a lot of “cash on the sidelines” that could still come into the market and push prices higher. I say another because this happens all the time in portfolio manager interviews and it bugs me to no end. It seems that rising to the level of mutual fund portfolio manager does not require the most basic of logic skills. For you see, there is no such thing as “cash on the sidelines”. When you put your money in a mutual fund and that inane portfolio manager buys a stock, he has to buy it from somebody. The cash he spends to buy the stock ends up in the seller’s pocket.
The amount of “cash” in the economy at any given moment is fixed and someone has to hold it. When you sell your money market shares the amount of commercial paper or cash equivalents being held in the economy does not change. Companies do not retire short term borrowings just because you decided to buy Tesla. Even if you buy newly issued shares in an IPO or secondary, the amount of cash does not change as the company issuing the shares now has the cash on its balance sheet. It might sit in their checking account or they might buy a money market fund or they might hire someone and pay them a salary. But the cash just changes hands, it doesn’t disappear.
We have certainly seen a lot of individual investors swap their cash for stock holdings over the last few years. 2013 was the best year for equity mutual fund inflows in over 20 years and the inflows have continued into 2014. In case you missed the significance of that, it means that more money flowed into equity mutual funds last year than in 2007 or 1999 which I don’t remember as particularly auspicious times to be a buyer of equities. Companies have been buyers too with stock buybacks last year the highest since just before the Great Financial Crisis of 2008. As a point of reference the lowest quarterly buyback activity came right at the market low in early 2009. Not what I would call great market timing and the track record of mutual fund investors is not any better.
Not only have companies and individual investors been buying stocks, they’ve increasingly been doing it with borrowed cash. Margin debt, no matter how you measure it, is at an all time high. Companies are very profitable and cash has indeed, as everyone seems to point out, been rising on corporate balance sheets. What you don’t hear often is that corporate debt also sits at an all time high. Non financial corporate debt is now nearly $9.5 trillion. That is, to a large degree, a function of the Fed’s purchases of Treasuries and MBS as the cash they conjure to buy those securities gets redeployed into riskier securities. The point is that the recent buyers of stock are increasingly leveraged and not the most stable of stock holders.
So if for every buyer there is a seller, the obvious question is who are the sellers? That isn’t as easy to answer as one might think. We don’t get to look at every individual’s and institution’s balance sheet and determine who is actually holding all the cash and cash equivalents that are floating around the economy. We do know that a lot of the cash created by the Fed’s QE programs has landed at banks in the form of deposits but we don’t know exactly who those deposits belong to. Checkable deposits and currency for non financial corporations, individuals and non profits have risen significantly since the start of the programs, up about $1.3 trillion since 2009. Add in excess reserves for banks and you’ll find most of the cash created by the Fed. So contrary to popular belief the money created by QE has not gone “into” the stock market.
What we do know is that there is a boom in IPOs right now with 49 deals since the beginning of the year. In a lot of those deals selling shareholders have represented a large part of the offering. It has been a while but when Facebook went public over half the shares sold were for existing shareholders, not the company. So speculative, venture capital backed companies are selling stock and at least some of that cash is returning to the early backers. We also know that insiders have been selling a lot of shares recently. If you just look at real corporate insiders – corporate officers and directors, not just large holders – they are selling at a ratio of about 6 to 1. Conspicuous among the sellers have been insiders at some of the hottest stocks around. With the exception of Elon Musk, Tesla insiders have been selling pretty heavily. LinkedIn insiders have also been regular and large sellers. Hot biotechs are also seeing a lot of insiders cashing out.
We also know that private equity has been doing some selling. Last year Leon Black of Apollo Group said they were selling everything that “wasn’t nailed down” and true to his word the announcement of Apollo backed company IPOs has been steady. PE company Blackstone has also been lining up IPOs for its companies. They sold shares of Hilton, which they took private in 2007, to the public late last year (although they didn’t sell any share in the offering) and La Quinta just filed recently. Overall, 2013 was a bumper year for PE backed IPOs with a total worldwide of $57 billion which by the way was the most since, you guessed it, 2007. New filings so far in 2014 show no respite with roughly 60 deals in the pipeline for IPO this year.
We also know that some pretty smart portfolio managers – mostly value oriented – are also sitting on a lot of cash. FPA Crescent fund, run by Steve Romick, is sitting on 44% cash in the fund. That is significant, in my opinion, because FPA managed to outperform the market by a rather wide margin in 2008 when it was down just 20%. Sequoia Fund, another fund that outperformed in 2008 and like FPA has a very long track record, has 18% cash. Yacktman Focused Fund, down 23% in 2008, has 20% of their portfolio in cash.
And last but not least, let’s not forget the author of the quote that leads this article, none other than Warren Buffet in a shareholder letter from 1988. While Berkshire has been adding to its stock holdings, cash is building up faster than Buffet and his acolytes can deploy it. Cash rose in the latest quarter to almost $50 billion against a stock portfolio of a bit over $100 billion. Now that sounds like a big allocation to cash but it really isn’t apples to apples compared to a mutual fund because Berkshire has a lot of operating businesses. Buffet has said he likes to keep $20 billion in cash around just in case his reinsurance business gets hit hard one year. But it should make you pause a bit that Buffet can’t find enough bargains to keep his cash down to his preferred level.
So, if you are still buying stocks in this rather frothy market are you the sucker? Well, if you found yourself sitting around playing poker with Steve Schwarzman (Blackstone), Leon Black (Apollo Group), 3 multi-billion dollar fund managers, John Doerr (Kleiner Perkins) and Warren Buffet would you think the patsy was one of them? Something to keep in mind the next time you push that buy button: Who is selling me this stock?
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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773. You can also book an appointment using our contact form.