The Bear’s Lair: The most precious thing is patient cash

Hundreds of billions in private equity and hedge fund money has been raised, and is bursting to be deployed in the market. Companies like Apple (Nasdaq:AAPL) with multiple billions of liquidity feel the need to find a home for it – in Apple’s case, possibly buying Disney (NYSE:DIS). Yet interest rates are too low, the market is overvalued and misguided investment is everywhere. The truly wealthy man is he who has liquidity in today’s market – and the patience to hold off investing until prices have collapsed and bargains abound.

The late Jean Paul Getty (1892-1976) at one time the world’s richest man, when asked how he became a billionaire, is said to have responded “Start as a millionaire and buy in 1932.” This in a nutshell is the key to truly successful wealth accumulation; if you can have uncommitted liquidity, free from any pressure to invest it, and wait patiently for the bottom of a depression (not necessarily as extreme as that of 1932) then you will end up very rich indeed. It is however much easier said than done.

Warren Buffett did “patient money” best, at least in his youth. When he had made his first fortune as an investment advisor, in 1969, he closed down operations and distributed the cash to investors (not coincidentally, at the beginning of a 13-year period in which the real value of the Standard and Poor’s 500 Index fell by 57%.) Consequently, Buffett had no need to buy during the 1970s until he saw really compelling opportunities, such as the Washington Post in 1973-74. The ability to have a pile of cash available at the beginning of a long period in which great deals became available is what propelled Buffett to his current net worth eminence.

In later life, Berkshire Hathaway continued in existence during downturns, making complete divestment impossible. Nevertheless, Buffett’s control of the vehicle was strong enough that when in 1999-2000, he saw no investment opportunities available he was able to remain on the sidelines even as contemporaries were piling in — and losing their shirt in 2001-02. Conversely, he had sufficient liquidity and financing capability available in the bear-market year 2009 that he was able to acquire Burlington Northern Santa Fe Co. that year, a $34 billion purchase that proved to be spectacularly successful, at least in its early stages.

Buffett had an additional advantage in being patient with his money: his frugal lifestyle. At least in his early years, before he became stratospherically wealthy, the lack of cash outflow to set against cash sitting in a bank earning interest (and the useful amount of interest that cash could earn) reduced the pressure on Buffett to deploy his wealth into something more immediately profitable than a bank balance. In the long run, this absence of pressure proved very profitable indeed.

None of today’s major money pools have the advantage of patience. Youthful tech billionaires tend to be billionaires on paper, because of their stock holdings, often in private companies, without anything like that quantity of cash to their name. Furthermore, they have very often geared up their spending habits to match their net worth, or some substantial fraction of it, so liquidity is a perpetual concern. Even if they have liquidity, the Fed’s zero-rate policies, which have been in force for most of their adult life, effectively taunt them for leaving the money idle, bringing them no return on it and making every monthly credit card bill is a dead loss to their net worth with no offsetting income.

It is likely that in the next downturn, most tech billionaires will be staring aghast at the disappearance of their net worth, swallowed up as it will be by the bankruptcy of loss-making private companies that had been thought to be “unicorns” or even “dekacorns” but had never got around to achieving a positive operating cash flow. Even worse, they will be dealing with their creditors, who have suddenly become a great deal less friendly and understanding as their net worth has shriveled. Most of them will probably retain a modest subsistence to eke out the reminder of their days, but they will not be significant investors in the opportunities which by then will have opened up.

Private equity funds will have an equally difficult time of it. Generally, these are invested with a finite time horizon, and there are strict conditions on when further capital can be called from investors. With quarterly reporting of investments made and their results, any attempt to keep “dry powder” in the fund will be stoutly resisted by investors, who will resent being made to pay a large management fee on money that has not been deployed.

Once a downturn hits, private equity funds, even if they are not leveraged, will suffer from the same problems as the entrepreneurs themselves. They will have a series of investments that appear to be failing and will be suffering negative cash flow, which will require support to avoid them going under. In addition, their “commitments” from investors will in many cases prove to be worthless as the collapse of their track record makes investors shun them. Consequently, just at the time when opportunities appear in profusion, private equity funds will not be able to take advantage of them.

As for hedge funds, their time horizon is even shorter than that of private equity funds, and their investors more impatient. While they may not suffer illiquidity problems in a downturn, they will find their bankers cutting off access to credit, just as the best opportunities appear. They will be called to deleverage, just as the opportunities for using leverage constructively are most attractive.

We have been in such a long expansion since 2009, with asset values steadily rising, that there are few investors who can take advantage of a downturn when it occurs. The implications of this are unpleasant.

In a normal downturn, the existence of new investors with uncommitted capital allows leveraged situations with poor cash flow to be acquired for some fraction of the outstanding debt, or possibly by assumption of the debt with a small payment for the equity. Either way, the entity carries on trading, and any mistaken strategies carried out by the previous management can be corrected. Joseph Schumpeter’s process of creative destruction is carried on at relatively little cost to the economy, with assets transferred into more competent hands.

In a downturn with capital starvation, however, this process does not hold. There are few or no investors with spare capital at the bottom. Hence companies that have got in trouble find no rescuers, and are forced to cease trading entirely. The losses to the economy, both in terms of capital value and of jobs, are far greater than in an ordinary downturn.

This is what happened in 1932. President Hoover, instead of pursuing Andrew Mellon’s policy of liquidation when the crash occurred, transferring assets to new, more capable owners, pushed businesses to keep up operations, employment and wage levels. At the same time, after the failure of the Bank of United States in December 1930 and Creditanstalt in May 1931, the U.S. and global banking systems suffered a massive wave of failures, with liquidity in the banking system drying up altogether.

At the bottom of the recession, there were very few people or institutions with any liquidity at all. Consequently, the liquidation of assets was much more complete than in most downturns, and the U.S. unemployment rate rose to 25%. Of course, those few lucky souls like John Paul Getty who had preserved their capital made out like bandits.

The next cyclical trough looks likely to resemble that of 1932, far worse than those lesser downturns we have endured since then. For the reasons outlined above, there will be very few people or institutions with capital to invest. At the same time, because the length of the upturn and the artificially low level of interest rates have caused an exceptionally high level of foolish investment, the amount of misguided investment needing to be restructured or liquidated will be exceptionally large. The result will be an exceptionally severe recession, with much greater loss of employment and output than would have been necessary if investors with spare capital had been available.

Needless to say, those few investors who go liquid now, and those few institutions whose backers allow them to remain quiescent during the boom will enjoy profits similar to those of the late Mr. Getty.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)