Is The Cash Option Priceless For Warren Buffett?

If you believe that making small returns on the cash in your portfolio is not a good thing, then it’s time you took a look at Warren Buffett’s strategy.

Warren Buffett, who is the richest and most successful value investor, is currently sitting on roughly $41 billion worth of cash in his Berkshire Hathaway company account. This is the most that he’s had in this account in over a year. Having all those greenbacks available to him is definitely a nice safety net. But that’s not its only purpose. And just like most things related to Warren Buffett, the strategy is much more complicated than it first appears, says Alice Schroeder.

She certainly would know. This former analyst on Wall Street would probably know more about Warren Buffett then most people besides his closest friends and family members. She actually spent over 2000 hours with Warren when she wrote the book The Snowball: Warren Buffett and the Business of Life.

Alice Schroeder claims that to Warren Buffett, cash is more than just an asset class returning very little on its investment. It is actually a call option that can very well be priced. If he happens to think that this option is cheap, in relation to his ability to buy assets with his cash, then he is happy to live with really low interest rates. Alice Schroeder actually followed Warren Buffett for many years prior to becoming his biographer.

She says “he thinks of cash differently than the conventional investors. This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”

This insight is pretty fundamental. Once someone begins to look at cash as an option – meaning they have the ability to pick up any bargain when it comes along – they are much less tempted to worry about earning relatively nothing during the short term while their money is only making a small percentage gain.

This opens up a whole new world of asset allocation decisions, and you aren’t stuck with making nothing in cash or putting your money in stocks and bonds. The key to your thinking will become: how much is this cash going to earn when I have it available to pick up other cheap assets, versus the upfront costs of holding onto it?

While in Toronto last week, Alice Schroeder drew upon the knowledge that she gained while spending five years working on her book The Snowball. She mentioned that “there’s a perception that Buffett just likes cash and lets cash build up, but that optionality is actually pretty mathematically based, even if he does the math in his head, which he almost always does.”

Much of her time was spent sitting on the couch in Warren Buffett’s office in Omaha, Nebraska. She says that nothing major happens except a lot of thinking and a lot of reading. During that time, and many hours digging through Warren Buffett’s files, she claimed to discover that even though he often speaks in folksy aphorisms, his investment strategy is actually quite complicated.

It’s key to understand the price of cash in relation to a call option, and this is extremely important for those people who are trying to locate undervalued investments, just like Warren Buffett. The “call premium” is the cost of opportunity on a cash option. It’s actually the difference between what Mister Buffett can earn somewhere else, and the very minor return by holding cash, which is what Alice Schroeder said while addressing a crowd at the Investment Industry Association of Canada conference. She also sat down for an exclusive interview after she was finished speaking.

“There are times when he feels like that option premium is really cheap, compared to the intrinsic value of the option itself,” she said.

This option theory of cash isn’t something that Warren Buffett often talks about when he is on the stage at his annual investor meetings. This is most likely the reason why he views himself as a teacher, and his goal is to reach a wide audience according to Ms. Schroeder.

She also said “generally speaking, he likes to keep concepts simple. He says, ‘I like to have all the cash around because you can use it.’”

Ms. Schroeder says that she believes this is a lesson that more people need to learn. There are many investors who believe that hanging onto cash is a copout. There are also investors who look at their fund managers holding cash and think that they aren’t actually getting their money’s worth, and this is the wrong way to think, according to Alice.

“If investors would realize that what they are paying for is someone to have the expertise to know when to buy a call option called cash, and move in and out of that, then perhaps there might be more value placed on that service.”

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