Warren Buffett's Biggest Secret: Cash on Hand at the Right Time

NEW YORK (TheStreet) -- Yes, Berkshire Hathaway (BRK.A) (BRK.B) underperformed the S&P 500 for the trailing 12-month period. But Warren Buffett and Charlie Munger's underperformance is likely to be temporary.

Just wait for this roaring market to turn. Buffett's investment picks tend to perform better as a result of dollar-cost averaging through a bear market.

According to Buffett:

"We will always maintain supreme financial strength, operating with at least $20 billion of cash equivalents and never incurring material amounts of short-term obligations. As we view these and other strengths, Charlie and I like your company's prospects. We feel fortunate to be entrusted with its management."

Berkshire Hathaway didn't outperform the stock market this past year because the company tends to keep cash safely tucked away for more favorable opportunities. Being conservative in an environment of rising equity valuation may sound somewhat foolish, but it has been proven time and time again that in a down market, excess cash buys the opportunity to buy companies at fire-sale prices.

Every value investor -- or investor attempting to become a value investor -- needs to understand Warren Buffett's key principle of having cash on hand for better opportunities. It is Buffett's most underrated trait.

Buffett goes onto say in his 2008 letter to shareholders:

"I have pledged -- to you, the rating agencies and myself -- to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow's obligations. When forced to choose, I will not trade even a night's sleep for the chance of extra profits."

As you can see, Warren Buffett has gone into every economic recession with an excess of cash on the balance sheet. In these recessionary periods, the average company is trying to shore up assets and deleverage. That's when Buffett swoops in and buys companies for pennies on the dollar. Plus, because Berkshire Hathaway has excess cash and no debt, he doesn't have to deleverage. He can use ongoing operating profit from his business to buy other businesses, rather than use retained cash to increase the size of his cash pile.

Financial advisers will often tell clients to dollar-cost average even through a financial panic. However, most investors won't follow that advice. Because they don't want to buy low, they consistently lose money to people like Warren Buffett, who consistently buys low and sells high.

When investors buy Berkshire Hathaway stock, they buy into a CEO who has the right temperament for managing money.

You don't need to read into every company that Berkshire Hathaway invests into. Heck, you might not even agree with Buffett's decision to buy shares in IBM (IBM) and Coca-Cola (KO). But what you do need to understand is that over the long haul, possibly the biggest component in Berkshire's outperformance is having excess cash in bad times to buy high quality businesses for good prices.

So if you're buying Berkshire Hathaway, be sure to have the patience to wait out two or three economic cycles. This will give you ample time to capitalize on Berkshire's long-term outperformance.

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At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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