This is quite logical, as stronger cash positions should be negatively related to risk and, thus, also negatively related to forward-looking return expectations. Therefore, higher cash positions result in higher valuations, and higher valuations forecast lower returns.
That said, Medhat found that, when controlling for valuations, higher cash is associated with higher returns, and also that “controlling for cash implies considerably more power for valuations, especially in regressions that also control for proﬁtability and investment.”
Specifically, Medhat found that a combined value and cash strategy “generates a highly signiﬁcant average return of 0.57% per month with a test-statistic of 4.22. It also generates a large ﬁve-factor abnormal return of 0.30% per month with a test-statistic of 2.90.”
These findings led Medhat to conclude that cash is highly nonredundant in factor models, and that controlling for cash restores the role of value alongside proﬁtability and investment. Interestingly, Medhat also found that “without controlling for book-to-market, cash does not have power predicting returns.”
Another important finding was that, because a cash strategy is a growth strategy, it will tend do well when the value strategy performs badly. Conversely, the value strategy will tend to do well when the cash strategy performs badly.
Medhat writes: “Indeed, the time-series correlation between the monthly returns to the cash and value strategies is -0.60 with a test-statistic of -18.85.” This suggests value and cash strategies will perform extremely well in combination with each other, just as a combined value and momentum strategy works well.
For Medhat, the important implication of his findings is that “failing to account for cash detrimentally conﬂates value with the proﬁtability and investment eﬀects. In other words, while it is true that value ﬁrms do not outperform growth ﬁrms with similar proﬁtability and investment, they do, in fact, signiﬁcantly outperform growth ﬁrms with similar proﬁtability, investment, and cash.”
I think it will be interesting to see whether fund families begin to incorporate Medhat’s findings into fund construction methodologies.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.