Companies in America and Britain are sitting on vast piles of cash, and with good reason. But as confidence returns there are risks that firms will blow the money on low-return enterprises.
“Money amassed either serves us or rules us,” said the Roman poet Horace. And companies have certainly amassed plenty of cash over the past few years.
In America and Britain, reserves stand at record levels for non-financial companies – $1.73 trillion (£1.1 trillion) and £731.4 billion, respectively. Apple alone holds $97 billion in cash, according to its January earnings report – even more than the oft-quoted figure of $76.4 billion it declared in 2011, which was notable at the time for being greater than the operating cash balance of the US Treasury Department.
After the financial crisis of 2008, companies embarked on a reactive programme of cutting costs, gearing down and shoring up their balance sheets. Minimising expenditure, whether through lowering debt, shedding staff or other means, was perceived as the only way to survive the crisis, and the prevailing corporate climate was one of “don’t spend, don’t hire”.
But is this magic mountain of capital a good or a bad thing? Surely companies are unlikely to sit on their savings for long. So what will they do with their reserves? (Strategy continues below)
There are several options. Companies could reinvest internally, via capital expenditure or research and development; this would clearly be of benefit where high returns can be earned from such investments. They could try to expand via mergers and acquisitions, or they could further reduce debt levels.
Another option would be to buy back stock or return capital to shareholders through increased dividends. From a market perspective, the rationale for increased dividends is perceived to depend largely on whether a company is a “growth stock” or has gone “ex growth”. Clearly this is nonsense. When a company holds more cash than it needs to continue growing, there is a huge risk that aversion to paying dividends will lead management to invest in new, often low-return businesses. There are countless examples of such investments, from Microsoft downwards.
To be fair, companies have much more to consider when deciding what to do with stockpiled cash. Complicating factors include the corporate taxes that would be levied on dividends or share buybacks. Such a redistribution of capital could also be affected by foreign taxation (technology titans Apple, Google and Microsoft, for example, all hold a large proportion of their cash in overseas accounts).
The lack of economic visibility into 2012 and beyond must also be taken into account. The unpredictability of events in Europe makes betting on one outcome an intimidating proposition, so companies are keen to keep aces up their sleeves. Certainly, further banking and sovereign debt problems could mean a shortage of credit, putting companies that held cash in a stronger position than less cautious peers.
”Corporations should use their excess cash to conduct share buybacks or, better still, pay or enhance dividends”
The global macro picture remains mixed, with recent developments including the Iranian oil embargo and its associated rise in oil prices troubling the markets. And most companies, having worked so hard to save, are understandably far from keen to splash out while economic conditions are still uncertain. Corporate confidence would be crucial to encouraging a spending trend, but that confidence is in short supply when there is so little evidence that governments are creating or managing policy effectively. The sovereign debt crisis has highlighted Europe’s seeming inability to act quickly and decisively. In bare terms, more cash is the best insurance against unpredictable macro events.
So, corporations have good reason to be cautious. And it makes sense for them to keep their powder dry for acquisition opportunities or other initiatives. But, depending on the quantum of cash they hold, and projected future cashflows from operations, there is no reason for them to hoard cash, especially when low interest rates make doing so less attractive.
It is clear that sitting on huge amounts of cash dilutes return on equity. But low as returns on cash might be, they are still preferable to those offered by investing in most sovereign paper, which remains too risky and mostly offers tiny returns. As an example: to invest in UK gilts for, say, 10 years, earning a return of 2% a year seems unattractive given an inflation rate of nearly twice that.
Despite the crises outlined above, there have been tentative signs of global recovery of late, especially from key American economic indicators. So while suggestions that the economic climate is too parlous for companies to do anything but hoard cash might still be valid, they are likely to become less persuasive if the recovery continues.
Corporations should use their excess cash to conduct share buybacks or, better still, pay or enhance dividends. At a time when many shareholders are struggling to obtain decent returns, a meaningful dividend yield is extremely attractive and should also be rewarded by corresponding share-price performance. Which, turning to Horace, would mean the money being put to work serving shareholders, rather than ruling companies by fostering too much caution.
Tom Walker is the manager of Martin Currie’s Global Portfolio Trust.