Many financial managers appear to be sitting behind a wall of cash. Ostensibly, this is a necessary precaution for the benefit of their organisations in an uncertain environment.
It is also a very expensive precaution, one that contradicts traditional ideas about returning surplus cash to shareholders if there are no positive net present value (NPV) projects available.
Agency theory suggests that some managers are tempted to be ‘recklessly prudent’ or overly cautious for career or personal reasons, ahead of the interests of shareholders. But what’s the truth of the matter?
Cash hoarding by companies seems to have started around the year 2000, which coincides with the bursting of the dotcom bubble.
In the run-up to the millennium, during a boom in IT shares, investors began to take a ‘this time it’s different’ stance, apparently persuaded that traditional business valuation fundamentals had ceased to apply.
Stock markets worldwide peaked in the wake of the dotcom experience. Then, in early 2000, reality reasserted itself and technology stocks lost about 60% of their value.
This was accompanied by a decline in stock markets worldwide, as illustrated by the FTSE 100, which traded at 6930 towards the end of 1999 and today, almost 17 years later, is currently still trading below that figure.
Traditionally, treasurers would manage liquidity on the debt side by techniques such as revolving credit facilities (RCFs). However, since the global financial crisis and the development of Basel III, RCFs are not as attractive to banks.
Consequently, corporate treasurers who can’t offer attractive ancillary business face a combination of reduced availability and/or higher interest and fees for RCFs. Hence, many treasurers now manage liquidity via a combination of cash and debt.
So, while some may argue that treasurers tend towards being overly cautious, that caution is a product of today’s business environment. Since the global financial crisis, treasurers have concluded that they cannot always rely on the bank facilities being there when they need them. Thus, corporates worldwide continue to build up large cash balances.
The US has some striking examples. US businesses collectively have currently amassed around $1,900bn in cash on their balance sheets. Specific examples include:
Is this situation likely to change in the near future?
In a word, no. A survey by the Association of Financial Professionals shows that the recent trend and forecast trend is for cash balances to increase.
The indicators measure recent and anticipated changes in corporate cash balances by calculating the percentage of survey respondents reporting an increase (or expected increase) in cash holdings minus the percentage reporting a decline (or expected decline).
The survey’s authors comment: “Declining indicators are indicative of increasingly confident businesses. Conversely, rising indicators suggest growing pessimism.”
So what does this say about traditional financial theory? According to agency theory, the build-up of cash balances serves to:
However, given concerns about availability of finance when needed, holding cash should reduce the danger of ‘costs of financial distress’ or having to dispose of assets at fire sale values.
Another traditional tenet of finance theory is that if there are no positive NPV projects available, surplus cash should be returned to shareholders as holding cash, especially in the current low or negative interest rate environment, which will generate far lower returns than the company weighted average cost of capital.
However, today the conclusion is not so clear-cut. Holding cash means that it is possible to make opportunistic takeover bids or exploit a major new investment opportunity. For IT companies, acquisitions are seen as an essential means of keeping abreast of changes in technology and customer preferences.
Indeed, it is said that Google undertakes an average of one acquisition a week.
To quote Adam Davidson in The New York Times Magazine: “For a company such as Google, this means that investors are behaving as if they trust the executives in these industries, like Larry Page of Alphabet, to be smarter about using that money [ie the cash balances] than the investors themselves could be.”
Berkshire Hathaway’s $1bn investment in Apple earlier this year would appear to back that sentiment. But not all investors appear happy about Apple’s cash mountain, however. Activist investors David Einhorn and Carl Icahn have each campaigned at times in the past for Apple to return cash to shareholders. Einhorn even went so far as to take legal action in 2013.
Investor sentiment is clearly divided on this issue, and much depends on the industry, and on investor confidence in the management.
Research by Rohan Williamson and Lee Pinkowitz, quoted in Davidson’s article, suggests that, while in some industries investors support the build-up of cash balances, in other sectors, such as defence and coal, investors valued every $1 of stockpile at a mere 40 cents.
At face value, it makes little sense to hold cash balances and simultaneously have borrowings, as the cost of carry will inevitably work against the company. That value destruction effect will be even greater if, as has been suggested, banks begin to charge negative interest rates on them.
However, there are two possible explanations of this apparent anomaly.
With Apple, for instance, the vast majority of cash is held outside the US and beyond the reach of the Internal Revenue Service. If Apple repatriated the cash to the US, under current tax law, which may change, it would have to pay about 35% in tax.
So long as the US corporate tax law remains unchanged, it is more economical for Apple to borrow any money it distributes to shareholders from US sources than to use its overseas cash balances. In 2014, Apple issued a $17bn bond to fund its buyback, rather than depleting its cash balances.
Corporate treasurers who can’t offer attractive ancillary business face a combination of reduced availability and/or higher interest and fees for RCFs
It’s not just tax that has an impact. The other advantage of cash mountains that can be cited to outweigh the cost of carry argument is the buffer they provide against economic turbulence.
As Ben Wright, writing in The Telegraph, put it: “The scars from the credit crunch – when banks suddenly pulled their credit lines – are even fresher [than the dotcom crash]. A whole host of companies have since learnt that they can’t necessarily rely on the banks being there when they need them and have increased their own balances accordingly.”
Bearing all this in mind, and as John Grout, the Association of Corporate Treasurers’ former policy and technical director, said when asked about his primary advice for treasurers, it may be simply that the answer lies in the old edict: “fund early and fund long”.
The rise of corporate cash balances has not changed traditional financial theory, but it does add extra dimensions and nuances that should be considered on a case-by-case basis.
Paul Cowdell is associate lecturer at Sheffield Hallam University.
This article was taken from the October 2016 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership
