On Corporate Cash

In human terms, we are most often best off with the via media, that is, the middle way.  So it is with corporate cash.    The first article I wrote on the internet (in 2003) argued for the value of excess cash in the hands of intelligent management teams.

But there is a limit to that, and more so when many companies build up large slack cash balances.  Think of the converse: only one really intelligent company has a lot of slack cash.  That company starts buying up other companies like a clever private equity buyer, but taking account of synergies with existing companies in the process.

Such a buyer would understand the value of each company purchased, and how much fat could be cut out, synergies realized, etc.  But even as that one company acted, valuations would rise with each purchase, until the “intelligent company” stopped buying, because it was no longer reasonable to buy at the higher valuations.

If this is true with one clever buyer, it is true with many not-so-clever-buyers, but it takes longer, and there will be errors, failures even, and more.

It is hard to deploy cash effectively as a corporation, aside from the simple routes of dividends and buybacks.   But companies that are good at doing small acquisitions that improve organic prospects can do far better than companies that blindly acquire for reasons of scale.

The company with a lot of cash will look for a scale acquisition, and will overpay, or, will overpay for an acquisition in an unrelated industry, creating a conglomerate that is hard to manage.

It would be far better to pay it out as a dividend, or buy stock back.  The shareholders as a group have a better idea of what is valuable in the public markets than the management team does, particularly aas public valuations get high.

Thus, I agree with Michael Santoli of Barron’s in his recent article.  The additional cash in the hands of many growth companies is depressing valuation measures, and should be paid out as dividends, or with an eye to the price, buy back stock.

And, I disagree with the fellow who wrote this article, that large corporate cash hoards are a reason to buy equities.  That might make sense if one knew what companies would get bought  out, but no one knows that.  In general, it is hard to pick acquisition targets profitably.  If major corporations can’t do it, odds are you can’t do it either.

For one more point on corporate cash generally, don’t pay much attention to it, because corporate cash often serves as collateral for futures positions, and other derivatives.  Cash on the balance sheet is often encumbered.  Maybe accounting standards should be modified to reflect that, because knowing the true liquidity of a company is valuable.

4 Comments

  • Abulili says:

    Two quick thoughts, contradictory though they are:
    1) It’s a dangerous proposition for a company to hold large amounts of cash for prolonged periods in times of high unemployment and big public deficits. The temptations to “temporarily” tax that (I can imagine all the arguments) are too big.
    2) Companies may be quite rational to hold so much cash. When credit markets can freeze up very quickly (as they have in recent times) you don’t want illiquidity to lead to insolvency. It’s about surviving more than anything else.

  • maynardGkeynes says:

    I’ve often wondered how much of the cash being talked about is retained earnings, and how much is simply money borrowed at 0% or at ultra-low long rates because rates are so low now? Companies that are borrowing the Feds free money on a ‘why not’ basis look like they have lots of cash on hand, and they do, but it also has to be paid back. That is not the same as cash from retained earnings, like Apple.

  • miguelmartinez says:

    Another factor to consider is that very large companies often have enough trouble wrapping themselves around their own companies and understanding what needs to be done let alone trying to buy other companies.

    It is very difficult to coordinate the successful merger of two corporate structures when the company doing the buying cannot even coordinate itself.

  • HelicalZz says:

    David,

    One takeaway I appreciated from Gary Shilling’s recent book and deflationist mindset related to his explanation of why successful high technology companies often have an affinity for high cash balances (Microsoft, Apple, Google). They tend to operate in a deflationary environment in regards to their often short product lifecycles, rapid obsolesce, and constant exposure to disruption. Cash is an inventory / operating asset that they don’t need to worry about writing down.

    As a dividend fan, I agree that more should be put back to shareholders, but I would never expect these companies to lever similar to what may be practical in other industries.

4 Trackbacks