The media has been paying attention lately to the swelling cash pile held by Canadian and American corporations.
However, the real story dates back to the 1980s, when liquid assets held by non-financial U.S. corporations began rising. Companies’ cash-to-assets ratios more than doubled from 10.5% in the 1980s to 23.2% in 2006, according to a 2009 Journal of Finance study by Thomas Bates, Kathleen Kahle and René Stulz.
This rising trend came to a standstill in the aftermath of the financial crisis, when firms began depleting cash reserves to survive.
But since then, S&P 500 company earnings have grown 78%. At the same time, dividends, wages and capital expenditures all rose, but at a lower rate than profits. The result: more cash. The U.S. Federal Reserve estimates corporations are sitting on $1.8 trillion in cash reserves, which is 17% higher than 2007 levels.
In Canada, corporate cash holdings have doubled over the past decade, far surpassing the $500-billion mark. Meanwhile, the global economy is still sputtering along and employment growth is stagnating, causing those high levels of cash to draw heightened attention and criticism by governments, shareholders and the media.
So are corporations actually hoarding cash at the expense of lower investment returns for shareholders and the economy?
Business scholars have long urged business managers to hold less cash and assume more debt. But from a company’s point of view, it makes sense to increase cash buffers, especially after enduring a post-crisis credit squeeze.
How much is enough?
Firms need cash to perform daily operations, such as purchasing inventory and paying employees, and to cover unanticipated expenses. Having cash also provides the luxury of time so companies can wait to select only the best projects.
But philosophies differ on how much cash companies should hold. Some proponents believe 2% of revenues is the right amount, while others believe cash is in excess if it’s above the industry average.
It turns out there is no magic number. Cash is in excess when it is unnecessary for ongoing operational needs.
A company’s cash holdings need to be examined on a case-by-case basis while taking into consideration unique needs, such as cyclicality and planned capital expenditures.
What to look for when investing
So where’s the best place to put your money to work? Invest in businesses that are responsible cash managers.
Find a company with a team that has generated returns above the cost of capital, and has ultimately created value for shareholders over the long term.
When it comes to cash, too much of a good thing can be dangerous. Having excessive amounts of cash has the potential to render management lax and encourage imprudent acquisitions and spendthrift expansion. Steer clear of businesses where management has an overall poor record of capital allocation—no matter how good the share price.
Look for dividend payments and share repurchases that are made only when it is responsible to do so. This entails repurchasing equity when shares are undervalued and only paying dividends when it’s not at the expense of efficient business operation, promising growth opportunities or an adequate liquidity position.
Companies rarely tinker with dividends. Cutting them is considered a desperate move, although it might be the right move. At the same time, don’t shun companies that have cut dividends without digging deeper to determine if it was a short-term glitch and the company has the possibility to recover. If so, it may be a great time to pick up the stock of a long-term investment at a discounted price.
Despite these concerns, the transition towards higher cash holdings and liquidity is a positive sign of healthy corporate balance sheets. Most importantly, it has not hurt returns for investors.
Nevertheless, investors are better served by having fewer dollars today but owning a share of a business that has greater value, as well as the ability to pay substantial dividends, in the future.
Top 10 Corporate Hoarders ($millions)
Short- and Long-Term Assets
Short- and Long-Term Assets
Teck Resources Limited
Suncor Energy Inc.
George Weston Limited/Loblaw
Barrick Gold Corporation
Research In Motion Limited
Husky Energy Inc.
Kinross Gold Corporation
Magna International Inc.
The push to spend cash
Governments are searching for ways to coax corporations to spend cash, but results have been mixed. For instance, U.S. tax laws allow American companies to defer paying taxes on foreign profits, as long as those profits are then reinvested outside of the country. In 2004, Congress passed the Homeland Investment Act, providing companies with a one-time tax holiday for the repatriation of those earnings in hopes of spurring domestic investment and creating hundreds of thousands of jobs.
More than $300 billion was repatriated, but the benefits never ended up trickling down to create increased domestic investment or employment—the funds were ultimately used to boost shareholder payouts.
A more recent example is when the Canadian government lowered the corporate tax rate in an effort to make our country more attractive and competitive globally.
In 2012, the federal and provincial tax rates fell to a combined 25%, giving Canada the lowest rate in the G7 countries. This has given Canada the top ranking as the best business domicile in the world by Forbes.
However, increased after-tax corporate profits should have been re-invested in operations that would eventually boost economic growth, productivity and jobs. But studies have shown that what materialized were higher CEO compensations, lower government revenues, higher federal deficits, cuts to public service and increases in cash reserves.
Can we trust cash-flow statements?
Figures on the cash-flow statement are merely adjustments of numbers that come from the income statement.
Many of the problems that exist with income numbers tend to leak into cash-flow statement figures, because not enough correcting adjustments can be made to bring the accrual income figures back to being anything close to actual cash flows.
Income figures are based on numerous management assumptions. In short, management estimates what expenses belong in the quarter in order to match them to their estimate of how much revenue should be recorded.
Actual cash-flow figures do not match up to revenue and expense estimates. Sometimes cash comes before revenue, sometimes after; the same goes for expenses.
The period in which “cash” is recorded on the cash-flow statement can be completely disconnected from actual cash flows in and out of the bank. That’s the first big miss when it comes to the cash-flow statement; the second is when it comes to categorizing cash flows. The cash-flow statement is divided into three categories of cash: operating, investing and financing. The problem is that cash can be miscategorized by management or, alternatively, misinterpreted by investors. Investors place significant emphasis on cash from operations and/or free cash flow. Unfortunately, this is akin to looking at only about one-third of the information on the cash-flow statement.
–Al and Mark Rosen
Susy Abbondi is a portfolio manager at Duncan Ross Associates.