The Investment U e-Letter: Issue #695
Monday, July 23, 2007 Corporate Cash Surplus… A Look at the Dangers of Corporate Cash
by Alexander Green, Chairman, Investment U; Investment Director, The Oxford Club John Templeton, one of the pioneers of global investing and the legendary manager of the Templeton Growth Fund, was interviewed a few years ago about his value approach to the stock market. "I used to buy companies at a discount to their cash on hand, in effect getting the business for free. But you can't do that today. You haven't been able to do it for over 30 years." Still, some analysts try to emulate him. They like to recommend companies with a corporate cash surplus, the larger the better. But is this really a worthwhile strategy? Not today… Unused Corporate Cash is a Drag Most shareholders would be better off if that money were put to work. In a new study by Thomas W. Bates and Kathleen M. Kahle, finance professors at the University of Arizona, they note that publicly traded companies in the U.S. hold so much cash that, as a group, they could pay off all their debt and still have money left over. The professors found that the average cash-to-assets ratio for corporations more than doubled from 1980-2004, to 24% from 10.5%. This cash-heavy shift reflects a major shift over the last 20 years. And, for investors, it is not a good thing. As individuals, we tend to feel it's better to have low levels of debt - or at least a comfortable cash-to-debt ratio. But corporations aren't individuals. They exist, among other reasons, to maximize returns for shareholders. Do you want to see a CEO and his colleagues pulling down tens of millions of dollars in compensation each year while the company sits on a surplus of unused cash? Not me. Yet ExxonMobil and Microsoft, for example, are each sitting on over $30 billion in cash and short-term securities. And Bates' and Kahle's study shows that smaller companies showed even larger percentage increases in cash. The usual explanations don't apply. It's not because of the flood of initial and secondary offerings, which tend to fill corporate coffers. And it's not just because companies hold cash overseas from international operations to avoid the penalties of repatriation. Corporate Cash Surpluses and Dividends No, it turns out that many companies simply don't want to cut or eliminate a dividend once they start paying it. Top executives know that shareholders expect a dividend to grow - or at least be maintained - once it gets instituted. If it gets cut, the share price is likely to suffer. And if the share price suffers, so will their compensation since much of it is tied to stock options. However, most of these companies would be better off using their cash to buy back shares. Why? Because dividing earnings by fewer shares outstanding accelerates growth in earnings per share. That's why a buyback announcement itself is often a catalyst for higher prices. After all, management is ringing a bell, alerting investors large and small that a bargain may have developed. My research shows that small- to mid-cap companies with high price-to-book value ratios are generally the best investment candidates when a buyback announcement is made. One study found that the 50 stocks that met these conditions in every year from 1992 to 2002 produced gains 65% greater than the S&P 500 over the next four years. Don't get me wrong. I enjoy receiving a dividend as much as the next shareholder. But what we're all really after is higher total returns. And it's growth in earnings per share - not dividends - that ultimately drives stock prices higher. Good Investing, Alex Today's Investment U Crib Sheet According to Bloomberg, companies have bought back $443.9 billion in shares so far in 2007. That's a 31% jump compared to this time last year. Here are few businesses leading the charge… General Electric (NYSE: GE) recently doubled its stock buyback program, to $14 billion. Shares just hit a 5-year high. Johnson & Johnson (NYSE: JNJ), which has $5.2 billion in cash on the books, plans to buy back up to $10 billion of its own stock, or 5.5% of its market value. The company would use a combination of cash and debt to finance the repurchase plan. Oil giant ConocoPhillips (NYSE: COP) said it would buy back up to $15 billion of its shares through the end of 2008. That's 11% of its market value. (Read our free report on Conoco.) Yum! Brands (NYSE: YUM), the international fast-food conglomerate, said it may add as much as $2.5 billion in debt to repurchase its own shares. The company operates the Pizza Hut, Taco Bell, A&W, KFC and Long John Silver's brands worldwide. (Yum!, by the way, is an Oxford Club holding, up 83%, adjusted for dividends and splits.) Related Articles Investment U Archives 
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