The Dangers of Corporate Cash
Before he died in 2008, John Templeton - one of the pioneers of global investing - was interviewed 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.”
Yet some analysts still try to emulate him. They like companies with lots of cash in the till, the more the better. But is this really a worthwhile strategy?
U.S. companies currently hold record amounts of cash, including $2.5 trillion in overseas markets alone.
But most shareholders would be better off if that money were put to work.
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 shareholder returns.
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 war chest of unused cash?
Not me. Yet many companies are each sitting on a mountain of cash and short-term securities. Apple (Nasdaq: AAPL) holds $67.9 billion. Cisco Systems (Nasdaq: CSCO) holds $71 billion. Microsoft (Nasdaq: MSFT) holds $121.2 billion.
Why? It’s not due to a flood of initial and secondary offerings, which tend to fill corporate coffers. And it’s not only because companies hold cash overseas from international operations to avoid the penalties of repatriation.
Some are setting aside money for big projects or research and development.
Other companies have cash set aside for acquisitions. For instance, Google’s parent Alphabet (Nasdaq: GOOG) - which currently holds $86.3 billion in cash - buys an average of one company a week. It’s obviously cheaper to pay cash if you have it, especially since - with today’s low rates - companies aren’t earning high yields any more than you are.
But it turns out that many companies are hoarding cash simply because they 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 that a bargain may have developed.
My research shows that small cap to midcap companies with high price-to-book value ratios are generally the best investment candidates when a buyback announcement is made. But any buyback that reduces the net number of shares outstanding is a step in the right direction.
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.
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Editor’s Note: We’re coming up fast on our 19th Annual Investment U Conference in St. Petersburg, Florida. On March 15-18, 2017, Alex will be joined by Marc Lichtenfeld, Steve McDonald, Matthew Carr and other renowned financial experts from around the world. Together, they’ll reveal their favorite investments to get you through the next economic boom-and-bust cycle. But don’t worry - it isn’t too late to sign up. Click here for full event details.