Mountains of Corporate Cash
At the end of 2012, U.S. corporations were holding $1.8 trillion in cash reserves. That’ll buy a whole lotta corporate logoed coffee mugs!
The amount has been steadily increasing for decades. Why?
An analysis answering that question is in a SIEPR policy brief this month (July 2013) by economist Dr. Laurie Simon Hodrick.
Don’t let a youthful smile fool you; she knows her stuff backward, forward and upside down!
Dr. Hodrick notes, remarkably, that precious few corporations share in most of the bounty. She examines the who, what and why in her informative review.
Who are the Hoarders?
According to Hodrick, “convention dictates that a typical firm should hold only a small fraction of its revenues as cash”. In general, that remains true.
However, five U.S. companies hold 25% of all cash reserves. They are:
- General Electric
Just 22 companies hold some 50% of the total.
Why Hold Cash?
Instead of reinvesting to grow the business, why do companies build cash reserves?
Regardless how you feel about Keynesian macroeconomics, John Maynard Keynes pointed out these logical motivations in 1936:
A company needs to maintain enough cash-on-hand to pay for all the transactions occurring during the ordinary course of business.
A business may hold cash-on-hand as a buffer against “adverse cash flow shocks” brought on in riskier cash flow industries… like technology. For them its feast or famine.
The speculative motive is the practice of having enough cash-on-hand to pounce on business opportunities as they arise.
But Wait, There’s More!
Another measure of corporate holdings is the ratio of cash assets to short-term liabilities as shown in this Hodrick graph. The higher the percentage the more ready cash a company has.
Since 2000 it has went well above the 30% average. The dip in 2007 was company survival spending at the height of the Great Recession.
Modern Reasons Companies are Holding Cash
Dr. Hodrick expands on the reasons companies hold more cash:
- Business flexibility
- Tax codes on repatriated foreign earnings
- Uncertain economic environment
- Uncertain fiscal policy
- Uncertain Fed monetary policy
- Quantitative Easing
Hodrick defines the term “unexercised option value” for flexibility during “heightened uncertainty” based on those reasons. A high unexercised option value means companies will hold or build bigger reserves. A low option value indicates companies will spend.
Business flexibility means having cash-on-hand for takeovers or unexpected downturns in the market. Microsoft’s Bill Gates insisted on having $20 billion cash-on-hand to conduct full business operations for an entire year without making any profit at all.
Warren Buffet had cash flow available to “obtain cheap assets at fire sale prices during the financial crisis”. Buffet used it to purchased $5 billion in Goldman Sach assets.
Tax codes encourage building cash reserves, too. U.S. corporations must pay 15% taxes on foreign earnings that they already paid foreign taxes on when they are brought back into the United States.
$102B of Apple’s $145B cash reserves is foreign earnings being held in Irish banks because of their favorable tax laws. Ironically, the tax code allows corporations to hold foreign earnings deposited in U.S. banks without being repatriated.
Congress can’t get its act together to fix government’s long term debt. That adds fiscal uncertainty to the mix.
Monetary policy keeping Fed rates near zero is specifically designed to keep borrowing costs low. Its unintended consequence is encouraging companies to refinance debt or borrow to make dividend and other cash payouts rather than dip into cash reserves. QE encourages that even more. Apple is doing that to the tune of $100B.
For example, rather than pay down debt with cash reserves, General Electric chose to refinance debt with higher-yield bond purchases to take advantage of low interest rates.
Hodrick does an in-depth analysis backing up the “unexercised option value” concept. She cites many eye-opening examples.
U.S. companies are holding record levels of cash reserves. It isn’t just because they are greedy.
The reasons are many and varied. The vast reserves are unexpectedly concentrated into a small number of highly profitable, multinational corporations.
Corporations live within a perfect storm of volatile markets, a fragile economy, tax codes, Fed policy and uncertain government fiscal policy. That is why they hold more cash reserves.
Hodrick’s analysis is backed up by economic research and well worth the 6-page read.