On Deploying 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.

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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.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.