Horizon Kinetics highlight corporate risk reduction in their market commentary for March, 2014
Clients frequently ask what we expect the S&P 500 Index (“S&P 500 (INDEXSP:.INX)”) to return in a given year. Our answer is nothing if not consistent: we do not know (and are wary of those who claim they do). However, we have been building an analysis set for some time now that indicates that institutional biases increasingly emphasize liquidity needs for their enormous pools of capital over investment merit, all in the name of reducing volatility.
At the index level, this trend is reflected in the prevalence of the float?adjusted market capitalization weighted index construction methodology, the results of which include increasingly top?heavy indexes and the exclusion or under?representation of smaller or more closely?held companies, even of entire industry sectors. Unfortunately for index investors, the same large companies that dominate index returns also face the greatest challenge with respect to future growth. How can a company with a $100 billion sales base generate enough incremental sales each year to move the needle when it has already saturated its market? Complicating matters further, since investors wish to experience low volatility, the company with a $100 billion sales base is expected not only to increase its revenues and earnings materially, but to do so in a manner that does not result in a variable earnings stream or stock price.
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In the face of these two seemingly antagonistic goals, the largest corporations appear to be favoring risk reduction over long?term value creation. One way of measuring this trend is to use the basic corporate liquidity measure, which is cash as a percentage of assets. The following table shows this measure for the 12 largest nonfinancial companies in the S&P 500; this discussion considers only nonfinancial companies because cash as a percentage of assets for Bank of America Corp (NYSE:BAC), for example, is not a meaningful figure. Note, too, that the top 12 nonfinancial companies in the S&P 500 happen to comprise 19.83% of the market value of the entire index, which is not a small number.
Of course, the 12 companies—Apple Inc. (NASDAQ:AAPL), Exxon Mobil Corporation (NYSE:XOM), Google Inc (NASDAQ:GOOG), Microsoft Corporation (NASDAQ:MSFT), Johnson & Johnson (NYSE:JNJ), Chevron Corporation (NYSE:CVX), The Procter & Gamble Company (NYSE:PG), Pfizer Inc. (NYSE:PFE), Verizon Communications Inc. (NYSE:VZ), International Business Machines Corp. (NYSE:IBM), AT&T Inc. (NYSE:T), and Merck & Co., Inc. (NYSE:MRK)—are all very different businesses. On average, however, cash as a percent of total corporate assets is 23.3% for the group, and some companies, as one can see, are holding considerably more than that.
The 23.3% average is an interesting statistic. If portfolio managers were active and holding 23% cash in their portfolios, they would be considered reckless, at a minimum relative to their mandate to be invested in equities and to not assume other risks such as timing the market, and much worse than reckless, at a maximum. These companies, however, are holding cash at those levels. What is the difference, one might ask, if the companies hold a 23% cash balance and the managers hold a 23% cash balance? Is it not all the same? Actually, it is not, because the more cash on the balance sheet, the less volatile the equity is going to be. It is clear that the companies themselves are interested in reducing their volatility.
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Via Horizon Kinetics