A recent USA Today article by Matt Krantz discussed the massive amounts of cash now being held on the balance sheets of large US corporations. Krantz says that according to S&P, non-financial companies in the Standard & Poor’s 500 are now carrying a record $837 billion in cash – up 26% from just a year ago. “That’s enough to pay 2.4 million people $70,000-a-year salaries for five years.” However, as Bernanke & Company are keenly aware, companies are neither hiring new workers nor investing aggressively in new plants and equipment. Rather, most companies are content to sit on their fortunes while earning just a fraction of a percent on their money. Why? First and perhaps most importantly, corporate managers are not seeing the sustainable end demand necessary to justify hiring and other investment. But perhaps just as important is the policy uncertainty with regard to future tax rates and healthcare costs. And finally, many companies (especially smaller and mid-sized companies) have seen their access to credit sharply reduced as banks struggle with capital deficiencies, new regulatory requirements and soaring loan losses. Rather than be held hostage to the whims of the banks (and bank regulators), many companies are simply holding on to what they have. So in a nutshell, there is a general lack of confidence to commit money to new workers and equipment at this time. As a result, we are seeing widespread hoarding on scale we’ve not seen before.
The reluctance to hire new workers is creating a lot of anxiety within the Obama administration, but for now nobody seems to have the right prescription. For our part, we too fail to see the catalyst that will lead to the hiring necessary to replace 8 million+ jobs lost since the beginning of the recession. Rather, we think corporate managers will use their cash in a variety of other ways until visibility improves and it is clear that investments made can produce attractive returns. First, while mergers and acquisitions are down 9.5% year-to-date through the second quarter (according to Dealogic), we believe cash-rich companies will use their money to more aggressively acquire competitors in the future. We are getting more and more news about these so-called “strategic” acquisitions as economic data increasingly points to a slowing in economic growth (from 4Q and 1Q levels). We believe the targets will be those companies who have been less successful in reducing expenses to bare-bones levels. The logic goes like this: If organic revenue growth opportunities are unavailable, companies must look for other ways to grow earnings and satisfy their shareholders. One way to do this is to buy bloated companies and cut the fat.
A second use of cash may be dividend increases, a trend which has already started. According to a June 26, 2010, Wall Street Journal article, “This year through mid-June, there were at least 135 dividend increases or initiations among the companies in the Standard & Poor’s 500-stock index, up roughly 55% from the first six months of last year.” We believe this trend will continue, with the prospect of higher tax rates on dividends encouraging some companies to consider special one-time dividends before the rate increase is put into effect in 2011. (Without Congressional action, the top tax rate on qualified dividends will rise from 15% to 39.6% next year). The most likely companies to consider a large one-time dividend may be those companies with high insider ownership. Undoubtedly these large shareholders would rather be taxed at a 15% rate than 39.6%.
Corporate managers may also consider large buybacks to soak up some of their cash. Buybacks are another way to return cash to shareholders. Buybacks can support the stock price, offering downside protection, as well as lowering the amount of shares outstanding. A lower share count results in higher earnings-per-share and theoretically a higher stock price. While buybacks have increased of late, we would expect the pace to increase in as corporate managers look for ways to create shareholder value in an environment of weak demand.
In summary, we believe that the strength of corporate balance sheets is perhaps one of the best arguments for owning stocks right now. This especially applies to the types of companies that Farr, Miller & Washington favors – large, defensive, multinational blue chips with sizable market share. At a time when government and consumer balance sheets are in disrepair, corporate balance sheets provide downside protection while also providing growth potential and dry power when the economic environment improves. Moreover, dividend yields of 2-4% look very favorable when compared to the few basis points available on money market accounts and the 3% available from the 10-year Treasury. This is especially true when you consider the fact that rising interest rates could lead to sizable capital losses on bond holdings. Therefore, we continue to recommend stocks in large and financially-sound companies. The combination of downside protection and growth potential should support prices while we ride out the economic storm.