Research

Why companies stockpile mountains of cash

Since the collapse of Lehman Brothers in the fall of 2008, corporate officers around the world have been building up their balance sheets with mountains of cash and marketable securities — a lot of it in other countries. At the kickoff of the 30th anniversary season of the Economic Club of Phoenix, Professor Thomas Bates, chairman of the Department of Finance at the W. P. Carey School of Business, delivered a primer on cash holdings.

2014-10-10

Question: Bloomberg News estimates that U.S. companies hold upwards of $2 trillion in cash and cash-like instruments in foreign subsidiary reserves. Why are companies stowing cash off shore?

Bates: When the U.S. corporate tax rate was raised to 35 percent during the Clinton administration, this rate was approximately the average tax rate charged on corporate earnings across the Organization for Economic Co-operation and Development (OECD) countries. Today, the 35 percent U.S. corporate tax rate, combined with state and local taxes on earnings, is the highest among OECD countries and creates a tax-based dis-incentive to repatriate cash earned outside the U.S.

Earnings obtained by U.S. multinationals are taxed at the local rate, and if repatriated are taxed by the U.S. at the corporate tax rate net of any taxes paid in the foreign jurisdiction.

Given this disparity in tax rates it is easy to see why U.S. multinationals hold significantly more cash on their books than do similar firms that do business only in the United States. And it’s understandable that this tax differential explains why cash balances have been increasing over time, and why these balances remain on the balance sheet of their foreign subsidiary.

Question:Some have suggested a tax holiday similar to the “Homeland Investment Act” enacted by the Bush administration in 2004. What do you think about this idea?

Bates: The one year tax holiday established in the act limited the domestic tax rate on repatriated funds to 5.25 percent. Roughly $300 billion in cash came back to the multinational parents of foreign subsidiaries — five times the normal rate of repatriation. But a 2010 study by economists at MIT and Harvard found no evidence that these companies significantly increased domestic investment, employment, or R&D in the year of and following the tax holiday. However, repatriating firms did engage in an unusually high volume of re-purchases and dividends, providing capital back to their investors.

Would a tax holiday on repatriated earnings today provide economic stimulus? The answer is a big maybe. U.S. firms have taken full advantage of incredibly cheap debt rates to finance domestic investment. Debt financing is a very cheap alternative to repatriated earnings. This having been said, repatriated cash will be a much more important source of funding for domestic investment when borrowing rates eventually go up. But most executives in multinational firms are very aware of the public debate around a tax holiday, and are more than likely delaying some investment — exacerbating the problem. Barring direct capital investment, however, repatriated cash could be distributed back to investors, and from the supply side, broaden the base of investible capital in the domestic economy.

Question: How much cash and securities are currently sitting on the balance sheets of U.S. corporations?

Bates: At the end of 2013, U.S. non-financial corporations were holding upwards of $4 trillion in cash and marketable securities — or roughly twice the value of cash balances held by public companies immediately before the crisis. The top three include Apple ($160 billion), Microsoft ($84b) and Google ($59b), with the top five rounded out by Verizon and Pfizer. For some perspective, a report published by Moody’s earlier this year estimated that America’s top five corporate cash reserves exceeded the reserves held by most Asian countries and were well in excess of the sum total of the cash reserves of all of the countries that comprise the Eurozone ($221 billion). But it’s worth noting the Wall Street Journal’s report that South Korea’s Samsung Corporation holds approximately $60 billion US dollars in current cash reserves, a figure that represents approximately 30 percent of its market capitalization.

Question: Are these large amounts something new?

Bates: Not really. U.S. industrial firms have been holding large cash stockpiles for four or more decades. I worked with two colleagues on this time series of cash holdings for U.S. firms over a 30-plus year history (see slide). At the time, we were interested in trying to explain the unprecedented buildup in cash reserves of non-financial and unregulated firms prior to the financial crisis. After looking at the pre-financial crisis data, scholars were shocked by what we observed. During our sample period, the average cash ratio (cash/total assets-cash) for public companies listed in the U.S. more than doubled from about 10 percent to almost 25 percent, while the holdings of the median firm almost tripled from 5 percent to almost 15 percent in the mid-2000s. Much of the media attention has been focused on firms like Microsoft and Apple, but this is an economy-wide phenomenon that existed well before the firms on the top-five list achieved their stature. Furthermore, this trend has persisted through a number of economic expansions and recessions, changes in tax regimes, and mild and severe economic and political shocks.

These results are counterintuitive. Improvements in information and financial technologies, coupled with the growth in the financial markets and access to lines of credit since the early 1980s should have reduced corporate demand for cash balances. For example, firms can now hedge their risks more effectively as more types of derivatives have become available at significantly lower transaction costs. This presented a real puzzle.

Question: How much debt were those firms carrying during this period?

Bates: In the 40 years prior to the recent crash the net leverage ratio, defined as the ratio between the book value of all debt maturities minus the firm’s holdings of cash and marketable securities divided by total assets, declined substantially. Immediately prior to the crash, the average and median U.S. public corporation held more cash than the face value of their outstanding debt. At any point in time, these firms could have repaid all of their outstanding debt maturities!

One explanation for this trend might be that U.S. firms dramatically reduced debt during the sample period, but this is not the case. Leverage accounted for about 26 percent of assets (on average) in 1980 and about 22 percent in 2006. This finding dramatically changes the way we should be thinking about corporate capital structure decisions: if cash is net debt, the average U.S. firms held very little leverage prior to the crisis.

Question: Did the picture change following the crises?

Bates: Firms dipped into their cash holdings substantially between 2008 and 2010. Despite this, cash balances during the last four years have continued to grow as in the past, but at a far faster rate than we have seen during similar intervals in the last 40 years. As of the end of 2013, the average U.S. public firm held over 25 percent of the book value of their total assets in cash and liquid securities.

The pattern in net leverage is similarly quite striking. In the last four years, net borrowing by U.S. public corporations has surged. This is even more astounding considering the rapid increase in cash holdings over the same period — a trend that was actually outpaced by the relative level of borrowing by firms in the U.S. economy. Why? Firms are borrowing more today because of the unprecedented low corporate borrowing rates that are a byproduct of low absolute U.S. Treasury rates and historically low spreads. Our research suggests that as the cost of borrowing goes down, cash holdings actually go up. As those borrowing costs fall, cash and debt financing become close substitutes for one another, so firms retain a higher proportion of their operating cash flows.

What’s the explanation for this 40-plus year trend?

Bates: There are three simple answers, and in most cases I find them reassuring as they relate to the robustness of our economy.

First, the world has gotten riskier for the average U.S. corporation. One way to think about risk at the firm level is to think about the reliability of their operating cash flows. This is really the source of internal funds necessary to make regular investments in capital assets and R&D, as well as repay the interest and principal associated with their debt without increasing their borrowings or accessing other sources of capital. Cash flow risk has increased substantially over the last 40 years. Managers of firms in the U.S. economy are much less certain about the level of operating cash flow they will generate in a given year for investment. To hedge the risk of underinvestment and reduce the risk that they will not be able to pay dividends or interest, firms have had to hold more cash reserves.

And, by almost any measure, the U.S. corporate landscape is more competitive now than ever before. The majority of U.S. industries are now less concentrated than they have been in several decades, where concentration is measured by the dispersion of sales across the firms that make up that industry. A second measure of competition is industry turnover. Today, more firms are entering and exiting industries in a given year than ever before. As competition has gone up, firms have an added demand for cash to provide investment flexibility as they respond to their competitor’s entry and pricing decisions.

A second reason for the long-run trend in cash holdings is that the economy has changed for the average U.S. corporation. They are not investing less — they are investing differently. Investment in capital expenditures is down substantially from the 1980s while the investment in research and development are up. In the 1980s, average capital expenditures were more than double average R&D expenditures (8.9 percent vs. 3.2 percent of assets). In contrast, in the 2000s R&D actually exceeded capital expenditures (6.7 percent vs. 5.4 percent). Why does this affect the corporate demand for cash? First, R&D is difficult/impossible to defer midstream. These expenditures really represent the salaries of scientists and other innovators; companies can’t simply stop investing in their salaries and labs when operating cash flows come up short. Capital expenditures, on the other hand, are much easier to defer until more internal funds are available for investment. They are also easier to finance, particularly with debt, because the assets are physical.

A third reason for the trend is that publicly-traded U.S. corporations are more efficient than they have ever been. Thanks to supply chain management, inventory holdings are at an all-time low. In the 1980s, inventories represented 20 percent of the assets of U.S. firms, while today they represent less than 10 percent. In addition, corporations have become significantly better at collecting their receivables earlier. In the 1980s, accounts receivable represented 21 percent of the total assets of the average publicly-traded firm, but only 14 percent today. Since cash is a natural substitute for these current asset lines, firms have had to save more cash as a compensating balance to maintain their current ratios.

Question: What does this mean for investors?

Bates: This graph illustrates the marginal value of a $1 in cash for the average U.S. firm over the last 30 years. In a nutshell, this tells us the effect of an additional dollar of cash savings on the stock price of the saving company. The blue line is the annual estimate of the value of one dollar expressed as a five-year moving average. The evidence suggests that through the 1980s and early 1990s, stockpiles of cash were very costly for investors in that $1 of incremental savings was worth far less than $1 in market value. There are several explanations for this, the most persuasive being that excess cash holdings allowed managers to invest in bad acquisitions and their pet capital projects.

By the 1990s, however, this relationship changed dramatically, with incremental cash holdings valued well in excess of the dollar of savings. This evidence is generally consistent with cash holdings being an important investment hedge in markets characterized by increasingly volatile operating cash flows and more intense industry competition.

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