The Wall Street Journal published a front page article this morning regarding how many companies are hoarding record high levels of cash. The tendency to hoard liquid assets can be viewed as a “survival instinct” in light of the turmoil in the financial markets and specifically the near death experience many companies faced when the commercial paper market ground to a halt during the worst of the financial crisis. However, taken to extreme levels, this hoarding instinct can clearly destroy shareholder value.
“Peace of Mind” But at What Cost?
Companies legitimately need to maintain prudent levels of cash on the balance sheet in order to meet working capital requirements and to have a buffer against unexpected headwinds that impact all businesses from time to time. In light of the turmoil in the financial markets over the past two years, it makes sense to be more risk averse than in the past.
To the extent that additional cash is required to hedge against a return to the conditions afflicting the credit markets last year, companies are implicitly also accepting near zero returns on this additional cash. This may be justified to ensure survival of the business during a repeat of late 2008 conditions, but it is not justified simply to provide “peace of mind” to executives.
Problems Associated With Excess Cash
Maintaining excess cash above and beyond levels justified by the business and in the absence of intelligent internal reinvestment opportunities usually leads to trouble or, at the very least, sub-optimal results. Here are a few examples:
- Managers with the luxury of vast amounts of excess cash on the balance sheet may be less inclined to optimize the business. If “peace of mind” leads to complacency and lack of motivation to improve the efficiency of a business, shareholder interests will be harmed.
- Cash has a tendency to “burn a hole in the pocket” of executives. Empire building managers with a large cash pile can pursue value destroying acquisitions much too easily. While it is true that many well run companies maintain excess cash for intelligent acquisitions, the risk is always present that the cash will be squandered.
- In today’s environment, the returns on cash are next to nothing so excess cash is not producing reasonable returns on capital employed by the business.
Managements that are compensated heavily with stock options may want to hoard cash even if there are no intelligent reinvestment opportunities because most options have strike prices that do not adjust for retention of earnings. Therefore, paying cash out to shareholders will reduce the intrinsic value of options held by management.
The combination of stock option incentives and the desire of many managers to simply have a greater level of peace of mind can lead to suboptimal capital structures with excess cash on the balance sheet. While there are very valid reasons to have a generous amount of cash on hand in today’s recessionary environment and in light of the recent financial crisis, this should not be a license for managers to hoard cash above and beyond reasonable levels at the expense of shareholders.
Shareholders should never forget that they own the assets of the business and the burden is on management to prove that they are holding cash for legitimate reasons rather than simply for their own “peace of mind”.