In the most recent copy of the St. Louis Fed’s Regional
Economist, two of its
researchers query the status of corporate cash. Specifically, they’re
interested in why companies are hoarding so much of it. Normally, such an
article wouldn’t be noteworthy, but in this case we feel that delving into
such an issue will be of assistance in terms of helping the average person to
understand the truly broken nature of our economic and monetary systems.
During the course of the article, the researchers pose what would be
considered normally expected explanations for this pile up of cash:
tax-avoidance, structural changes in the business environment, and even the
cost of research and development. We don't doubt that these are probably
among the subset of correct answers, perhaps with a few additions varying by
particular fields. However, we found it much more interesting and instructive
to ask where the cash came from than why it was being
accumulated. The media, especially in America, has gone out of its way to
portray a robust economic recovery. This would lead one to conclude that
these piles of cash came from business activity. We’ll see if the data and
trends validate that conclusion.
Certainly we get the sense in our daily conversations that people are
starting (finally) to realize that something is wrong, but it is hard to get
into a detailed discussion because most willingly profess at least some level
of ignorance to the tenets of corporate finance. Our goal, therefore, is not
to craft a treatise on corporate finance as there are already too many of
them, but to rather distill out the most pertinent information so the average
person can form a basic understanding of money at the corporate level and
what the hoarding of money by corporations in the aggregate tells us about
everything going on around us.
If one is to understand investments, it is imperative that a basic
understanding of how monetary strategy at the corporate level plays out in
terms of financial statements, ratios, and such. Corporations are indeed
loaded with cash, especially when compared with historic measurements. Let’s
pose a couple of questions, then provide the reader with information to
answer them as we progress.
- Is it possible that captains of industry know
which way the wind is blowing regarding interest rates, the
macroeconomic environment, and the capital markets?
- Is this a trend that is spanning out amongst
all business or are the numbers being skewed by certain sectors?
- What role does government interference (either
positive or negative) have on the cash strategies of corporations?
- What is the likelihood that there are hidden agendas at work regarding the
hoarding of cash, especially considering the fragility of the dollar
standard system?
Where Does a Companys Cash Come From?
For the purposes of this discussion when we say the term corporation,
were referring to fully incorporated entities rather
than sole proprietorships and most partnerships. Companies really dont
have many traditional ways of getting their hands on
cash. They can issue stock through various types of offerings, issue debt instruments
through similar mechanisms, or generate revenues. While subsidies are a very
real occurrence, were not going to focus on them as a
primary form of cash generation.
All of these means, save for revenue generation, are
self-limiting, however. A company that focuses on debt to increase its cash
position and doesnt have a worthy
revenue stream would traditionally find itself either unable to borrow
additional funds or would be required to pay a much higher rate of interest
on borrowed funds or perhaps offer some type of collateral much in the way a
home owner with a mortgage offers their home
as collateral. We call this a secured loan; there is some type of security
that the lender will get its money back. It is essential to note that while
the focus these past several years has been on lender discipline in the
retail credit markets, there has been very little attention paid to the same
discipline as it applies to corporations. The result has been predictable;
corporations are using debt (specifically cheap debt) as one of its means of
primary cash generation.
As can be observed from the above graphic, non-financial corporate
debt is quickly approaching the $4 trillion mark. Note that the Great
Recession of 2009-2011 as pronounced by the American
Government barely affected the slope of the debt curve. In similar fashion to
almost every other debt metric, the accumulation of significant amounts of
corporate debt began shortly after the end of Bretton Woods and the gold
standard in 1971.
Put plainly, corporate America never retrenched. Where the consumer
enjoyed a brief period of contraction in certain of its debt categories,
corporate America never blinked an eye. This would beg another important
question: Did America ever really experience a
credit crunch in the 2008-2010 period? Banks certainly might have been a tad
skittish about lending to each other, but corporations had no problem
continuing to grow their appetites for financing. We posit here that the idea
of a full-blown credit crunch was largely a media event, driven by hysteria
and a desire for shock headlines more than any tangible event. There were
many benefactors of the idea of a credit crunch, however, that is another
topic for another endeavour.
This is where we get to an important point. Both the American and
European media love to use financial ratios with colorful arrows to
accentuate whatever point theyre trying to make. One of the
common metrics used to measure the creditworthiness of companies is the
debt/equity ratio. Simply, total liabilities/shareholder equity. The higher
the number, the worse the shape a company is in. The
lower the number, the better. Opinions vary greatly on the exact levels that
signify danger, but lets use 1.0, meaning one dollar of
equity for every dollar in total liabilities.
What we have seen over the past nearly 4 years now is a media that is
literally frothing with the news of healthy American companies and
they point to falling debt/equity ratios as proof, as is evidenced in the
graphic below, which portrays D/E ratios for the S&P500 Industrials
components:
It is absolutely critical that the reader understand the equity
portion of the formula referenced above. Shareholder
Equity or Equity is
another term for stock price times the number of shares outstanding. The
higher the stock price goes, the greater the equity
given a constant number of shares. So if a company can grow its equity (via
stock price) faster than its debt, well see
the D/E ratios fall all other things constant,
including earnings.
From the chart below it is pretty easy to see that earnings have not
been a positive contributor, at least from a growth perspective. While
aggregate earnings have increased, at least in nominal terms, growth has all
but stalled. Note, the chart below contains
forecasts for Q4 2011 forward rather than actual earnings data. The point
here is to show the decreasing availability of cash from earnings from the
2009 period. A healthy S&P500 would have derived the lions
share of its cash from revenues (earnings) rather than via debt acquisition.
The other primary area of cash acquisition is through equity
offerings. This happens when companies either go public
with an initial offering or do secondary offerings to generate more cash.
Obviously equity offerings dont count as debt, so many might
construe an equity offering to be a win-win because it increases both a companys cash and its shareholders
equity. The problem exists in that a company cant
just constantly run to the capital markets and do secondary offerings every
time it needs some more cash. These moves are generally strategic and
longer-horizon in nature and are planned well in advance. A history of
running to the proverbial well does not generally bode well when it comes to
successful subsequent offerings or bond sales for that matter. A company that
abuses the privilege often runs into lower proceeds from future offerings or
finds that the market commands higher rates of interest.
We can note from the graphic below that 2012s
total of $168 billion was the highest since the last major bubble year
2000. Perhaps oddly, 2009 was the third highest in the first decade of the
new century coming in at $157 billion. There is a definite trend in place
here. 2000 represented a cycle (1982-2000) peak followed by three years of
declines, then another run up into 2009. 2010 dropped off
dramatically and the next
trend resumed.
Of 2012s total of $168 billion in total offerings, just $34
billion of that were initial offerings, along with $7 billion in 2009, $14
billion in 2010, and $32 billion in 2011. The vast majority of offering
dollars were from secondary offerings and the amount is increasing, meaning
that companies are coming to rely more heavily on the equity offerings for
cash.
In conclusion, of the three major sources of cash that we pointed out
at the beginning of the article, the only one that is derived from business
activity (earnings) is on the decline while reliance on debt and equity
offerings is on the increase. So we can answer semi-quantitatively the
question of where firms are getting their cash.
Oddly this conclusion, for the most part, agrees with the article in
this quarters Regional Economist, although you
have to read between the lines a bit to find it. The Federal Reserve has
never been terribly secretive about the information it is willing to provide
to the public and has come to rely on ignorance, apathy, and misdirection
promulgated by media outlets to accomplish the ultimate whitewash.
As we are sure most readers already realize, the Federal Reserve and
US Government are two of the most active economic agents working at the
macroeconomic level today. The Federal Reserve being the lender and buyer of
last resort while the US Government is the consumer of last resort. When the
people refuse to spend and instead go into Japanese mode and become savers or
even the slightest bit credit-averse, the US Government spends on their
behalf. The majority of the 50 states and many smaller subdivisions of
government have followed this model as well.
As is illustrated in the chart above, the Federal Reserves
balance sheet has ballooned to nearly 4 times what it was pre-crisis. And
these are the public acquisitions and the data are skewed at best. The sum of
QE actions alone in the past year is not being accurately depicted, not to
mention the assets held at the money center banks that are ostensibly the
owners of the Federal Reserve. It is long past time that this be accepted as
an established fact rather than debated as a theory. The fact that a private
bank is believed by so many Americans to be part of the US Government
provides a great deal of humor for those in other parts of the world, but
only to a certain extent as their countries are also dominated in a similar
fashion.
Which brings us to the topic of prior knowledge. The
media has purported many of our financial crisis events as either economic or
financial accidents that happen due to the velocity and confluence of certain
factors. The bottom line is that the idea is projected that these events
cannot be predicted with any real accuracy.
A quick anecdotal look at the money raised by corporations in equity
offerings might help us to shed a bit of light on this. We can see a
reasonable trend leading into the 2000 technology rout. We can see a very
well defined trend leading into the market crash of 2008. Companies were
going to the well more and more often. While this rush to accumulate cash
certainly lines up rather nicely with crisis events, it doesnt
line up so well with the business cycle when looked at in authentic,
non-traditional GDP terms. For example, using the Cobb-Douglas production
function, which is an alternative measurement of output, America entered the Great
Recession in late 2006 as properly identified in this
publication at the time, and despite heroic measures, has yet to leave that
recessionary event.
The exodus from the recession event in traditional terms has been due
almost entirely to government activity rather than that of business or
consumers. This is one of the reasons the recovery, if youll forgive us for calling it that,
has never achieved what is referred to as escape velocity. The deficit
spending and Federal Reserve intervention are still necessary to maintain the
appearance of growth and even that was not in enough this past quarter.
There have been a bevy of analysts globally who accurately have
predicted the technology-led downturn that started in 2000 and the crisis of
2008, the crash of the US residential real estate market, and the subsequent stagflationary period. Prior knowledge was easily
obtained in all these instances by merely studying the information available
in its proper context. This context will never be achieved by those who wish
to absorb a steady diet of propaganda from conventional media outlets either
in the United States or elsewhere.
We can safely recognize that captains of industry the globe over knew
what was going to happen, if not specifically, at least in generalities with
regards to the capital markets, and acted accordingly. The fact that
corporations are stockpiling cash in the face of what we are led to believe is
a slow but thriving economic recovery represents prima facie evidence
that the recovery is a concocted sham and that corporations are expecting
further difficult times. The reality that theyre accumulating
dollars given the future prospects for the king of paper currencies does
nothing but underscore that point.
Graham Mehl is a
pseudonym. He currently works for a hedge fund and is responsible for
economic forecasting and modeling. He has a graduate degree with honors from
The Wharton School of the University of Pennsylvania among his educational
achievements. Prior to his current position, he served as an economic
research associate for a G7 central bank.
This is the second paper theyve collaborated
in authoring and are planning at least one more paper
during 2013. Next week, My Two Cents
will revert to its traditional role of providing commentary and analysis of
current economic and financial events.
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