Cash may be considered king in the corporate world, but just having lots of it doesn’t mean that a company will necessarily reign in investors’ eyes.
It turns out that history shows a significant correlation between how a company builds and uses its cash holdings and the future return of that company’s stock price. Investors tend to reward share buybacks, dividends and debt repayments, but are less enthusiastic about capital spending, research and development and acquisitions, at least one new study suggests.
Of course, investing in the business could help a company build for the future, which could eventually boost its stock price. That may very well be true in theory, but it might not hold up in practice.
All this is something to think about as companies move to spend some of the cash they’ve been hoarding amid uncertainty about the stock market and the economy. Companies in the Standard & Poor’s 500 stock index are now holding $618 billion in cash, just shy of the all-time high of $626 billion hit in December, according to S&P.
In fact, corporate liquid assets, which mostly consist of cash, now equal 22 percent of net sales, well above the average over the last half-century of 15.6 percent of net sales and not far from the record high set back in 1955, said Lord Abbett senior economic strategist Milton Ezrati.
But not all cash is created equal, in Wall Street’s eyes.
Investors generally place a higher value on cash that is derived from profitable operations rather than earned through some kind of capital financing deal, like a stock or debt offering. That’s the findings of a new Charles Schwab Corp. study tracking 3,200 U.S. companies over the last 20 years. It shows that the 20 percent of companies with the highest cash flow from operations outperformed the average stock by 4.6 percent in the subsequent year.
Take Goodyear Tire & Rubber Co., which had nearly $2 billion in cash on its books at the end of last year and said that its cash flow from operations went from a loss of $289 million in 2003 to a gain of $720 million in 2004. Goodyear’s stock is up about 40 percent from last fall and now trades around $13 a share.
The study also found Wall Street favors corporate actions that return cash to shareholders, who then have the option to invest the money as they wish.
Investors are less likely to trust corporate executives to invest the cash on their behalf — perhaps a residue of poor decisions in the past. Not too long ago, many investors who had paid a premium for telecom stocks watched their shares collapse despite massive capital expenditures that management promised would turn big profits.
The top 20 percent of companies making the largest capital expenditures saw their stocks decline on average by 7.7 percent in the year following their capital outlays vs. a 1.7 percent gain in the shares of the 20 percent of companies with the least amount of capital spending, the Schwab study found.
“Those making the heaviest investments tend not to get a return on those investments that exceed the costs of capital,” said Greg Forsythe, author of the study and senior vice president at Schwab Equity Ratings. “Investors may perceive these concentrated investments as increased risk.”
Contrast that with the 20 percent of companies with a decrease or small increase in shares outstanding — which could indicate the company undertook a stock buyback, something investors usually welcome. They saw a 4.9 percent increase in their stock price in the year following a low rise in outstanding shares, while the 20 percent of companies with the largest increase in shares outstanding saw an 8.8 percent decline, the study found.
While this study only tracked stock-price returns for a year following companies’ investment decisions, its findings often reflect trends for the longer term, Forsythe said.
Still, there are cases when history doesn’t repeat itself.
Consider Microsoft Corp. The world’s largest software company holds $34.5 billion in cash, according to S&P, even after paying out a one-time $3 dividend in December, which consumed about $32 billion of its cash late last year.
Despite an initial bump up on news of the upcoming dividend, Microsoft shares actually slipped as the mid-November deadline for ownership to be eligible for the payout neared. Since then, the stock is down about 15 percent to around $25 per share, without any specific problem driving it lower.
And investors have repeatedly rewarded Microsoft’s big expenditures on research and development over the years.
It seems that Microsoft investors are willing to give management a little latitude when it comes to cash — a view that shareholders from a broader spectrum of companies don’t necessarily share.