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Dear Mr. Einhorn: Here's What Apple's Doing With All That Cash

Peter Foley/Bloomberg via Getty Images

David Einhorn is right to be ticked off at Apple's cash horde.

That money really should go to shareholders. But it probably won't unless Apple shareholders embarrass executives into surrendering it.

I explained the reason for Apple's cash last March:

Apple's managers do have a current use of capital, but not one that they are likely to acknowledge publicly. The current use of Apple's capital is to preserve the fortunes of executives, employees and large, undiversified shareholders at the expense of ordinary investors.

We don't need a secret memo or a tape-recorded board conversation to know that this is Apple's preferred current use of capital. It follows simply from the economic logic—and from the contemptuous view that paying capital to shareholders is a form of a "bribe."

The interests of the executives of Apple diverge from those of their shareholders. The executives have investment portfolios that are highly undiversified. Their incomes depend on the success of Apple. Their reputations would be highly damaged by Apple stumbling or needing to raise new capital. In short, their interests are tied up in the fate of one firm—where outside shareholders' interest are not constrained in this way.

This makes the executives risk-adverse when it comes to their own firm. Outside shareholders with diversified portfolios are only concerned about non-diversifiable risks.

This means that executives will prefer strategies that have lower expected returns than riskier ventures. Outside shareholders have the opposite preference.

Apple's current policy of cash hoarding is a classic example of a company preferring safety to shareholder returns. Indeed, even the defenders of Apple's policy talk in these terms. Sam Ro at Business Insider recently argued that Apple shouldn't pay dividends now, because this would make the company less safe. Well, yes. That's the point. Safety is for managers and undiversified investors. The rest of us want Apple to swing for the fences.

Choosing to hoard cash rather than buy back shares or pay dividends is a choice to preserve the fortunes of management at the expense of shareholders. No doubt many long-term Apple shareholders are fine with this, because their returns have been spectacular.

In fact, this might even be the best explanation for why the market allows Apple to avoid dividends. The safety given to executives by hoarding cash can be viewed as a form of non-taxed, undisclosed compensation. It may even be the cheaper alternative, since managers would otherwise demand higher compensation now to compensate for additional risk-taking.

Tech companies are famous—or infamous—for developing innovative compensation schemes that attempt to avoid taxes and skirt disclosure rules. Back-dating stock options was one method. Retaining cash is yet another—although not one that anyone has yet declared illegal.

But Apple shareholders should at least know why Apple executives hoard cash: it is how the executives compensate themselves at the expense of shareholders for running the company.

The Apple cash hoard is what economists call an "agency cost." In other words, Apple executives serving their own interests rather than those of shareholders.

Follow me on Twitter @Carney

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