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Too much cash on books should be a red flag for investors

  • Overflowing corporate coffers are a good indicator of successful business practices.
  • Lots of cash on hand does provide a safety net, of sorts, for corporate shareholders.
  • But too much excess cash, not reinvested in the business, can ultimately crimp shareholders' return on equity.

We increasingly hear about companies with mountains of cash on their books. While having plenty of cash to take care of anticipated expenses, ongoing liabilities and emergencies is essential, there's a question about whether having more than this — known as excess cash — is a good thing.

The subject became exceptionally topical with all the media attention about Apple's stockpile of cash, which has grown to about $250 billion.

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Companies that make so much money that they're rich with cash have something on the ball — because they made it. And lots of cash on hand naturally provides a safety net of sorts for shareholders. But generally, a great deal of excess cash can crimp shareholders' return on equity — a measure of what the company gives shareholders back on the money they've invested.

Companies that continue to accumulate excess cash can be viewed as lacking ideas for investment in the enterprise. Isn't there something these companies can do with the money to boost revenues, profits and earnings for shareholders?

Research shows that having too much cash on hand is almost as bad as having too little when it comes to auguring future returns to shareholders. Studying major companies with large amounts of cash between 2001 and 2016, Revelation Investment Research found that this foreshadowed poor returns the following year. The more cash, the lower the returns — into negative territory.

The returns of the biggest cash hoarders were almost as poor as those of companies studied that had the least cash on hand, whose poor performance was understandable because they likely lacked enough cash to take advantage of opportunities. The researchers suggested that the market punished the underperformers for "poor capital allocation or utilization." Consistent with the lesson of Goldilocks and the Three Bears, companies with relatively moderate amounts of cash registered the best market performance.

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Another study, conducted at the University of Toronto, found that companies with high levels of excess cash have tended to deliver lower market returns during market downturns. And even though the higher-cash companies invested more in their future, they didn't experience relatively high future profitability. Based on this finding, could it be that having too much cash lying around leads to less judicious decisions about how to invest in the company?

Further, a common trap for companies that have too much cash burning holes in their pockets may be more inclined to engage in share buybacks — a practice that can raise questions for shareholders.

Romantic poet William Blake wrote in the late 18th century that "one law for the lion and the ox is oppression." Applying Blake's logic, judging different kinds of cash-rich companies the same way probably doesn't make sense.

Tech companies tend to accumulate more cash because, as producers of high-margin products based on intellectual property, they don't have the same materials costs as non-tech manufacturers.

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As a result, they accumulate more cash. Of the 10 companies, global and domestic, that have had the most cash in recent months, four are tech companies: Microsoft, Cisco Systems, Apple and Intel. Though two of the other top 10 — Amgen and Johnson & Johnson — were pharma or pharma-related companies, which tend to accumulate more cash for the same reasons as tech companies. This list also includes General Electric, Toyota, General Motors and French oil and gas company Total. The accumulation of cash by such capital-intensive, heavy manufacturing companies may not be a good thing, so investors should take a close look at such companies to learn why they aren't finding places to reinvest their abundant cash in their enterprises.

Not that intellectual-property-intensive companies automatically get a pass on their penchant for hording dead presidents. Because some companies have so much excess cash, they — like a rich individual — may buy things just because they can, without enough discretion and due diligence as to whether they should. This can lead to acquisitions or the founding of new companies that may not be profitable themselves and thus can drain value or capital from the existing enterprise — a concern of shareholders.

"Investors should regard high levels of excess cash as a definite red flag — one that should prompt them to find out why this money hasn't been reinvested."

Too much cash on hand has played a major role in corporate acquisitions that resulted in losses so high that they're now regarded as classic blunders. Among these are AOL's purchase of Time Warner in 2000, Sprint's purchase of Nextel in 2005, Microsoft's purchase of aQuantive in 2012 and Hewlett-Packard's purchase of Autonomy the same year.

Though some highly profitable companies have excess cash, this doesn't stop them from going into debt. Last summer a range of tech companies, including Apple and Microsoft, sold more bonds than they did in all of 2015. The justification for this move, of course, is low interest rates, but when high-cash companies go after cheap money, it merely sustains abundant cash and the potential for the problems it can bring.

Investors should regard high levels of excess cash as a definite red flag — one that should prompt them to find out why this money hasn't been reinvested.

By David Gilreath partner/founder, Sheaff Brock Investment Advisors

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