Authored by Jason Shoup & Sonam Pokwal of Citi,
The Cash Myth
When it comes to popular finance myths, cash hoarding by corporates may be one of the most perpetuated. It's not that the data is wrong; US companies are holding more cash on their balance sheets than at any time in the past, as a report by Moody's this week notes. What's misguided is the narrative, in Citi's view, in particular among equity investors. What they most take issue with is the implication that corporates have lots of cash to return to shareholders. Indeed, there's plenty of data to the contrary that challenges the prevailing notion that corporates are the picture of good health.
For a start, dig just a little deeper into the specific companies contributing to the rise in corporate cash balances and it's evident that there's more to the story than meets the eye. For instance, using the Russell 3000 as a universe, we see that the top 20 corporates with the most cash on their balance sheets at the end of 2012 hold over $650 billion - almost 40% of all the cash and marketable securities of Russell 3000 companies. And among those top 20 companies, cash balances have grown between 15-20% for the last year, while the rest of the companies have seen far lower growth in the 0-5% range.
What's more, as the recently released Flow of Funds data makes clear, cash growth has lagged behind EBITDA growth and, more importantly, the accumulation of debt. So while corporates do indeed have more cash on their balance sheets than at any time in the past, they also have more debt.
As always, the nominal numbers matter far less than the relative ratios. Take cash as a percentage of total debt. That ratio is rapidly plunging and, at least to our minds, implies that further shareholder friendly behavior will likely be funded with more borrowing at the margin (see figure).
Similarly, we'd argue that corporate liquidity isn't nearly as great as many pundits have advertised. The idea that investment grade corporations have taken advantage of low rates to extend their maturities isn't quite accurate. While it's true that many corporates have meaningfully reduced their dependence on the commercial paper market in the wake of the credit crisis, companies as a whole have made remarkably little effort to issue a greater percentage of their fixed rate debt in longer maturities.
We think there are two reasons for this behavior. Either the demand simply isn't there for a significant step up in long duration supply and issuers are being told as much from the folks in capital markets or, more likely in our view, the attraction of the steep yield curve is just too great. Indeed, CFOs have been able to accomplish a remarkable sleight of hand in being able to add debt to the balance sheet without incurring a corresponding rise in their interest expense these past few years, but that illusion would be ruined if all the debt had instead come at the 30yr point.
Many investors argue, of course, that releveraging of this sort is an intended consequence of QE and, provided the companies use the funds in a way that contributes to growing the economy, the costs are likely to be minimal. After all, it's not as if interest coverage ratios are suffering as a result.
Yet we're not so sure that the increase in debt (and leverage) and decrease in liquidity will go indefinitely unpunished. For a start, the surge in shareholder activism this year has made it harder for risk-adverse CFOs to continue with a measured approach to levering the balance sheet—a fact that the agencies are increasingly taking note of. Indeed, the days when leveraging activity wasn't done at the expense of bond ratings are quickly becoming a thing of the past.
But more broadly speaking, the really troubling aspect to the deterioration in corporate fundamentals is that valuations do not appear to reflect reality any more. While the disconnect between the two is not on the level of Europe (where most EU economies are in recession, corporate fundamentals are in bad shape, and yet credit spreads haven't been tighter in six years), we believe that in a similar way US investors have been forced to ignore the factors that have historically driven credit spreads.
In that respect, the Fed deserves quite a bit of credit in cajoling investors into abandoning credit analysis. And there's no reason why easy money can't continue to exert its influence on valuations for an extended period of time or why the disconnect can't grow measurably larger.
But even if spreads are more likely than not to end the year tighter than current levels, that doesn't mean chasing every last bit of tightening is a prudent strategy from a risk perspective. For as the disconnect between fundamentals and valuations grows, so does our unease that IG spreads could snap back to reality given a nasty enough catalyst. In recent days, the goings on in Cyprus and Italy have at times looked like they could potentially fit that bill, even if the market has eventually ended up dismissing those initial concerns.
So as the tail risks simultaneously grow in probability and severity, we can’t help but get more cautious even though it’s extremely difficult to predict the timing of any potential sell off. Frankly, the asymmetry in credit is such that it’s hard to continue to favor an overweight unless the probability of a correction is incredibly low.