Sunday, 5 February 2012

Companies amassing huge cash reserves should use these intelligently

Companies with large cash reserves can use these for the direct benefit of their shareholders by giving dividends or can deploy these to grow their businesses in the future.

Benjamin Graham was critical of amassing huge cash reserves within a business unless the company had a genuine future use for the funds.  

A certain calculable amount of reserves are necessary to:

  • finance growth, 
  • guard against bad luck or down cycles, 
  • cover the settlement of a lawsuit, or 
  • eventually replace some important asset. 
Graham argued, there is a limit to that need.  

The purpose of business is to earn profits for its owners.  Owners are entitled to access to profits.  

If earnings are retained, Graham persisted in his argument, they had better be used intelligently.

Graham contended that when corporate management is stingy with dividends or withholds them altogether, it is sometimes for self-serving reasons.  It is easier to keep the cash on hand to bail management out of bad times or bad decisions.  Sometimes the dividend policy is simply a reflection of the tax status of management and large investors - they don't want the addition to their current taxable income.  Consequently, other investors get no income.

Probably the greatest retainer of earnings of all time is Berkshire Hathaway, which keeps and reinvests all its earnings.  Berkshire's 23% return on shareholder equity is almost double that of American industry, and Buffett says he will continue to hoard earnings so as long as a dollar of retained earnings translates to no less than a dollar of increased shareholder value.  In his case, investors are inclined to let him have his way.

It is not uncommon to encounter a company with huge cash reserves in their businesses earning only  fixed deposit interest rates for many years.  Shareholders should play their active role as business owners through raising the relevant questions to the management in the annual general meeting, to use these cash reserves intelligently.

In recent years, strong cash reserves have provoked takeover bids from corporate raiders.  Are they liberators of cash for shareholders or are they destroyers of business, interested only in their own personal enrichment?  These raiders often planned to use cash reserves to help finance their purchase, a tactic that often sucks the strength from a company.  The management may defend the cash reserve was needed for various reasons, for example, the company needed the cash to cover the next down cycle of the manufacturing business.  Corporate raiders love to find and are attracted to a company with huge cash reserves.

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