Massive Cash Reserves are a Sign of a Broken Economy

Who’s not investing?

A number of tech companies have significant cash reserves compared to their yearly costs and revenue. Microsoft, Apple, and Google all fall into this category with billions of dollars sitting in money markets or other liquid assets^. These highly profitable businesses are building huge stockpiles of cash instead of reinvesting it in their own business, purchasing other companies (M&A), or distributing it to shareholders through dividends. Let’s look at the motivations behind high profit companies sitting on mountains of cash.

There’s nothing good to buy

The most worrisome rationale for businesses hoarding cash is that there aren’t any good strategic purchases or internal investments. Instead of distributing the cash to shareholders these companies use large cash reserves as a form of risk management. In highly unpredictable markets, like today’s, when a company can’t make a decision for how to utilize capital, it defers to cash banking.

The cash theory is implemented by voting shareholders* to retain optimal future purchasing flexibility. This is done to snatch any rapid growth companies that could be potential market disruptors, competitors, or that compliment current product features fluidly. Because the company’s future is highly unpredictable, the corporation leverages cash as a way to hedge their bets.

Why stalled investment decisions hurt the economy

Consider a hypothetical example of a small village living in an arid region with only a handful of water wells.

The wells have all been privately discovered and the owners charge a tax on everyone who uses the water. The well owners become quite profitable because everyone needs water, and the owners fully optimize the distribution of water with brilliant aquifers maximizing their profit. The well owners have all grown wealthy and run out of investments for better water distribution leading to ever-growing reserves of gold and gems.

Word comes to town of mysterious shamans, who dance and foretell the coming of great rains. After one rain maker visits the village, a series of storms comes close enough to be seen. A heavy smell of rain is in the air, but none falls in the village. The wealthy well owners all grow deeply concerned because with rains comes an immediate drop in water prices, and an end to their businesses.

The well owners fiercely compete over hiring any rain makers they can find not to dance near their well. Some rain makers are good, but most have terrible track records. A little rain does fall, dropping water prices temporarily. The price of rain makers rises greatly and many come to the village promising not to dance for money and once paid, quickly depart.

Then more interesting news comes to the village. A neighboring town has developed a massive dam in a far off river to irrigate all their crops. The well owners realize that connecting these towns and having access to a river would destroy the water market. They quite rationally invest heavily in constructing a great wall between their village and the one with irrigation protecting the price of water.

You’ve got some ‘splaining to do Lucy

The well owners represent current high profit corporations with massive cash reserves. They do their best to maintain the value of their business, in the face of changing times. The rain makers are merely charlatans, who pretend to provide market value in hopes of getting purchased by paranoid and enormously wealthy corporations. The neighboring village has dam builders which symbolize startups which are actively developing new markets.

It’s not hard to see why the village’s local economy was broken. The most wealthy businesses were capable of sustaining themselves much longer than they should have. Long term optimization of a single form of business can seriously harm a local economy. Even worse, when resources are extracted from an economy and then sit idle, to wither under inflationary forces.

I’m not saying businesses or individuals can’t save mountains of cash. I’m saying we should look really hard at why they’re choosing to do so, and fix it.

Notes:
^= I would have added Intel but they purchased Mcafee for 7 billion dollars.

*= common stock shareholders voting rights are largely marginalized in modern corporate structures

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  • http://codingrelic.geekhold.com DGentry

    :s/Symantec/McAfee/

  • http://www.victusspiritus.com/ Mark Essel

    I guess talking the intel guys into picking up Symantec would be a tougher fix than my edit.

    Fixed, I’m in your debt as usual :)

  • http://codingrelic.geekhold.com DGentry

    I still don’t understand the basis of that acquisition. I guess it represents incremental business for Intel, in a market which is closely aligned with the markets they are already in, but $7 billion is a lot.

    I read one commentary that Intel has seen relatively few security products make use of its vPro chip features, and perhaps purchasing McAfee is a way to nudge the security market to embrace technologies which will require new hardware… but that still seems a pretty weak basis for $7 billion.

  • http://www.victusspiritus.com/ Mark Essel

    I had read the theory behind the acquisition was related to security for the Internet of things. The growing number of automated devices and sensors will require beefy security.

    You’re much more familiar with the hardware side of things, what’s your take on baked in hardware encryption, and message signing.

  • http://steamcatapult.com/ Dave Pinsen

    I met with a broker in Silicon Valley a couple of weeks ago who said that most of his clients and colleagues were surprised by that acquisition as well. The idea that we both thought of was that maybe Intel is trying to transition from manufacturing to services, sort of like IBM did years ago.

  • http://blog.dhananjaynene.com Dhananjay Nene

    Any cash reserves, unless held in physical cash, find themselves back into the economy via the banks or the sellers of the investment vehicles these resources get deployed into. So from a macro economic perspective, the money finds its way into the more investible options. Even if a company invests in short term paper, when such short term paper is combined over a large number of companies, a fair amount of it could instead find its way either into longer term debt or even into equity investments by the banks or the Financial Institutions. Broken economy ? Not at least on the count of the fact that companies have large cash reserves.

    The other point is that companies sit on cash reserves. But lets take Oracle as an example. Buy spending their cash and grabbing control of Java and MySQL, have they helped improve the economy ? I suspect not. The point is that each investment decision needs to be rated on its own merit and there is no way one can reasonably assign judgements to broader policies of conserving or spending cash.

    Now lets assume that the company returns the cash to its shareholders. Whats the likelihood of such cash getting deployed more efficiently than how the bank or financial institutions who hold the large cash reserves on the behalf of the corporate do so ? It just boils down to the money management skills of these respective managers, and there’s little reason to believe that one set of managers will always be more efficient than the other.

    And yes large cash reserves will help a badly run company survive longer, just as thin reserves may force an otherwise well run company downhill in an cyclical downturn. So that can cut both ways too.

    I am not contesting the specific interaction that you’ve drawn between the well owners, the rain makers and the irrigation dams. Its likely though not the only way things can play out. I just fail to see where large cash reserves lead to a broken economy as you so boldly state in your title.

  • http://www.victusspiritus.com/ Mark Essel

    Thank you Dhananjay, it is clear to me you are much more familiar with finance than myself.

    The guys at lunch took a similar position to yourself, stating that banked or money market capital is redeployed instantly. My response was a question which is a derivative of the post title:
    “What quality and types of investments are available to short term returns vs longer term investments?”

    Any aggregators of wealth (banks/money markets) redeploy money, but they must do so with a very strict set of principles that primarily maintain current wealth (ultra low risk investments).

  • http://blog.dhananjaynene.com Dhananjay Nene

    The manager of corporate finance will be driven by the following aspects.

    a. What is the best return he can make by ploughing the money into business vs. the return that financial institutions will offer him. If he is unable to find a way to invest the money in his own business that will generate good returns, he will turn over the money to his banks who “generally” are expected to make much better returns and pass on a part of it back to him as a return.

    b. If he is unable to invest into business with a high rate of return, he can also choose to return the money back to his investors as dividend. This is generally not always the preferred option for very high growth sectors such as those that Microsoft, Google and Apple operate in. Thats because the fortunes in this industries can swing far more wildly and more quickly than in good old stable industries such as say mining or manufacturing. That pushes these companies to build a bigger war chest. Also given the nature of the business sometimes some acquisitions can prove to be very critical (eg. Intuit acquiring mint.com). Thus all the more reason to build a war chest to be able to do the right acquisition when the time comes.

    With regards to your final comment on how banks should redeploy money, it is my empirical belief that for the FIs (financial institutions), the opportunities to invest in ultra low risk investments are probably far exceeded by those of higher risk. So while some venture funds might attract and then redeploy high risk capital, there is often a scenario where low risk capital is attracted and then has to be redeployed into slightly higher risk investments. I suspect thats the nature of the business. The insurance industry works that way as well. So banks actually strive to offer low risks to their investors by investing parts of their funds into high risk high return schemes. Doesn’t always work – but I don’t know if there is any other way.

    PS: My awareness of finance is far more theoretical than you might imagine. My day job is writing code :)

  • Barbon

    damn = is a curse word.

    The neighboring town most like built a massive DAM.

  • http://www.victusspiritus.com/ Mark Essel

    Corrected the misspelling, thanks for the heads up.