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Cash: A Strategic Asset or an Expensive Luxury?

Authors: Mansha Lalwani
Published on: January 12, 2025

Introduction:

In recent years, stories of massive cash reserves held by world’s most prominent companies have gained public’s attention. But in midst of these companies treading on this path, a critical question emerges: is Cash truly a strategic asset or has it been reduced to an inefficient outdated relic being eroded by inflation and dragging down returns whilst preventing investors from effectively exploiting the market opportunities? Many things contribute to a company’s cash position like the industry it’s part of, future cash flows, business cycles, capital expenditure plans, upcoming liability payments etc. On surface a higher pile of cash reserve is indicative of strong company performance but if it’s a permanent fixture on the balance sheet than investors need to be wary of the opportunity cost of holding it i.e. what the company could earn by investing that cash in various avenues. But let’s plunge deeper into the rationale behind cash holdings.

US companies with the most Cash in Hand Source: TradingView

  • U.S. firms now hold large amounts of cash, amounting to almost 20% of their total assets. Apple, world’s largest company, is also one of the world’s biggest cash-machine and the owners of its stock have been the biggest beneficiaries of this. The company has returned nearly $732 billion to its investors through share buybacks and dividends since the start of 2013, majority of it arising due to the tax changes introduced in USA in 2017 which was designed to get companies to bring back money parked overseas and reinvest it in the U.S.
  • Firms listed in Japan held ¥506.4 trillion ($4.8 trillion) in cash as of their latest filings (2019), the highest level on record, according to data compiled by Bloomberg. Such big piles of cash lower return on equity and the companies are criticised for not efficiently using their cash but at the same time repurchases of shares by Japan listed firms rose to about $60 billion in 2018, most of which were financed through their own Balance Sheet.
  • Warren Buffett’s Berkshire Hathaway sold a significant portion of its Apple shares in Q2 2024, boosting its cash reserves to a record $277 billion. This isn’t the first time Buffett has opted to hold cash—he did the same during the dot-com bubble and the 2008 financial crisis. Stakeholders have varying views pertaining to the reason behind the same. Some speculated that Buffett could be concerned about the market becoming overheated, raising cash for successors, or is merely not captivated by other investment options. Some are also of the belief that this has to do with the fact that Berkshire is the biggest re-insurer and the piles of cash allows it to charge premiums that others can’t.

Source: Investopedia

 

Negatives:

Examining the standing of large companies on cash as an asset we are presented with contrasting views:

  • Opportunity cost:

Holding more cash than necessary for transactional needs is financially wasteful since it earns very low measurable returns and incurs large opportunity costs implying excess cash should either be invested in positive NPV projects or paid to shareholders in the form of dividends or share repurchases. This necessitates comparing investment yields to cost of capital. If investment yields exceed the cost of capital, projects are value-adding. If not, holding cash or returning it to shareholders is often better. For e.g. – Helios’ fund manager and founder, Samir Arora, estimated that the Oracle of Omaha suffered a loss of $60 billion from not investing in the US markets’ current run and instead holding onto cash as was stated above.

  • Managerial Opportunism (Agency Cost):

Moreover, when there is excess cash beyond the transactional needs then managers may misuse this “free cash flow” to pursue personal gains like empirebuilding (expansion of the company’s size or influence) or to bolster their own job security by avoiding risky investments. Again, this can be remedied through high financial leverage by substituting debt for most of the equity, thereby engendering strong governance.

  • Investor Sentiment:

Investors may interpret large cash holdings as a signal that the company doesn’t have attractive investment opportunities or doesn’t know how to deploy its cash effectively indicating sub-optimal use of capital.

  • Inflation & Interest Rates:

Holding too much cash is risky in an environment of rising inflation. When inflation increases, the real value of cash holdings diminishes over time. But during times of low interest rates, the return on cash held in low-risk assets like treasury bills is very low making cash even less appealing as an asset class, as its returns are not keeping pace with inflation or the return on more productive uses of capital. Many a times to avoid taxes, companies accumulate cash offshore which is evident from the fact that Apple in 2018 it began to repatriate the cash it had long stockpiled overseas following tax reforms at the end of 2017 in the Tax Cuts and Jobs Act.

Positives:

  • Uncertainties:

Firms face external uncertainty in macroeconomic conditions, demand, regulation, legislation, new entrants, energy costs, etc. When faced with uncertainty, such as choosing between two production technologies, a firm can use cash as a buffer to delay decisions until uncertainties are resolved. Meanwhile, it can invest in exploring both options, like building pilot plants, to gather comparative insights and make an informed, strategic move. Moreover, knowledge-based firms typically have high cash burn rates and must initially incur losses to succeed. But little collateral capacity shrinks their ability to borrow thus obligating them to keep cash to manage uncertainty. Research posted in Harvard Business Review states that small firms (lowest 20% by market value), with high current liabilities and firms prone to frequent business shocks (with the highest 20% of idiosyncratic stock-return volatility) have a 10% likelihood of delisting per year, and to bring this likelihood in order to continue to survive in the market they need to have a large reserve of cash.

  • Research & Development:

In fast-moving innovative industries like pharmaceuticals, computers, and consumer electronics cash allows the pursuit of innovations because it protects the organization from the uncertainty of success. They find that R&D-intensive firms can have high returns to holding cash if proper governance mechanisms are present, and this effect is amplified with increasing uncertainty. For e.g.- We read above how apple is one of the biggest cash machines in the world.  Abhinav Davuluri, Morningstar equity and credit strategist, was quoted saying that apple has been increasing R&D pretty significantly, from $8 billion in 2015 to $26 billion in 2022”.

  • High idiosyncratic volatility:

Whether due to market disruptions, supply chain risks, regulatory changes, or other firm-specific factors—creates uncertainty about future cash flows. To mitigate this, many companies like Apple, Delta Airlines, Tesla, ExxonMobil, and Moderna in industries ranging from tech to energy and biotech have accumulated large cash reserves in response to high volatility in their businesses. These reserves help companies tackle periods of uncertainty and tap on future opportunities.

Ray Dalio’s U-turn of his view that “cash is trash”

On a more individualistic level let’s look at the attractiveness and benefits of holding cash (from here on relating to overnight maturities to two- year maturities) by understanding the reasoning Ray Dalio, the billion investor who founded Bridgewater Associates, gave for changing his view on cash from it being “trashy” (as he was quoted saying in 2020) to it being “pretty good” (2022).  This explanation of his revolves around interest rates being trashy (less than 1 percent) back in 2020 to being “pretty good” (around 5 ½ percent) in 2023.

He undertook four parameters to simplify this financial decision:

  • The levels of interest rates relative to prospective inflation rates (i.e., the real interest rate)-

To understand the relationship between interest rates and inflation consider Scenario A, a nominal interest rate of 6% and an inflation rate of 3% yield a real interest rate of 3% (6% – 3%). This positive real rate makes cash appealing, as it preserves and grows purchasing power. In Scenario B, a nominal interest rate of 2% and an inflation rate of 4% result in a negative real interest rate of -2% (2% – 4%). Here, cash loses value over time, making it less attractive. This highlights how positive real rates encourage holding cash, while negative rates push investors toward higher-yielding assets.

  • Whether the Fed (or central bank of the country in question) is likely to tighten or ease rates based on whether inflation and growth are higher (which will make them tighten) or lower (which will lead them to ease) than the Fed wants them to be-

If the Federal Reserve is likely to tighten policy by raising interest rates due to high inflation or rapid economic growth, cash becomes an attractive option. This is because higher interest rates increase the returns on cash-like instruments, such as money market funds, without the risk of price depreciation associated with bonds or equities and vice-versa.

  • The attractiveness of the expected cash return relative to the attractiveness of other investments based on their prospective returns

When deciding the size of cash holding, a business compares the returns on cash with the potential returns of alternative investments. For example, if holding cash in a low-interest account generates 2%, but investing in a growth project could yield 10%, the company would weigh the stability of cash and the market sentiment against the higher risk and reward of the investment. A well-informed decision considers both the safety net cash provides and the opportunity cost of not investing in higher-return options that could stimulate growth.

  • The supply-demand picture for cash and other investment avenues-

To understands this let cash and long-term bonds be the two avenues between which a decision is to be made. Ray Dalio notes that the here supply and demand for bonds will influence the attractiveness of cash. Say for e.g. with high government deficits, the U.S. is expected to issue more Treasury bonds, increasing their supply, while demand could be lower due to concerns over political and economic instability, especially from foreign buyers. This imbalance would mean investors would want a higher yield from bonds taking compensating for its lack in demand, inflation and the real growth rate. In this environment, cash is a safer and more appealing choice than bonds if we keep other variables constant.

Ray Dalio

 

Conclusion:

This brings us to the conclusion that there is no one-size-fits-all formula for determining optimal cash holding. Managers must thus thoroughly understand their business model and its unique characteristics, the risks and opportunities the market poses, and accordingly estimate the optimal cash holdings. While holding cash above the transactional need may not be financially prudent if we take into account the opportunity cost borne, the agency cost and the over bearing effect of inflation but it also places the company in a position to tide through uncertain circumstances, seize opportunities and place themselves at a pedestal in the market. Though one thing remains undebated- cash is a tool, to either boost growth or provide haven midst chao, and not an end in itself. Whether a company equips this tool effectively to thrive in an ever-changing environment or be suffocated and downtrodden by the ever increasing competition is a matter of financial judgement that makes all the difference.

 

References:

  1. Dalio, R. (n.d.). The thinking behind why cash is now good, not trash. LinkedIn. Retrieved from https://www.linkedin.com/pulse/thinking-behind-why-cash-now-good-trash-ray-dalio/
  2. Fortune. (2022, October 4). Bridgewater Associates’ Ray Dalio U-turns on long-held view that ‘cash is trash’. Retrieved from https://fortune.com/2022/10/04/bridgewater-associates-ray-dalio-u-turns-on-long-held-view-that-cash-is-trash/
  3. Bates, T. W., Kahle, K. M., & Stulz, R. M. (2009). Why do U.S. firms hold so much more cash than they used to? The Journal of Finance, 64(5), 1985–2021. Retrieved from https://onlinelibrary.wiley.com/doi/pdf/10.1111/j.1540-6261.2009.01492.x
  4. Investopedia. (n.d.). Cash reserves and their importance in business. Retrieved from https://www.investopedia.com/articles/fundamental/03/062503.asp
  5. Ang, J., & Chen, Y. (n.d.). What factors determine the cash holdings of firms? SMU Lee Kong Chian School of Business Research Collection. Retrieved from https://ink.library.smu.edu.sg/cgi/viewcontent.cgi?referer=&httpsredir=1&article=5395&context=lkcsb_research
  6. Economic Times. (2019, September 3). Japan’s companies are sitting on a record $4.8 trillion cash pile. Retrieved from https://economictimes.indiatimes.com/markets/stocks/news/japans-companies-are-sitting-on-record-4-8-trillion-cash-pile/articleshow/70953546.cms?from=mdr
  7. Harvard Business Review. (2024, February). Why are companies sitting on cash right now? Retrieved from https://hbr.org/2024/02/why-are-companies-sitting-on-cash-right-now
  8. Morningstar. (n.d.). What Apple’s cash problem means for its stock and investors. Retrieved from https://www.morningstar.com/markets/what-apples-cash-problem-means-its-stock-investors
  9. Moneycontrol. (2023). Sitting on cash is tough; it may have cost Warren Buffett a loss of $60 billion: Helios’ Samir Arora writes. Retrieved from https://www.moneycontrol.com/news/business/markets/sitting-on-cash-is-tough-it-may-have-cost-warren-buffett-a-loss-of-60-billion-helios-samir-arora-writes-12827242.html