In a recent post, The Buyback Paradox, we suggested that cash on corporate balance sheets was one of many Bullish Mirages. We stated, “Companies do hold piles of cash that could potentially be used to buy back shares. But why do they have this cash? I would submit that there are a few reasons, none of which have bullish implications. One, low interest rates encourage managements to issue debt – in some cases a lot of debt. Note that these new claims on the business are higher in the capital structure than equity, so stockholders should not be particularly excited about high cash balances which result from selling debt. Two, the regulatory and political environment is not exactly pro-business in case you haven’t noticed today. Companies are holding cash because it is very difficult to make long term investments when the rules of the game and their tax consequences are impossible to predict even one week forward. Cash on the sidelines is a sign of uncertainty, and frankly, I don’t see anything on the horizon that will change this.”
It is nice to know that every investment manager out there is wearing their “bubble-vision goggles” today. In his latest weekly, John Hussman provides some hard facts to illustrate our point. The full commentary is worth a read, but at a minimum, read the section titled, Are Corporate Balance Sheets Really the Strongest in History? A few excerpts are below, for those not tempted by links within blogs:
“As the following chart shows (based on Federal Reserve Flow of Funds data), the debt burden of U.S. corporations is near all-time highs, having retreated only modestly since 2009. Debt burdens are elevated regardless of whether they are measured against total assets or net worth. Certainly, corporations are presently benefiting from very low interest rates on corporate debt, which substantially reduces the servicing burden of these obligations. But the combination of high debt levels and low servicing burdens does create a potential risk to corporate health in the event that yields rise in future years. Overall, the picture is fairly stable at present thanks to low yields and high levels of cash-equivalents, but it is important for investors to keep in mind that cash can burn fairly quickly during economic downturns, and debt is not spread evenly across corporations.
“The bottom line is that at an aggregate level, corporate balance sheets look reasonable, but are certainly not “stronger than they have ever been in history.” Cash levels are elevated, but this is at best a second-order factor (with excess cash representing only a few percent of total assets), while debt remains near record levels relative to total assets and net worth. In any event, balance sheet risks should be evaluated on a business-by-business level, rather than accepting the blanket notion that cash levels are so high that nobody needs to worry about corporate credit risk.”
“In going through the Flow of Funds data this week, I thought a few other features of the data were interesting. First, was the profound decline in tangible assets as a percentage of total corporate assets since 1980. This decline goes hand-in-hand with an increase in financial assets held by non-financial companies. At present, more than half of the total assets held by non-financial companies in the U.S. represent financial assets such as debt securities and equities. This is striking, in that we presently have a menu of prospective returns on financial assets that is among the most dismal in history. While the move toward zero interest rates has certainly been excellent for bonds when we look in the rear-view mirror, the fact that prospective rates of return are now so low suggests that a large portion of corporate assets are unlikely to achieve very much in the way of future returns, barring a decline in those asset prices. Something to think about.”