It is well known that companies in Canada are piling up cash.
How that hoard is used remains an unanswered question, but one that has a significant impact on the economy and on markets.
It is easy to accept that small investors may be purchasing real estate in some form or buying shares in newly formed companies, but the larger investors are supposed to be knowledgeable and privy to worthwhile information.
In the latter case, there are strict laws prohibiting the use of inside information, so those with excess cash have to find alternatives.
Frequently, companies use buy-backs to purchase their own company’s shares. If it is inferred that company executives assume their own company’s shares are a good investment, perhaps others should assume so too. Nevertheless, evidence shows that executives are not very good at market timing.
According to Andrew Lapthorne, a strategist at Societe Generale, multinational banking and financial services company, it was disclosed that in January 2008, just as the market entered one of its worst years in history, companies in the Standard and Poor’s 500 (a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S.) were using almost half of their cash flow to buy back their own shares.
Yet two years later, when stocks were approaching a bottom after the precipitous decline, only about 20 per cent of cash flow was used to purchase company shares.
Hence, it appears that executives seem to be influenced more by the market than anything else. A rising share price leads executives to believe the trend will continue, just as most unsophisticated investors conclude.
Buying back company shares pushes up earnings per share as there are fewer outstanding, so a virtuous circle can be anticipated. Regrettably, executives are no better at market timing than the average investor.
This leads back to the problem facing managers with what to do with cash. It has been revealed that companies with a low dividend payout experienced slower growth than companies with higher dividends. According to a study by Robert Arnott and Clifford Asness, those companies were overly optimistic and went on an acquisition spree to prop up share prices (and their own salaries).
Clearly, that was taking excessive risks, motivated in part by selfish goals. A more rational use of common cash would be to shore up company pension funds, as many have huge deficits. Hoping that the market will make up any shortfall is unrealistic in view of the rise already experienced by the market.
Overall, cash reserves of companies should be used rationally, but so far there is no indication that company executives really know how to use properly these reserves.