Are cash rich companies riskier for your portfolio?

Jun 11, 2014

In this issue:
» Is Infosys paralyzed by a cash drag?
» What led to the UPA's downfall?
» Why both Obama and Fed are equally guilty for the current downturn...
» Why you should not ignore gold now...
» ...and more!

 Chart of the day
Amidst poor show in FY14 cash pile of India Inc has ballooned. So much so that the number of companies in the BSE 500 Index with a cash surplus reached a 5 year high at the end of FY14. But this is not because their cash generating capability has improved. In fact, policy paralysis and indecisiveness made India Inc circumspect. As a result, corporates preferred to accumulate cash rather than invest. This has resulted in excess cash pile on their balance sheets.

Let us just have a look at a few top cash surplus companies as at the end of FY14. Quite naturally, the list is dominated by PSU and IT companies. Coal India tops the list. It is followed by Infosys which has always been on investor radar for its conservative cash management practices.

Should these companies return excess cash to investors?

So, what should India Inc do with this excess cash?

Invest this cash and generate a return higher than the cost of capital or give it back to shareholders, isn't it? However, we have hardly seen a liberal dividend payout by any company which stashes cash in excess of its working capital requirements.

There is a general tendency amongst corporates to amass cash for a variety of reasons. When asked why they generally stereotype that excess cash will be invested skilfully in the business and they are looking out for a suitable opportunity. Inorganic expansion is another card which they have on their sleeve.

We agree that conserving cash is the right approach to fund future capex plans. But it also tests management's capability to deploy this cash in a most profitable manner. For instance, there have been number of instances in the past where cash rich companies have indulged in wasteful expenditures or mindless acquisitions.

Hence, investors get into a dilemma in knowing whether cash hoard is actually a risk or not. And the best way to know the same is by gauging management integrity. Take the case of Infosys for example. While it has been subject to deep scrutiny for holding excess cash, management integrity is undoubtedly high. As such, the probability of this cash being utilized in wasteful expenditures is low. However, strong management quality does not absolve the company to hoard cash at its will. After all, this cash is best utilized by investing in business. One must remember that idle cash on balance sheet earns risk free return. However, cash invested in the business has a potential to earn the RoE thereby increasing shareholder wealth.

It is natural for investors to assume that cash rich companies are great value buys. Moreover at a time when economic revival is on the cards, companies with a cash war chest are likely to be the ones to invest and grow aggressively. So investors may even be willing to pay a premium to buy such stocks. However, it is pertinent to scrutinize the capital allocation skills of the management of these companies before doing so. According to us, at a time when sentiments are buoyant, cash rich companies are subject to maximum risk of poor capital allocation. Particularly if the management has a track record of being callous during periods of high growth.

The bottomline is that any company with excess cash must either return it to shareholders in the form of dividends or buybacks. Both options are detrimental to existing shareholders. Cash rich companies without enough track record of enhancing shareholder wealth can be a bigger dampener to investor portfolio.

During periods of high growth, are cash rich companies the safest ones to invest in? Let us know in the Equitymaster Club or share your comments below.

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When discussing companies with huge cash piles, IT bellwether Infosys just cannot be ignored. As seen from the chart above, the Rs 260 bn cash pile is a massive chunk, which stands at nearly half of the company's revenues. In fact, Infosys has been maintaining such high cash levels for a while now. When compared to its market capitalisation, the same stands at about 14% currently. It may be noted that major shareholders in the company had pressurized the management to utilize such funds in a much more efficient manner. However, Infosys' management did not give in. As such, what the company should do with its massive cash reserve is a debate that has been ongoing for a while and seems like it will continue in the future as well. While it has not gone in aggressively for any acquisitions, it has also stayed away from investor friendly measures such as buybacks too. However, it did up its payout ratio in recent times. All said and done, we believe it would be better for investors if the company had a clear 'cash utilisation' policy in place; something that its peers like TCS and Tech Mahindra do have.

They called themselves 'the dream team'. Armed with a bevy of economists and technocrats, the UPA II found itself loaded with technical solutions to practical problems. However, the policy makers failed to realize that they need to test the solutions with ground realities. As per an editorial in the Hindu Businessline, the fact that the UPA government had too many 'experts' led to its downfall. We partially agree to this. The keenness to use tried and tested methods to solve problems may have been the primary cause of the government's failure. But one cannot deny that apart from lax decision making, poor execution of decisions was also a big reason for the poor show. In addition, corruption ate away into whatever little progress the economy could have benefitted from over the past 10 years. A company which has a very qualified management cannot succeed in creating shareholder wealth without good execution. Similarly, even the government cannot take credit from its readymade solutions. So yes, the new government will certainly have to be more innovative and realistic in decision making. However, the buck cannot stop there! Good execution with minimal wastage and transparent practices will go a long way in making the current government as successful as it wants to be. We keep our fingers crossed.

The US economy has pretty much been in the doldrums since the 2008 global financial crisis. Since then the US Fed went on a massive quantitative easing (QE) program in the hopes that more money in the hands of the people would induce them to spend. But that hardly happened. As job prospects began to look bleak and unemployment rose, the average American was wary of loosening his purse string.

The Fed and the Obama administration for that matter have been criticized for their loose policies. And the latest to join the bandwagon is Steve Forbes, editor-in-chief of Forbes Media. He is of the view that both the Fed and the Obama government are to be blamed for the lack of recovery in the US economy. He believes that both the parties have no clue about what they are doing. All that QE has done is to inflate the Fed's balance sheet to US$ 4.3 trillion. Basically QE as well as a low interest policy have made it easy for the government and big corporates to borrow but have given savers a raw deal. The other parties at the receiving end have been small and medium sized companies, which are one of the biggest job creators. Because the Fed pressurized banks to tighten up lending norms, most of these companies were deprived of funds required to grow their businesses. All in all, these Fed policies have only distorted financial markets and how the US will be able to come out of this dilemma is anybody's guess. Indeed, it will hardly be surprising if this entire problem will lead to Obama's downfall.

The fall of the indecisive UPA and the rise of the pro-reformist NDA have renewed revival hopes for the Indian economy and the markets alike. That the change in guards at the Centre has set the equity markets roaring new highs, is no news anymore. Notably the retail investors have been dancing to the tune of the brokerages with the latter predicting optimistic Sensex levels. Very recently we highlighted this euphoria in our 5 minute Wrapup.

In a quest to make good money and laughing all the way to the bank, investors have increased their risk appetite too. But this has deterred the demand for an asset that is considered a must-have in one's investment portfolio. Yes, we are talking about the yellow metal! The demand for gold in India has been sliding since a year now. A lucrative investment avenue, as it turned out to be especially post global financial crisis, has lost its shine to equities. But there is more to why gold is losing sheen. The domestic gold prices are on a correction mode. This coupled with strong momentum in the Indian equity markets have dampened gold demand. But this is a temporary phenomenon we reckon. For, in a scenario of inflation and negative real interest rates, gold proves to be a fine hedging instrument. Not just that! Weak global cues and geo-political risks are expected to lead to massive distortion in asset prices and financial markets. And with this magnitude of uncertainty prevailing around, gold as an asset class has to emerge even stronger.

The Indian stock markets, after opening flat, were trading weak. At the time of writing, the benchmark BSE-Sensex was down by 179 points (down 0.7 %). Barring IT and pharma, all sectoral indices were trading in the red. Realty and powerstocks were the biggest losers on the bourses today. Asian stock markets were trading mixed with Japan and China trading positive. European markets have opened the day on a weak note.

 Today's investing mantra
A public-opinion poll is no substitute for thought - Warren Buffett

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