US Corporations Hoarding Trillions, Part One

From www.mcgeepost.com .Copyright © 2012 Michael H. McGee. All rights reserved. Please feel free to share or re-post all or part non-commercially, hopefully with attribution.

There is significant harm being done to the US economy by corporations who are holding almost two trillion dollars in excess cash assets on their balance sheets. I’m calling the cause of this harm “The Swedish Disease.” This naming of the harm will become clear as you read.

The exemplar company will be Cisco Systems, Inc., which currently holds about $48 billion in excess cash assets on its balance sheet. More than eighty percent of Cisco’s excess cash assets are being held outside the United States. Holding their assets outside the US is a small and rather shabby problem. Holding these assets at all is the big problem.

The value of shares of Cisco stock has remained relatively flat for more than two years after an earlier significant drop, even though the company holds this enormous treasure trove in reserve. The gigantic cash reserve is not enhancing the company’s value, nor is it making any meaningful contribution to their bottom line.

The problem is that Cisco has in effect become two companies. The market cap of the whole enterprise is right at $100 billion. The value of the portion of their company which is held in cash is $48 billion. So, half of the entire enterprise is a low-yield financial management company, run by faceless administrators who just move money around. Only fifty per cent of the company “sticks to the knitting” by creating and manufacturing the fabulous new technological advances the company is known for.

I don’t want to give the impression I’m only picking on Cisco Systems. Ford Motor Company’s 2011 annual report, reading it conservatively, shows a cash reserve of about $18 billion. Their market cap as of today is about $38 billion. Their stock has moved little in the past two years. So, they’re in almost the same situation as Cisco, in transforming half their operation into a passive cash-management company, and contributing to the Swedish Disease.

So the apparent glittering wonder of having so much cash on hand dissolves into a non-core enterprise which produces income at about the T-bill level, which is not really enough income to contribute to the overall profit of the enterprise. Thus the investment administration half of the company is really a serious detriment to the company.

It is much the same with all the other US corporations who make up the list of those holding in aggregate almost two trillion dollars in cash reserves. Cisco’s cash holdings are a detriment to and a drag on the growth and profitability of their company. The aggregate excess cash reserves held by many corporations constitute a detriment to and a drag upon the whole economy of the United States. These reserves are one of several reasons our much-heralded economic recovery has been so slow to appear and grow.

I’m naming this overall almost two trillion dollar macro-economic drag on the economy the “Swedish Disease.” The naming convention in the field of economics comes from the use of the “Dutch Disease” to describe Holland in the 1970′s. This now generic term describes a rise in the exchange rate value of the currency of a country which has one overwhelmingly dominant export. The rise means that any other exports of the country are too expensive, and therefore will not sell on the world market. The only thing the two phenomena have in common, though, is that both are “diseases.”

The phenomenon is fully described in the article “Corporate Control and Value Destruction,” by Lars Scholdstrom and Karl-Johan Wattsgard, Stockholm School of Economics, 2006, published on the site http://www.essays.se/about/separation+of+control+rights+and+cash+flow+rights/ . These two guys did the extremely difficult theoretical work. I’m giving their work a name, and describing the macro application of their thesis to the current situation in the United States.

These most perceptive Swedish economists, Scholdstrom and Wattsgard, describe a situation where the entire economy of Sweden is being dragged down by the widespread disconnection between the ownership rights and the control rights of corporations. Those who have the control rights (usually in Sweden through stock with restricted voting rights) often do not act in the best interests of the common stockholders, who have the majority ownership of the enterprise.

As a result, the commonly traded shares of stock in the corporation remain stagnant in value relative to the book value of the company. Since many different Swedish corporations follow the same practice, the whole economy grows at a much slower rate than the level of economic activity would predict. And according to Scholdstrom and Wattsgard, the situation has persisted in Sweden for many years and will continue to persist into the foreseeable future.

The Swedish economists also demonstrate that the excess of control rights in the hands of a minority of owners leads to the theft of corporate assets. “Depending on institutional framework, the controlling shareholders might be able to extract this value at the expense of the minorities. The value extraction can be performed through a variety of methods such as tunneling to other companies within their control, extensive compensation packages to shareholder directors and management etc., pecuniary private benefits of control, all basically amounting to theft.”

In the case of American corporations with cash reserves greatly in excess of the normal amounts needed for liquidity, the primary problem is that the control of these excess funds is not in the hands of either the shareholders or the board. The control of this excess trillion-plus dollars of funds is in the hands of middle-level investment managers, who work on a completely parallel and unrelated track from the “owners” (the stockholders and the board).

Cisco’s in-house investment managers really have no incentive to maximize the returns on the investment of the billions entrusted to them by the corporations with excess liquidity. Much of the money will be outsourced to managed funds which are entirely beyond the control of the owners, i.e., stockholders and board.

Only the increase or decrease in the total dollar amount of the invested cash tranche will appear on the company’s balance sheet. These days the best-case “profits,” generated by conservative investment managers, will be from cautiously invested and predominately safe government and corporate bonds, and there will still be losses when the funds are spread widely. In any event, the increases are a paltry contribution to Cisco’s overall profitability, and such increases may not be booked at all in a given year if the dividends are paid only at maturity. About half of Cisco’s total market value is tied up in excess assets handled by middle-managers, where the upside potential is probably no greater than 3-4 per cent income maximum.

Thus in order to show a decent profit the operating portion of the company, as opposed to the “dead cash” portion of the company, has to perform at roughly twice the level as one might expect of a well-run corporation. Thus even in the best case the corporate ship is being anchored to the ocean floor by a giant non-core, non-productive, and largely non-performing fifty per cent of the enterprise.

Is it any wonder that the stock of Cisco Systems is muddling along without a prayer for improvement? Is it any wonder that with all those corporations holding almost two trillion dollars in the same manner as Cisco, the United States economy is muddling along without a prayer for immediate improvement?

Now let’s look at the worst-case scenarios of the economic pandemic. Significant harm is being done to the US economy by corporations who are holding almost two trillion dollars in unused assets on their balance sheets.

Tunneling is a European concept, defined as the transfer of assets and profits out of firms for the benefit of their controlling shareholders. One reason this concept is not really present in the United States is that it is very likely that tunneling will be viewed as a violation of the anti-trust laws.

And if we make the probably slim assumption that the trillion dollars in excess cash is being actively managed by the stockholders through their board of directors, then it is likely that these active managers will run into legal problems. For example, one corporation may use its excess cash to tunnel into an interlocking ownership of a competitor, or into a vertically integrated part of the company’s supply or distribution chain. Anti-trust violations are a really big deal.

A look at Cisco Systems’ balance sheet for the end of fiscal year 2011 shows that it’s unlikely this particular company is tunneling. Of the about $48 billion in excess cash, only $1.4 billion is invested in publicly traded securities. The rest is in cash equivalents and in fixed income securities, which means anti-trust manipulations are unlikely. What is almost certain, though, is that Cisco fits the profile of a company with middle-managers passively sitting on billions, without any owner, i.e., stockholder, control, or concern for the profitability of the company as a whole.

To recapitulate in the context of American corporations, the primary Swedish Disease is that the control of these excess funds is not in the hands of either the stockholders or the board. The control of these excess two trillion dollars of funds is in the hands of middle-level investment managers, who work on a completely parallel and unrelated track from the “owners” (i.e., the stockholders and the board), moving around passive (here meaning not used for the production of goods or services) assets.

So what can go wrong? Many passive asset people will find ways to tunnel by investing corporate cash in money-management accounts or companies set up by themselves for their own benefit. The Swedish authors in their study refer to “loss-leading funds.” This is charitable of them. Some mid-level money managers will blatantly invest in their own money-management accounts, and then write off all the assets as a loss. On a $43 billion balance sheet, $10 million, or even $100 million, may pass unnoticed as a rounding error.

This outright theft, a tiny fragment to the company, will be enough to set up the grey faceless middle-manager for life. Remember, the people who manage these excess funds for the company don’t have to be licensed brokers. They are not in any way regulated in their activities beyond the distant oversight of their own boards.

Let me be clear, though. I’m not accusing anyone of theft.

I don’t even want to think about what will happen if any such thefts are taking place at the top level of the company. There’s not much limit to how much the directors and top people could tunnel into their own accounts, using their own authority to cover up the transactions. So I won’t even mention that possibility.

In conclusion, we have in the United States at the present time many corporations similar to Cisco Systems. At least half of Cisco’s market cap is devoted to non-performing assets sitting on the sidelines. The other half of the company has to carry the laboring oar of developing and producing the products and services which make the company what it is.

No jobs are being created, and no new product research and development is being done, by the passive half of the company. Nothing is happening which can increase the value of the stock of the company, or increase the vitality of our economy.

What can Cisco do with their massive stash of cash? First of all, they can repatriate it from overseas and pay to the government the taxes which are due. After all, the assets are probably already invested in US securities, in the form of American corporate and government bonds purchased on the Singapore or Hong Kong exchanges. So the location of the transactions is a distinction without a difference.

Cisco could open more huge new research laboratories and factories in the United States, designed to create and produce the most cutting-edge products for the next generation of digital devices. This will not only create jobs, it will make this “old-line” company more competitive against the new upstarts.

Cisco could increase its dividends to its shareholders substantially. This will move the money into the economy and help support the price of the stock. They could also give each current and retired employee a meaningful annual bonus, again moving the money back into the economy while increasing the loyalty and morale of employees.

They could also do a series of substantial stock buy-backs, which again would help support the price of the stock. I’m sure everyone could come up with other ideas for putting the stash of cash to work.

Most of all, and most to the point, remember that I’m only using Cisco as an example. Each of the other corporations which are retaining funds in excess of normal liquidity requirements makes its own contribution to the Swedish Disease. Only if all or most of these major companies step up to the plate, in this way and others, will there be any significant amelioration of the present sluggish pace of the economy in growing the GDP and decreasing the jobless rate.

To end on a more positive note, the Federal Reserve Board reported that at the end of 2010 the level of cash holdings by corporations, in constant value dollars, is the same now as it was back in 1959. If the corporations find it in their interests to begin to release some of their cash holdings, we may find ourselves in an economic recovery similar to the robust situation in the 1960’s. Sweden has maintained its muted economic growth for many years. Here in the US we need to turn off the Mute button and let the music play!

To reach Part Two of this two-part series, click here: https://mcgeepost.com/2012/10/18/the-swedish-disease-part-two-revised/