How Companies Should Spend Their $1.9 Trillion in Cash
With corporate profits and cash levels at record highs, you'd think financial markets would be booming. And they are. Under the current administration, stocks are doing better than they have under any president in the last 65 years. (President Obama's predecessor, former President Bush, presided over the worst stock market within that period.)
But in order to keep the stock market growing, more cash is going to have to move off the sidelines. Investors are going to have to shift cash away from bonds and commodities and into stocks. And companies are going to have to invest that cash in profitable growth opportunities. But how are they going to find those? The short answer is to seek projects that will gain them market share in rapidly growing countries.
Cash Levels Rising
Companies boosted their cash balances by $600 billion in the third quarter, bringing their total cash to a 51-year high of $1.9 trillion, according to the Federal Reserve. According to my analysis of data from S&P's Howard Silverblatt, corporate cash has averaged 6.8% of the market value between 1980 and 2010. In the third quarter, it towered over that average at 9.9%, which actually represented a drop from a record 11.6% in the second quarter. The high balances are great news for corporations and come on top of record 2010 estimated profits of $1.66 trillion.
The stock market is behaving as if it had anticipated all this good corporate news. From Jan. 21, 2009 through early last month, the S&P 500 had been climbing at an average annual rate of 26.9%. This performance is in welcome contrast to the stock market under the 43rd president, when index declined at an average of 4.5% per year during his eight years in office.
You would not know this from listening to some media commentators, such as Fox News's Glen Beck, whose diatribes against debt -- and in favor of gold -- may have directed buyers to the products of an advertiser, Goldline -- a company that's now being investigated by California authorities.
That may be part of why money has been flowing everywhere but stocks, in spite of the strong market. In the first nine months of this year, investors pulled $58 billion from U.S. stock mutual funds while directing $221 billion into bond mutual funds and more than $7 billion into commodity funds, according to the Morningstar Direct Funds Flow Report in October.
And with the price-to-earnings ratio of 14.75 on the S&P 500, it looks like the stocks -- whose earnings are expected to grow 13% next year, according to S&P's Silverblatt -- may be fairly valued now unless they can boost growth above that forecast.
How might companies do that? This is where that $1.9 trillion in corporate cash comes in to the equation. Sure, company CEOs are paid to beat quarterly earnings targets and boost their growth forecasts. But they can't achieve that for several quarters in a row unless they find profitable growth opportunities in which to invest.
How Should Companies Spend Their Cash?
And for now, companies seem to be short on ideas about where to invest it. Here's a hint: Look for countries with economies that are growing rapidly. According to the International Monetary Fund, the six fastest growing economies -- based on 2011 GDP forecasts -- are China (9.6%), India (8.4%), Vietnam (6.8%), Indonesia (6.2%), Chile (6.0%) and Peru (6.0%).
But just because those countries are growing fast, that does not mean that all companies will be able to find profitable growth opportunities there. A quick way to jumpstart their presence is to find attractive acquisition candidates in those fast-growing countries.
The most cash-rich industries right now are information technology and health care, with $347 billion and $193 billion in cash and short-term securities, respectively, as of the third quarter, according to Silverblatt. Of the S&P 500's total $902 billion in cash, IT accounts for 39% and health care makes up 21%.
Pfizer (PFE), for example, has $23.2 billion in cash. If it wanted to take a piece of the health-care market in fast-growing countries, it could consider investing in Teva Pharmaceuticals (TEVA), which sells generic drugs in 60 countries, including many emerging markets. Teva has $15.5 billion in sales, which have grown at a five-year-average rate of 24%, and $2.9 billion in profit, which has grown at an annual average of 43%.
Capturing some of that growth would likely come at a high price for Pfizer, given Teva's $49.3 billion market capitalization, so this particular deal may never happen. But one thing's for sure -- unless companies find profitable ways to spend their cash, they won't be able to sustain the profit growth that's been propelling stocks for last several years. And that would be a big disappointment to all that investor cash coming off the sidelines.
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