I got a lot of interesting feedback / pushback on yesterday’s “Weekend thoughts: net cash in a rising rate world”, so I wanted to provide some quick follow up.
This is an interesting topic. Here's maybe a tad of perspective (not a prediction!) that you may find of interest. When I started on Wall Street in 1980, there were many companies with sizeable cash balances and nearly debt-free balance sheets (or only mortgage debt on owned properties). Why so conservative? A few reasons. 1) many companies were run by CEOs who had survived the Great Depression only because they were not debtors. They knew nobody was going to bail them out (for decades, the same was true of banks - not in the last two or three decades). Factor in a terrible downturn from 74-75, and then Volcker jamming rates to the moon in '81 - a period of immense challenge for most public companies - and that concern was only enhanced. 2) Hostile takeovers (and greenmail) were unheard of as no major investment bank was willing to go hostile. Only after the rise of a few mavericks (and Mike Milken at Drexel) were hostile actors able to get the financing they needed to be a real threat. In today's world a non-controlled company that keeps way too much cash will eventually attract an activist who tries to get the cash sent back or used up. 3) Stock buybacks were illegal throughout the 60s and 70s unless you made a tender offer to all shareholders (as Henry Singleton did when his stock got super cheap after he had used it as a super expensive currency to acquire 50 or so companies). And management was not generally incentivized with stock, so there was no imperative to "enhance shareholder value."
It has been a long time since an economic downturn with the magnitude of the Great Depression or the 73-75 debacle which was shortly followed by Volcker and his 20% interest rates. Given all of the other incentives to "optimize" cash, it's entirely possible that the next persistent downturn (whenever it occurs) will result in outsize #s of bankruptcies and loss of equity value as companies that could have maintained a financial cushion to pay down debt or see through a period of operating loss gave up that flexibility to the altar of stock buybacks and enhancing shareholder value.
One of the most interesting aspects of financial history to me is trying to understand the mechanisms of how markets get super cheap and super expensive relative to normalized valuations. And it seems that in recent years, many have internally accepted premium valuations as "normal." We may be about to find out if that belief has been misplaced.
this is an interesting thought, but I don't think it's crazy to think MSFT should / could take leverage up to 1x FCF. Even if we went into another depression, I think at that reasonable level of leverage they would be fine
(Realize you weren't specifically calling out MSFT, but same applies for a lot of companies, and I'm not sure smaller companies should run themselves preparing for a depression)
Yes, my point really was not to predict another great depression. While possible, it really was about the relatively recent demand that public companies dispose of their ready liquidity (and I don't count bank lines which can get pulled in a real crisis). I don't think there's a business school around that doesn't preach an "optimum" amount of leverage. Of course, Microsoft has become a rather special case given the largely recurring and essential nature of a good chunk of its business, but many companies often have cyclical markets and have no such certainty of revenue or margin, nor do they have the kind of access to capital markets of MSFT. Even further, it's one thing to have issued a ton of long-term debt (beyond 15 years) in recent times, though few were willing to do that as short rates were so much cheaper (and therefore earnings higher). Which was the right strategy? So, yes, nature of business matters and capital structure matters. My point was a little more about recency bias and the fact that so many seem to think liquidity is overrated. Interesting factoid about great corporate capital allocators: Most have highly liquid balance sheets at times, often criticized for not buying in stock or doing deals. But then, when crisis strikes, these great allocators act. So it's not about having liquidity *all* the time but having it and being willing to deploy it when others do not. Thinking BRK, WTM, LUK, and similar.
One thing is, what are they going to do with all that leverage? I mean, in this time, rates are higher and so they won't find an easy way to reinvest it and earn the spread. Even if they do, it might not even move the needle much. Second, if it is going to have a material impact on their bottom line, might as well use that 100B! I doubt that cash balance will be insufficient for whatever opportunity they find.
Even if it were some smaller company, they would not go all in on an opportunity by taking a lot of debt. That would be way too risky. I do agree that beyond certain level, holding cash might be toooo much of a drag on performance, even if it provides the company with flexibility
I saw many quite suprised that ROIV didn't rally after the Roche drug acquisition annoucement. Yet another example of (soon to be) too much cash on the balance sheet. One could also say the same thing about BUR and the YPF news. Though yet to be collected, a windfall is all but guarenteed. In Burfords case the stock popped for a short period of time and settled back to where ot traded pre-YPF win. I guess having a crystal clear capital allocation framework is important. I'm not sure what the lesson is but interesting to think about
This is an interesting topic. Here's maybe a tad of perspective (not a prediction!) that you may find of interest. When I started on Wall Street in 1980, there were many companies with sizeable cash balances and nearly debt-free balance sheets (or only mortgage debt on owned properties). Why so conservative? A few reasons. 1) many companies were run by CEOs who had survived the Great Depression only because they were not debtors. They knew nobody was going to bail them out (for decades, the same was true of banks - not in the last two or three decades). Factor in a terrible downturn from 74-75, and then Volcker jamming rates to the moon in '81 - a period of immense challenge for most public companies - and that concern was only enhanced. 2) Hostile takeovers (and greenmail) were unheard of as no major investment bank was willing to go hostile. Only after the rise of a few mavericks (and Mike Milken at Drexel) were hostile actors able to get the financing they needed to be a real threat. In today's world a non-controlled company that keeps way too much cash will eventually attract an activist who tries to get the cash sent back or used up. 3) Stock buybacks were illegal throughout the 60s and 70s unless you made a tender offer to all shareholders (as Henry Singleton did when his stock got super cheap after he had used it as a super expensive currency to acquire 50 or so companies). And management was not generally incentivized with stock, so there was no imperative to "enhance shareholder value."
It has been a long time since an economic downturn with the magnitude of the Great Depression or the 73-75 debacle which was shortly followed by Volcker and his 20% interest rates. Given all of the other incentives to "optimize" cash, it's entirely possible that the next persistent downturn (whenever it occurs) will result in outsize #s of bankruptcies and loss of equity value as companies that could have maintained a financial cushion to pay down debt or see through a period of operating loss gave up that flexibility to the altar of stock buybacks and enhancing shareholder value.
One of the most interesting aspects of financial history to me is trying to understand the mechanisms of how markets get super cheap and super expensive relative to normalized valuations. And it seems that in recent years, many have internally accepted premium valuations as "normal." We may be about to find out if that belief has been misplaced.
this is an interesting thought, but I don't think it's crazy to think MSFT should / could take leverage up to 1x FCF. Even if we went into another depression, I think at that reasonable level of leverage they would be fine
(Realize you weren't specifically calling out MSFT, but same applies for a lot of companies, and I'm not sure smaller companies should run themselves preparing for a depression)
Yes, my point really was not to predict another great depression. While possible, it really was about the relatively recent demand that public companies dispose of their ready liquidity (and I don't count bank lines which can get pulled in a real crisis). I don't think there's a business school around that doesn't preach an "optimum" amount of leverage. Of course, Microsoft has become a rather special case given the largely recurring and essential nature of a good chunk of its business, but many companies often have cyclical markets and have no such certainty of revenue or margin, nor do they have the kind of access to capital markets of MSFT. Even further, it's one thing to have issued a ton of long-term debt (beyond 15 years) in recent times, though few were willing to do that as short rates were so much cheaper (and therefore earnings higher). Which was the right strategy? So, yes, nature of business matters and capital structure matters. My point was a little more about recency bias and the fact that so many seem to think liquidity is overrated. Interesting factoid about great corporate capital allocators: Most have highly liquid balance sheets at times, often criticized for not buying in stock or doing deals. But then, when crisis strikes, these great allocators act. So it's not about having liquidity *all* the time but having it and being willing to deploy it when others do not. Thinking BRK, WTM, LUK, and similar.
One thing is, what are they going to do with all that leverage? I mean, in this time, rates are higher and so they won't find an easy way to reinvest it and earn the spread. Even if they do, it might not even move the needle much. Second, if it is going to have a material impact on their bottom line, might as well use that 100B! I doubt that cash balance will be insufficient for whatever opportunity they find.
Even if it were some smaller company, they would not go all in on an opportunity by taking a lot of debt. That would be way too risky. I do agree that beyond certain level, holding cash might be toooo much of a drag on performance, even if it provides the company with flexibility
I saw many quite suprised that ROIV didn't rally after the Roche drug acquisition annoucement. Yet another example of (soon to be) too much cash on the balance sheet. One could also say the same thing about BUR and the YPF news. Though yet to be collected, a windfall is all but guarenteed. In Burfords case the stock popped for a short period of time and settled back to where ot traded pre-YPF win. I guess having a crystal clear capital allocation framework is important. I'm not sure what the lesson is but interesting to think about
these are some great examples that I'm very familiar with and agree are well worth thinking about!
Great post and reply. Thanks for sharing your insights and knowledge. Valuable stuff, both sides of the same coin