Cash Is Trash: Are We Headed For Recession?

In the financial markets, widespread acceptance of the mantra that "cash is trash" has often been a prelude to a major selloff. These days, a similar perspective is increasingly prevalent on Main Street, suggesting we are poised to see an analogous reaction in the real economy.

A recession, in other words, or something worse, given the fact that gargantuan amounts of increasingly unserviceable debts are likely to be involved.

No doubt the jaded views towards liquid assets partly reflect the phenomenal "success" of the private equity industry, which has helped convince many of the wonders of leverage. According to Bloomberg:

Buyout firms logged $699 billion of deals in 2006,...fueled by a mix of record fundraising and borrowing costs for sub-investment grade companies near the lowest in 40 years. Deal-making is set to continue as firms target larger companies, bankers say.

But it isn't just dealmakers who are spreading the word. In "Investors Demand 'Show Me the Money,'" the Financial Times notes that money managers are also doing their part.

Investor demands for companies to hand back cash to their shareholders have reached new highs, according to a Merrill Lynch poll of fund managers.

More than 50 per cent of investors want cash returned – via dividends, share buy-backs or cash acquisitions – rather than used for capital spending, debt repayment or pension top-ups, the survey found.

The poll showed that a record 53 per cent of fund managers want cash returned, up from 44 per cent a month ago. Some 60 per cent of respondents said they felt company balance sheets were underleveraged, while 46 per cent believed pay-out ratios were too low.

“Investors are urging companies to return cash to shareholders as never before. They perceive corporate cashflow to be very stable, very strong and unlikely to be derailed,” said David Bowers, consultant to Merrill Lynch.

Some of the so-called "smart money" types, in fact, are deriding the idea of holding any liquid reserves at all. The Australian writes:

Fund managers will increasingly demand that listed companies use their "lazy capital" to make acquisitions that optimise returns to shareholders, rather than leave it sitting in cash for a rainy day, a leading fund manager says....

"What's the use of a public company having a lot of cash sitting on its balance sheet for a 'rainy day' earning 6 per cent when it could be earning 20 per cent by being actively employed and geared up elsewhere?" Mr van Munster said.

"Private equity investors scoop up that cash and gear up the company, too, so any returns they make are magnified."

While ever increasing levels of gearing would ratchet up pressure for investment returns from private equity and see some poor results, investor attitudes to listed companies still needed to change.

"In particular, attitudes regarding investment horizons, capital investment risk, board structures and executive remuneration (need to change) so they can adopt some advantages of private equity.

With all the pressure to throw caution to the wind, it is not surprising that at least some of those in the firing line have decided it is better to switch than fight.

In "A 'Do It Yourself' LBO HMA Adds on Debt, Spurning Its Suitors," the Wall Street Journal writes that

Hospital operator Health Management Associates Inc. yesterday opted for a do-it-yourself leveraged buyout, using private-equity tactics to recast its finances even as it spurned buyout offers from private-equity suitors themselves.

HMA will take on $2.4 billion in new debt to fund a one-time dividend that will return $10 to stockholders for every share they own.

The proposal makes it much harder for buyout shops to take the company over because it will have so much debt when completed. At the same time, it will give shareholders the ability to quickly cash out on some of their investments. The one-time dividend is scheduled to be paid in March....

It is also one of the most potent signs yet that public companies are adapting to the debt-heavy strategies of the private-equity world. The buyout shops use the targets' cash flow to fund interest on new debt. The debt is used to fund the acquisitions and sometimes to pay special dividends.

Until, of course, the music stops.

Comments

[Jeffrey Todd]

As of Dec 2006, the US stock market has been in a bull rally for 3 years and 9 months. The talking heads, portfolio defenders, fund managers, and others can't help but be ecstatic as they trumpet their success. But none are talking about Historical Market/Stock Cycles.

These cycles, (market bottom-top-bottom again), average 53 months in length according to Martin Pring in his book The All-Season Investor. He also notes that these cycles can be altered by Federal Monetary Policy. If we use March 2003 as the start of the current bull cycle, then using his figures, we will have a new cycle beginning in Sep 2007 and would have had a market top in June 2005.

The present cycle has obviously been elongated for many reasons. Two I would like to mention, and not stated often enough: 1. The US Dollar is no longer the lone proxy currency anymore. 2. Emerging markets are almost done emerging. This present cycle, beyond Fed Policy, has been altered by forces beyond our border.

If one looks at the present Market Cycle, it would start out in 2003 at the bottom and begin an Economic Recovery. Consumer Expectations are revived, Industrials, Cyclicals are strong, the price and demand for Raw Materials is increasing, and Basic Industry is smoking. As the rising slope gets steeper we begin to see weakness in Real Estate. Sound Familiar? As we reach the top, Energy prices soar and continue to pace the market until the top begins to ease. In the rest of the model cycle, a decent begins that favors Consumer Staples, Services, Utilities, and Financials.

All this time the Fed worries about the upward pressure on wages, inflation, GDP, and what tie to wear at the next Senate Hearing. While the Fed wrestles with interest rates in light of the Dollar or in spite of the Dollar, Gold is watching this battle from the corner ready to strike at any time.

We are experiencing an extended creep to the market's top and we may be walking on a weakly cantilevered plank over the edge.

[Malkiel]

"2. Emerging markets are almost done emerging"--I would love to know what this proposition is based upon. Given the general standard of living and labor cost advantages of places like India, China, Pakistan, etc., Emerging markets have about 250 years' worth of growth potential before they lose any of those advantages. This dubious thesis alone is enough to sink your whole exposition.

Dramatic but subtle trends like the massive inflow of private pension money into stocks or the cycling of our trade deficit back into our economy through Chinese government bond-buying require new models for any historical approach to predicting the behavior of the markets. Old school simulation modeling based on the cozy closed US economy of 1965 aren't going to cut it. There isn't going to be a "recession" in the classic sense without some outside geopolitical shock (i.e., oil market disruption) and the recession of 1993-96 may actually be the last classic "recession" we see for the rest of our lifetimes...

[Robert Hein]

Cash is not trast. Shareholders are only demanding their just due. It is better that to continue to let management reward themselves for poor performance of steal it outright.