In recent years, U.S. companies have been building up cash on their balance sheets to the point that cash held by companies in the S&P 500 Index has repeatedly set record highs.
Cash and equivalent holdings of S&P 500 companies exceeded $1 trillion for the first time in the fourth quarter of 2011, excluding financials, utilities, and transportation companies that maintain high cash reserves as part of their normal operating businesses.1 By the third quarter of 2016, the figure topped $1.4 trillion.
Where has all the cash been going?
To the extent that companies have dipped into their cash balances, much of the money has been directed at buying back shares of common stock, increasing dividends, or both. In addition, the difficulty in achieving organic growth in the current economy, coupled with a low cost of capital, has driven mergers and acquisitions (M&A) as companies seek to grow through add-ons. The lack of robust economic growth and historically low capacity utilization rates have left many companies reluctant to spend on capital improvement, despite the low cost of capital. This reluctance has fueled a backlash from some politicians who believe that U.S. companies are long overdue to upgrade plants and equipment, and by not doing so, are failing to stimulate the broader economy. However, the fact remains that companies have lacked the incentive to increase their capital spending.
We take what we consider to be a holistic view of the best ways that a company can allocate free cash among its potential uses. As for capital improvement projects or M&A, a company should pursue those initiatives if it can earn a return on invested capital that is higher than its cost of capital. Any remaining free cash should be returned to shareholders through cash dividends, share repurchases, and debt reduction—three other principle uses of cash that we define as shareholder yield. Optimal capital allocation typically consists of a mix of the five uses of cash.
An improved political climate for capital spending might not be enough
It may appear that capital improvement could soon ramp up as a result of ongoing changes in the U.S. political and economic environment. On taking office in January 2017, President-Elect Donald Trump is expected to pursue substantial reductions in corporate tax rates, and with both houses of Congress under Republican control, meaningful reductions appear to be likely. In addition to boosting cash flow, reduced corporate tax rates could result in U.S. companies repatriating large sums of cash to the United States. Mr. Trump has stated that the tax-beneficial repatriation of assets may come with the caveat that the companies must invest in capital improvements in their U.S. operations. Whether the caveat is imposed or not, an influx of cash on company balance sheets coupled with a stronger domestic economy could lead to some level of increase in capital spending by U.S. companies. However, the impact of such an increase could be muted, as it could be offset by one of the effects of today's rapid pace of technological advances and efficiency gains: In order to grow, companies do not need to invest the same amount of capital per dollar of revenue that they once did. While an increase in capital spending is possible, we believe growth in other uses of cash is likely to be more substantial, particularly dividends and share buybacks, which are already at record levels.
Keep a close eye on cash flows and capital allocation
While Mr. Trump's administration is expected to pursue fiscal policies and infrastructure spending that could provide economic stimulus, we are cautious, and continue to expect U.S. GDP growth is likely to remain closer to 2% than 4%. With interest rates expected to rise, the support for expansion of price-to-earnings (P/E) ratios is likely to diminish. With P/E multiples no longer expanding, we expect that dividends and earnings, the other two components of equity return, will become more important for investors. The companies that we believe will do well in this environment are the ones that generate solid cash flows and are prudent in their capital allocation policies, as reflected in shareholder yield and capital investment opportunities.
1 S&P Dow Jones Indices, 2016.