Cash Reserves: Both Safety and Strategy!
•There is a positive correlation between a company’s cash reserves and its future market share and stock value growth.
•Cash provides not only a safety net for times of crisis, but also long-term strategic advantages.
Financial research has traditionally shown little interest in cash holdings, which have generally been perceived as merely negative debt. However, since the late 1990s, various studies have shown that large companies often have very large stocks of cash. They represent an average of 15% to 20% of total assets; prior to the crisis, this figure was as high as 25%to 30%in the United States. In fact, cash holdings have increased considerably since the 1970s, when they rarely represented more than 10% of total assets. More recently, the economic crisis and ensuing capital shortages have revived interest in the issue of cash. What advantages do large reserves offer companies? Laurent Fresard offers a novel response to this question and shows that “in highly competitive environments, cash is a bona fide strategic tool.”
A NEW WAY OF SEEING CASH RESERVES
For a long time, abnormally large stocks of cash were considered dangerous. People were afraid that they offered business leaders too much room for maneuver, to the potential detriment of shareholders. If corporate governance was inadequate, cash could indeed be used to finance projects that benefited the former far more than the latter. That said, Laurent Fresard says, large cash reserves constitute a strategic advantage rather than a risk. “Especially during a crisis,” he adds. “Companies that have large cash reserves do better than their competitors because they do not need to go through capital markets to obtain financing. Cisco proved this during the 1997 Asian financial crisis.”
A STASH OF CASH: MUCH MORE THAN A SAFETY NET
But is cash just a “safety net” for tough times? Fresard says it is more than that, explaining that it also plays an important role in long term business performance. He points to two “cash effects.”
• A company that has a large reserve of cash has more strategic flexibility than one that does not. In a highly competitive environment, this enables the firm to lower prices, enhance customer service, hire good employees, or improve its distribution networks. Such short term “sacrifices” help build a strong position on the product market and thus foster good long term performance.
• In addition, cash can have a dissuasive effect on competitors, because companies’ strategies are often influenced by their competitors’ cash holdings. “A company’s decision on whether or not to enter a new market or launch a new product is undeniably influenced by the potency of potential competitors.”
CASH HOLDINGS AND MARKET SHARE
Fresard has studied how a company’s cash holdings (in relation to competitors’ average cash reserves) affect market share. He shows that for each additional unit of cash (in relation to rivals), a company increases its market share by an average of nearly 3% within two years. More detailed analysis reveals the specific factors that contribute to this strategic effect.
• Competitors’ financing restrictions. The effect is two to three times greater when competitors have trouble coming up with funds.
• The nature of market competitiveness. The more competitive the market (in other words, the more players there are), the more pronounced the effect.
• Technological proximity. Fresard also demonstrates that the effect of is more powerful among companies with similar levels of technology.
CASH AND BUSINESS VALUE
Fresard shows that cash reserves have a positive effect on market share, and this raises the question of how the market perceives this strategic factor. “Rapid growth of market share is not necessarily good for a company,” Fresard comments. Still, he demonstrates that each extra unit of cash that a company holds translates into a 6% a corporate stock value advantage over its rivals. The recent economic crisis seems to have accentuated this phenomenon, which leads to the conclusion that, in all likelihood, investors feel confident when companies have significant reserves of cash.
Based on an interview with Laurent Fresard and on his article, “Financial Strength and Product Market Behavior: The Real Effects of Corporate Cash Holdings” (forthcoming in The Journal of Finance).
• For investors: Fresard’s study shows investors that it is important to evaluate a company’s cash holdings not in and of themselves, but in comparison to those of its potential competitors. According to Fresard, this difference between a company’s cash reserves and those of its competitors is the decisive factor for future market share and long-term business performance.
• For managers: While managers are generally aware that cash is useful, they tend to think that this applies primarily when times are tough and market funding is scarce. Fresard shows that, on the contrary, the greatest benefits of cash derive from its use as a long-term strategic tool.
Laurent Fresard studied the effects of cash holdings on the strategy of over 5000 American corporations. To do so, he studied the relation between a firm’s cash reserves (in comparison to the average level of reserves of its main rivals) and its subsequent market share. He also considered the connection between a company’s relative level of cash and its stock market value, measured using “marketto- book” ratios. Data was provided by Compusat and covered the period from 1973 to 2006. Fresard deals with problems of endogeneity (Is it truly cash holdings that affect market share?) and causality (Isn’t it market share that influences cash holdings?) by studying how companies use their cash to respond to unexpected increases in competition. Levels of competitiveness were identified by looking at variations in import tariffs between 1972 and 2001. Fresard thus provides an empirical demonstration of the direction of causality between cash and strategic performance.