Excess Cash: The Jobs vs Buffett Approach

Some of the more dramatic stories of the great recession have been of companies suddenly finding themselves bereft of liquidity. Lehman Brothers found itself belly up as it scrambled to find cash, and countless other financial, real estate, and manufacturing firms suddenly found themselves in trouble as the economy turned south.

In many cases the underlying operating business may have been able to limp along, but without the cash to make it through the downturn and with the credit markets frozen, there was no way to keep going. In some cases, like MGM Mirage, last-minute financing heroics were needed to keep the business afloat. Although the credit markets have rebounded handily, investors are still keeping a keen eye on firms' liquidity situations.

With these headline-grabbing antics of distressed companies, it is easy to forget that there were still high-quality firms producing a ton of free cash flow even in this environment. These firms often have little reinvestment needs and are able to stockpile large amounts of cash on their balance sheet.

The boards and management teams of these companies also had an important decision to make, what to do with all this cash? Being too timid could result in missing opportunities that presented themselves, while being overly aggressive could land the firm in the distressed category if everything didn't go to plan.

To deploy or not to deploy
So what can companies with excess cash do? And how should investors evaluate management's decision?

One option is to do nothing. Just keep producing cash and holding on to it for a rainy day. Apple is a good example of a company that has pursued this strategy. In September 2008 the firm had over $20 billion in cash and short-term investments, an amount that now stands at over $31 billion. Of course the firm spent money in the research and development of its new software and hardware products, but it completed no major acquisitions. Apple doesn't return any of that cash to shareholders through dividends or share buybacks, either.

The upside to this strategy is obvious. Firms that just sit on a pile of cash are able to retain financial flexibility even in very harsh times. If the economy stays beaten down for longer than expected, these firms still won't have problems investing in growth initiatives.

But the downside is that they might be missing out on huge opportunities in the marketplace. A crisis is often the best time to scoop up beaten-down competitors or to make an aggressive push to expand market share as others are licking their wounds. In other words, there is a true opportunity cost to not deploying cash--which doesn't earn much of a return sitting in a bank account. My colleague Josh Peters argued in a recent article that most firms in this situation would be better served by paying out a dividend and letting investors find better returns.

One company that did seize the moment and deploy a lot of cash was Warren Buffett's Berkshire Hathaway. Berkshire has gone from $44 billion in cash at the start of 2008 to $25 billion by the end of the first quarter of 2009. Buffett--who is also known to sit on cash when assets look pricey--clearly saw an opportunity to profit by being greedy when others were being fearful. He bought shares of beleaguered financial companies and expanded his business into new areas like muni bond insurance. Many of these initiatives have already paid him back handsomely. He has earned a paper profit of over $2 billion on his investment in Goldman Sachs and another $1 billion from Chinese Hybrid Carmaker BYD.

But Berkshire's declining cash balance was a factor in Moody's decision to downgrade the firm from its top Aaa credit rating. Of course other factors were at work with respect to the ratings downgrade, and no one seriously believes that with $25 billion in cash Berkshire would get in trouble anytime soon. Still, by making all these investments, the company took on quite a bit of additional risk. And if the economy had tanked further, or if the government had taken more aggressive actions like nationalising the banking system, Berkshire could have found its earnings power permanently impaired.

A good problem to have
So whose cash philosophy is right? Apple or Berkshire? There isn't one right answer to this question. Both firms appear to have emerged from the wreckage of the last 18 months stronger than before. This is likely because each played to its strength. Apple has no history of major acquisitions and Berkshire has one of the best investment records around, so it would seem silly for Berkshire not to deploy its cash hoard when opportunity knocked.

The moral of the story seems to be that having a lot of cash is a good problem to have. But it is still a problem. Investors have to trust management to make the right call and to know what their business core competencies are. So it could be wise to dive into corporate history and see what kind of stewards the current management team have been before jumping into the stock.

Jeremy Glaser is the Markets Editor for Morningstar.com.