You also have to guard yourself against those instances in life where rational decision-making on your part creates perverse incentives for counterparties that you may encounter. For example, I don’t think most people realize a danger that arises when you try to pay off your home mortgage early. If you ever lose a job, take a pay cut, or encounter some difficulty with making your mortgage payment once a good chunk of the principal has been paid off, the bank is going to be less likely to work with you if they have clarity that they will make a profit.
This clarity doesn’t exist when most of the loan amount is still due. If you run into trouble after just twelve payments, the bank has a heavy incentive to work with you because foreclosure proceedings will require significant fees that will nearly guarantee losses for the bank. The repayment of one’s debts–a putative virtue–creates a reward-penalty incentive for counterparties that is the opposite of what you’d expect as you pay off more and more of your debt.
Scrambled penalty-reward mechanisms also occur when a small-cap publicly traded corporation begins to rake in profits. Once a growing company’s annual profits start to cross seven figures, the management team typically hires a bank or consulting firm to give it advice about balance sheet and resource allocation decisions.
Almost every bank gives the cookie-cutter advice to build up a cash position equal to a year’s profits and carry on debt that is triple a year’s profits.
Why are corporations consulted to carry a moderate amount of debt? Because high cash balances make a publicly traded corporation ripe for a takeover since the acquirer can use the target company’s cash position to repay any debt financing that gets used to fund the takeover. This means that the management team of the target company loses their jobs, and the banking/consulting teams get replaced by the bankers and consultants of the acquiring company. As a result, you will rarely find companies making $200 million in profits and carrying $1 billion in cash against no debt. It functions as a neon sign saying “Take me over.”
An aside: As much as I admire the investment philosophy of Benjamin Graham, I cannot spend time covering his philosophy verbatim because those types of opportunities no longer exist. He once purchased a Virginia insurance company for $12 per share when there were 1 million shares and $16 million in the bank. It was a bank being valued at $12 million while the cash on hand was $16 million! You can come up with draconian tests and demands for what constitutes a cheap stock and still find something to buy when there are corporations valued like that. But if there is anything good to say about 1930s economic conditions, it is that it was a great time to buy stocks. You can’t find those companies today.
The only small business that I saw resist this trend is Chipotle. Steve Ells, one of the founders, wouldn’t allow the balance sheet to suffer. He stockpiled four to five years worth of cash, and refused debt. Of course, it did lead to a McDonald’s takeover, so it may explain why other management teams have been reluctant to follow suit.
This is one of the oldest principal-agent problems.
I remember watching a Marshall Faulk interview right after St. Louis Rams won the Super Bowl in early 2000. He got asked the question: “Would you rather play terribly and win the Super Bowl, or play well and not win the Super Bowl?” While laughing, he chose the “play well” option and said: “If I don’t play well, I won’t be asked to remain on a team that wins the Super Bowl.”
Corporate management teams, and their slew of advisors, don’t like to be taken over and replaced. Their actions take this mind. That is why, even if the accumulation of high cash balances were deemed in the corporation’s best interests, it would not be pursued because of the takeover risk it would pose. Corporations with high-cash balances like Microsoft, Apple, Cisco, and Berkshire Hathaway don’t have to worry about this problem because they are too big to be bought out.
Originally posted 2017-02-06 10:20:11.