What Should Firms Do With 'Excess' Cash?

Last week a high profile fund manager appeared on a business television program and explained his "value" screening methodology that has generated positive returns over the last five years.

His quantitative approach screens for companies with the "highest shareholder yield" for possible inclusion into the fund. High shareholder yield is basically the sum of dividend yield and the returns generated by an existing company share buy-back program. A technical study known as price momentum (which in this case is a simple three- and six-month rate of change) is also part of the screening process.

Companies who embrace a "high shareholder yield" strategy may be good for Wall Street, but in the long run it may be bad for Main Street.

International Business Machines Corp. (IBM) is a good case study on the topic of high shareholder yield.

Back in 1995, IBM (dubbed Big Blue) began what was to be a series of dividend increases and share buybacks. On Nov. 26, 1996, IBM's board of directors approved the company's purchase of an additional $3.5 billion of its own shares on the open market. That is addition to already having spent nearly $10 billion since January 1995 buying back its stock.

Some analysts questioned whether this was good or bad for the shareholders. Over the short term the answer is "yes" because the share price tripled over the next three years.

But a long-time IBM watcher and critic argued that those billions should have instead been spent on investing in new businesses to generate growth. Bob Djurdjevic, president of Annex Research, described the buybacks as little more than a bribe to Wall Street to keep a "buy" rating on the company's shares. In other words, with a major stock buyback scheme, investors could hardly lose on the investment.

Wall Street knew that IBM was willing to spend billions to buy the shares so it can pump up the price.

The reality is that paying dividends suggests the company must, at least, have "excess" cash on hand. Thus, the question boils down to what should a company do with its "excess" cash?

Such a company has two alternatives either invest the money in projects (internal expansion or acquisitions) or distribute it to shareholders. The choice between these two alternatives is simple if the company has good growth prospects then it should invest in these projects as they would create value to shareholders and to the local community as they expand their work force.

Otherwise, the company should distribute the "excess" cash to shareholders in the form of dividends.

Super-investor Warren Buffett has always said that Berkshire Hathaway Inc. would never pay a dividend as long as there is a promising way to put the cash to work. Buffett claims that, in the past, Berkshire has earned well over market rates on retained earnings, and under such circumstances distribution (dividends) would be contrary to the interests of the shareholders.

Our chart this week plots the monthly closes of Dow component IBM above a very long-term, 40-month moving average.

Note the booming "Wall Street" period of the late 1990s when the company used excess cash to shrink the stock float and inflate the earnings per share. Note the subsequent "Main Street" period of 2000 to date when "Big Blue" sold off divisions and "restructured" its workforce.

A few weeks ago, IBM said it's cutting up to 13,000 jobs, primarily in Europe, as part of a global cost-cutting plan. IBM recently closed a deal in which China's largest computer company acquired IBM's personal computer business.

IBM's troubles began in July of 1980 when IBM representatives met for the first time with Microsoft's Bill Gates to talk about writing an operating system for IBM's new hush-hush "personal" computer.

For its problems today, I could use a four-letter word DELL. Dell Inc. did spend $3 billion last year on stock buybacks, but paid no dividend. The company explains its dividend policy on its website, "We believe that our earnings are best utilized by investing in internal growth opportunities, such as new products, new customer segments and new geographic markets."

Last April, IBM shares plunged from $90 to $70 in just 14 days and on April 26, 2005, IBM directors tried to halt the big slide by adding another $0.02 to the company's dividend and authorizing $5 billion to buy back stock. Here is a suggestion for IBM. Lose the high shareholder yield schtick and grow the company. In the long run, Wall and Main Streets will be better off.