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Horizon Kinetics March 2014 Commentary - Corporate Risk Reduction

Clients frequently ask what we expect the S&P 500 Index (“S&P 500”) to return in a given year. Our answer is nothing if not consistent: we do not know (and are wary of those who claim they do). However, we have been building an analysis set for some time now that indicates that institutional biases increasingly emphasize liquidity needs for their enormous pools of capital over investment merit, all in the name of reducing volatility.

At the index level, this trend is reflected in the prevalence of the float‐adjusted market capitalization weighted index construction methodology, the results of which include increasingly top‐heavy indexes and the exclusion or under‐representation of smaller or more closely‐held companies, even of entire industry sectors. Unfortunately for index investors, the same large companies that dominate index returns also face the greatest challenge with respect to future growth. How can a company with a $100 billion sales base generate enough incremental sales each year to move the needle when it has already saturated its market? Complicating matters further, since investors wish to experience low volatility, the company with a $100 billion sales base is expected not only to increase its revenues and earnings materially, but to do so in a manner that does not result in a variable earnings stream or stock price.

In the face of these two seemingly antagonistic goals, the largest corporations appear to be favoring risk reduction over long‐term value creation. One way of measuring this trend is to use the basic corporate liquidity measure, which is cash as a percentage of assets. The following table shows this measure for the 12 largest nonfinancial companies in the S&P 500; this discussion considers only nonfinancial companies because cash as a percentage of assets for Bank of America, for example, is not a meaningful figure. Note, too, that the top 12 nonfinancial companies in the S&P 500 happen to comprise 19.83% of the market value of the entire index, which is not a small number.

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AlbertaSunwapta
AlbertaSunwapta - 6 months ago

Interesting insights. My experience has been that the cash rich companies can tumble quite far despite their cash. Just look at Apple in 2009. It's the buyers and sellers that determine volatility and a large cash horde might put a floor under the price but inefficiently so. Moreover I now believe that the expectation that cash on the balance sheet and the hoped for optionality value it possesses is over rated. In 2009, '10 and on that optionality wasn't utilized because managements mirror the fears of the market place and may freeze up just as investors do. Buffett was one of the few that acted and deployed cash in that crisis. A look to Japan over the past 20 years might confirm or dismiss my view since their decline was slow and much different than the 2009 credit crisis and I believe in Japan there were a large number of cash rich firms, net-nets, etc. I would guess that they too also failed to deploy cash opportunistically.

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