CASH HOARDS AND CHANGES IN INVESTORS' OUTLOOK

• Author: Ebenezer Asem,Shamsul Alam
• Date: 01 February 2014
• Published date: 01 February 2014
• DOI: http://doi.org/10.1111/jfir.12031

CASH HOARDS AND CHANGES IN INVESTORS’OUTLOOK

Ebenezer Asem and Shamsul Alam

University of Lethbridge

Abstract

Declining markets reflect declines in investors’outlook for firm prospects, increasing

their expectation that firms will waste excess cash. In contrast, excess cash is useful in

mitigating financial distress associated with poor earnings. We find an inverted U‐shaped

relation between stock return and excess cash in declining markets, suggesting the

positive effect of excess cash dominates at low levels of cash, while the negative effect

dominates at high levels. We also document an inverted U‐shaped relation for firms with

weak shareholder power and firms with high information asymmetry in advancing

markets. These suggest investors’desire for cash reserves is limited.

JEL Classification: G30, G35

I. Introduction

Jensen’s (1986) influential excess cash theory suggests that excess cash reduces firm

value because managers tend to waste it. Accordingly, an unexpected increase (decrease)

in a firm’s excess cash increases (reduces) the market’s estimate of the amount of cash the

firm will misuse, reducing (increasing) the firm’s value. However, there is evidence that

firms continue to accumulate cash reserves and that investors might actually condone this

behavior.

1

There is evidence that firms hoard cash to cushion shortfalls in future cash

flows and mitigate the effects of economic downturns (e.g., Bates, Kahle, and Stulz 2009;

Palazzo 2012) or to provide cheap funds for growth (e.g., Simutin 2010). We test whether

investors sanction these cash hoards by investigating the relation between stock return and

cash reserves when investors expect declines in future cash flow or when they expect

increases in growth opportunity. We document an inverted U‐shaped relation between

stock return and excess cash when investors expect declines in future cash flow. When

investors expect improvements in investment opportunity, we generally find a positive

relation, but firms with high information asymmetry or poor governance display a

negative relation at high levels of excess cash. These results suggest that investors’

support for cash hoards is not ubiquitous.

We are grateful to Sattar Mansi (associate editor) and Jesus Salas (referee) for valuable suggestions that greatly

improved the paper. We also thank seminar participants at the University of Lethbridge, University of

Saskatchewan, and the 2009 participants at the Financial Management Association meetings for very constructive

and helpful comments. Ebenezer gratefully acknowledge the financial support from the University of Lethbridge

Research Fund #13136 and the Faculty of Management Seed Fund. Any mistakes are ours alone.

1

In an article entitled “What Will It Take for Companies to Unlock Their Cash Hoards?”in the Wall Street

Journal on May 28, 2011, Jason Zweig noted that the payout ratio for companies in the S&P 500 index has dropped

to 28.9%, the lowest since 1936.

The Journal of Financial Research Vol. XXXVII, No. 1 Pages 119–137 Spring 2014

119

© 2014 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

Prior research suggests that managers hold cash reserves to cushion future cash

flow shocks or to fund future investments. However, it is not clear if investors sanction

these cash reserves. One approach to investigating this is to study the behavior of stock

returns around changes in excess cash, but unlike other corporate events (e.g.,

announcements of dividend changes), it is difficult to determine the timing of changes in a

firm’s excess cash. An alternative is to study stock returns when investors’outlook about

firms’future cash flows or investment opportunities change. If investors desire that firms

hoard cash to mitigate future financial distress, the returns of the firms with high excess

cash should decrease at a slower rate than the returns of firms with low excess cash when

investors expect declines in future cash flows. If investors desire that firms hoard cash to

fund investments, the returns of firms with high excess cash should increase faster than the

returns of firms with low excess cash when investors expect increases in investment

opportunity. We proxy changes in investors’outlook for future cash flow or investment

opportunity by the market’s movement. A firm’s stock price captures its expected cash

flow or investment opportunity, and therefore, a decline in the price reflects a decline in

expected cash flow or growth opportunity. Similarly, an increase in the stock prices

reflects an increase in expected cash flow or growth opportunity. Thus, a decline

(increase) in the market’s return is a reflection of a decrease (an increase) in aggregate

expected cash flow or growth opportunity.

2

Accordingly, we study the relation between

stock return and excess cash in advancing and declining markets to shed light on whether

investors condone cash hoards to mitigate future cash shocks or fund investments.

The authors of two articles examine firms with excess cash when economic

conditions change. Harford, Mikkelson, and Partch (2003) report that firms with cash

reserves generate stronger (weaker) earnings than their industrial peers in the year of and

the years following industrial downturns (nondownturns). Simutin (2010) reports that

firms with high excess cash earn lower (higher) returns than firms with low excess cash in

monthly market downturns (upturns). Following Mikkelson and Patch (2003), we

measure market movement over one and two years because changes in investor

perception about a firm’s growth prospect likely take longer than a month, and we

document new results.

3

First, we document an inverted U‐shaped relation between stock

return and excess cash in declining markets. Second, we find an inverted U‐shaped

relation for firms with weak governance or high information asymmetry in advancing

markets, as well. This suggests that the positive effects of excess cash at low levels of cash

and the negative effects at high levels of cash are present in both declining and advancing

markets.

Declining markets reflect a decline in expected future cash flows or invest-

ment opportunities from investors’perspective. A decline in perceived investment

2

It is well known that market movements affect investor behavior. For instance, Docking and Koch (2005)

document different market reactions to dividend changes in advancing and declining markets, and Cooper,

Gutierrez, and Hameed (2004) and Asem and Tian (2010) find that investor asymmetric behavior in advancing and

declining markets generates momentum profits in the former markets but not in the latter markets.

3

Alternatively, declining (advancing) market can be interpreted as investor pessimism (optimism) about firm

prospects, and this alternative interpretation requires defining the market movement over periods longer than a

month (e.g., Cooper, Gutierrez, and Hameed 2004 measure market movements over one to three years to gauge

changes in investor sentiments).

120 The Journal of Financial Research