Investing: When Cash Takes a Vacation

For those who lost big in the crash of 2008-2009, there was one thing more galling than having to open those bright red brokerage statements: knowing that the smart money was profiting from your pain. It was hard enough to watch your home lose value; discovering that hedge fund manager John Paulson earned $15 billion for his investors from betting on the housing bust didn't make things any easier. So it might be comforting to realize that right now the smart money is every bit as confused as the rest of us.

Hedge funds are scaling back their trading as money managers absorb the impact of a 2.8 percent second-quarter decline—the worst second-quarter performance since 2000—and struggle to make sense of where global economies and markets are headed. Credit Suisse Group's (CS) prime brokerage unit estimates that its hedge fund clients increased their excess cash to 24 percent of their assets in June, compared with 19 percent three months earlier.

It isn't just hedgies who are frozen in the headlights. American households are sitting on nearly $8 trillion in cash—money that's earning virtually no return because people are so wary of additional losses. U.S. corporations are hoarding at a record pace as well. According to Moody's Investors Service (MCO), cash at U.S. nonfinancial corporations stood at $1.84 trillion in the first quarter of this year—a 27 percent increase from early 2007. As a percentage of total company assets, cash is at its highest level in half a century.

"There's a degree of not knowing what sectors or securities to emphasize," says Tim Ghriskey, chief investment officer of Solaris Asset Management, a Bedford Hills (N.Y.) firm with $2 billion under management. "There's also a high degree of correlation among stocks, so it's not the best environment for stockpicking or sector allocation. Investors are not moving money."

Max Trautman, a former Goldman Sachs (GS) proprietary trader who co-founded London-based Stoneworks Asset Management in 2006, is now paring his $460 million fund's market exposure. "We're trying to reduce risk by downsizing our trades," he says. "It's not that we have stopped taking views, but we're just putting less risk in them."

As Trautman and other hedge fund managers try to figure out the ramifications of such events as the European sovereign debt crisis, new U.S. financial regulations, and China's attempts to cool an overheated economy, they've been reluctant to put their money to work—even though having less money in the market makes it harder for managers who lost money to rebound from losses in May.

Still, some hedge fund investors want their managers to avoid large bets this year. Their caution will have been vindicated if the present market correction morphs into anything resembling the carnage of 2008—giving them a great new buying opportunity. "It's all about capital preservation at the moment," says Amit Shabi, a Paris-based partner at Bernheim Dreyfus, which farms out client money to hedge funds. "The losses of 2008 are still fresh in investors' memories, and so managers should be cautious." Hedge funds lost an average 19 percent in 2008, the industry's worst returns since Hedge Fund Research began tracking data in 1990.


When does holding so much cash go from being a virtue to a vice? When it conspires to undermine the attractiveness of the capital markets. Corporations that are offering neither a handsome dividend nor any real prospect for growth can scarcely expect to attract investors. And hedge funds with high cash positions and low returns are eroding their own high-priced reason for being. While individual investors are free to squirrel away legal tender—they have historically shown a knack for diving back into the market after a runup—their institutional and C-suite counterparts have no such luxury. Professionals are not being overpaid to run glorified certificates of deposit. By definition, businesses must earn a return above their cost of capital, while fund managers must keep watch over their own performance. "Shareholders demand a return no matter what the economic environment," says Sean Kraus, who manages $2 billion in client assets as chief investment officer of CitizensTrust in Pasadena, Calif. "If you don't put cash to work, they will simply sell." And if you lose their money, as so many funds did in 2008, they will sell faster—hence the newfound preference for cash.

The frozen moment can't last for hedge funds. They are mandatorily in the strong-conviction business. They need to keep moving to stay alive in their kill-or-be-killed world, an unforgiving ecosystem that saw almost 2,500 hedge funds die in 2008-09. And some aggressive motion of a specific kind is called for right now: A return to activist investing by hedge fund managers is precisely what the market needs. It could help prod cash-rich corporate behemoths to increase their dividends, thus making equities more attractive to investors in a time of low returns.

For as long as everyone sits on cash, the priorities of investment managers and corporate boardrooms will remain on a collision course. The longer companies do nothing with their dormant billions, the more their shareholders will realize they could be getting far more bang for their buck. "Why pay a stock market multiple for a company that is essentially acting like a bank—and a bad one at that?" asks Jason Trennert of Strategas Research Partners. He calculates that the overabundance of low-yielding cash this year has shaved 1.4 points off the equity market's earnings multiple.

Consider the predicament of flush companies such as Microsoft (MSFT), which despite having $40 billion in cash pays a dividend of just 2 percent. With the stock market down 5 percent for the year—13 percent off its late April high and 24 percent below where it was trading 11 years ago—slow-moving herbivores like Microsoft have been some of the worst performers of the lost decade. They continue to lag amid the recent flight from risk, and without strong intervention from somewhere to persuade them to up their dividends, there's little sign that will change. Bill Gross, who runs Pimco Total Return, the world's biggest bond fund, warns that "global financial market returns stand at the threshold of mediocrity," with annual equity returns in the low single digits expected to prevail for some time.

Put it all together, and you have the makings of a broad push toward big investor rebates in what could (and arguably should) become the richest period for dividend-paying stocks since the early 1980s. Those were the late innings of the great market stagnation of 1966-1982, a period that gave rise to an era of corporate raiders and greenmailers. Today, pushing for those dividends—if only to boost their returns—is the proper role of hedge funds, which should be leading the dance of the capital markets.

'Time to Cash Out'

For the time being, however, hedge funds are playing a less active, less risky, and ultimately less healthy game. Their passivity allows corporate financiers to remain complacent. A recent 200-page Credit Suisse treatise compared those cash-hoarding U.S. companies with corpulent seals. "Cash in a difficult time is like blubber on a seal: protecting the animal during the harshness of winter, but turning bothersome in spring and summer," read the report. "We believe that U.S. companies are now ending their recent enforced hibernation. Survival mode is over and Corporate America is breathing easier....Now it's time to cash out."

James Grant of Grant's Interest Rate Observer dedicated his June 11 newsletter to screening for big names like Wal-Mart Stores (WMT) and Kimberly-Clark (KMB) that throw off tons of cash and yield more than overrated, overprinted Treasuries. (Bonds have outperformed stocks in the past six months, even though 10-year government bills offer just 2.9 percent.) "As for the government's well-exhibited capacity to conjure money," writes Grant, "we can't think of a better reason not to own government securities. Hence our preference for...big, stable, dividend-paying corporations."

Grant points to Darden Restaurants (DRI), which runs the Olive Garden and Red Lobster chains. He notes its 25 percent return on equity and 2.3 percent dividend yield. Darden holds more cash on its books than it knows what to do with: $249 million as of May, a quadrupling over the same period last year. On June 23 the company goosed its dividend by nearly a third, to 3.1 percent. Yet the stock is still some 22 percent off its year's high. Investors are not impressed—at least not yet.

Or witness how Pfizer (PFE), the acquisitive megapharmaceutical behind the Lipitor and Viagra brands, yields 5 percent to no apparent avail: Its shares are near their low for the year. In downgrading the stock in late June, Goldman Sachs said management was not taking enough shareholder-friendly action to unlock embedded value (Goldman recommended a sizable dividend increase). Indeed, last year Pfizer cut its dividend to help fund its $68 billion purchase of Wyeth. One thousand shares of Pfizer bought 10 years ago would now be $29,115 underwater—$23,638 when factoring in the dividends it has since paid out. The drugmaker, which now has $26 billion in cash on hand, is practically inviting a long-suffering institutional shareholder to try to shake loose its cash.

Unfortunately, shareholder activists are still smarting from the agitations that were all the rage during the bull run of 2003-2007. In 2006, activist Carl Icahn prevailed upon Time Warner (TWX) to buy back $20 billion in stock that has since fallen 22 percent. Bill Ackman similarly prodded Target (TGT) to pay too much for its shares in a campaign that the discount retailer ultimately had to scotch to conserve cash. The epic tide of dividend cuts in 2008 and 2009 further soured investors on the efficacy of unlocking excess balance-sheet cash.

Sylvan Chackman, global co-head of prime brokerage at Bank of America (BAC), says he expects hedge funds to stir this quarter. "They need to put their capital to work to generate returns," he says. About 48percent of the 2,000 hedge funds in the HFRI Fund Weighted Composite Index are still below their so-called high-water marks. Until they return to that critical threshold, they are unable to charge investors performance fees. Stay in the hole long enough, and you might as well close up and start anew elsewhere.

Those hedge funds that do plan to stick around, however, will need a story, a game plan, a lever to pull—especially if we really are on the precipice of a chronically bad time for market returns. When it becomes clear that every point of return matters, fund managers will fight to wrest back every dollar of excess cash from their portfolio companies. There will be open letters, moral and immoral suasion, proxy battles galore.

And there should be, because CEO vanity springs eternal. Consider Eastman Kodak (EK), which blew upward of $15 billion on abortive acquisitions and product development in the 1980s and 1990s as its core film business shriveled. The whole company is now worth just $1 billion; wouldn't shareholders have preferred to get some of that $15 billion back? The obverse of that example is a company that also reinvested, ignoring an archrival's taunt that it should close shop and give its money back to shareholders. That company is Apple (APPL), and the problem today is that every chief executive officer wants to be Steve Jobs. It will be up to the hedge funds and other activist players to remind them that there's only one Steve. So hand over those dividends.

With Saijel Kishan, Katherine Burton, Jeff Kearns, and Nick Baker

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