Businesses are swimming in cash right now.
As of the beginning of the third quarter, the 500 largest U.S. companies collectively held $1.27 trillion. That's about 13.5% more than this time last year.
If you converted all this money into $100 bills and stacked them up, the pile would stretch 800 miles high.
So where is this cash coming from? And more importantly, how can investors take advantage of this $1.3 trillion problem?
Let me explain...
Borrowing accounts for some of the corporate cash hoard. But mostly, it's that companies are simply generating cash faster than they are spending it, creating healthy amounts of free cash flow (FCF) -- a company's fuel for dividends and growth.
I consider free cash flow the best measure of a company's earnings power. The calculation is simple. You start with operating cash flows and then subtract any capital expenditures made for property, plants and equipment (PPE).
The result is the true cash generated by the business after all the regular bills (salary, rent, etc.) have been paid and after any discretionary spending needed to maintain and grow the business.
If a company generates $100 million in operating cash flow for the year and invests $25 million on new machinery and facilities, then it is left with $75 million in free cash flow. It's this pool of money that is used to pay dividends, repurchase shares, make acquisitions and pay down debt.
Investors usually cheer the first two activities, and for good reason. And acquisitions, when done at the right price for the right reasons, can drive shareholder value significantly higher. Debt reduction, on the other hand, usually elicits little more than a yawn.
That's because the benefits are not felt right away. But I don't mind seeing a portion of the surplus cash used to repay loans, even if it means accepting a lower upfront yield. Because this sacrifice quite often leads to even stronger returns over the long haul.
Consumers are often faced with the choice between investing in a solid mutual fund with an average 4% annual return or using the money to pay off a credit card balance with a hefty 15% interest rate. Paying off the credit card might make more sense, considering every dollar spent to chip away at that balance essentially earns a 15% return.
Many businesses are in a similar position.
There's nothing wrong with debt. When used correctly, it can be a powerful tool. But the interest payments that follow can drain cash. After all, every dollar spent to service debt is a dollar that won't be available for dividend payments.
So if a company is in a position to pay off some or all of its borrowings ahead of schedule, it can wipe out millions in future interest expenses. Those savings can then be applied elsewhere.
And there are other benefits that don't reflect on the balance sheet. A heavy debt burden can cause anxiety and weigh down a stock. Reduce that burden, and you cut the anchor -- allowing the shares to trade higher.
While many companies have been piling on debt lately, some have been digging out. In the chart below, you'll see the five companies with the largest debt reduction over the past 12 months.
|Company||Net Debt Reduction||Annual Dividend||1-Year Return|
|General Electric (NYSE: GE)||$4.3 B||$0.76||+36.9%|
|Verizon (NYSE: VZ)||$3.3 B||$2.12||+17.5%|
|Devon Energy (NYSE: DVN)||$2.0 B||$0.88||+17.9%|
|Hewlett-Packard (NYSE: HPQ)||$1.8 B||$0.58||+106.1%|
|Walt Disney (NYSE: DIS)||$1.8 B||$0.75||+49.3%|
Combined, these companies are $13 billion lighter in debt than they were a year ago. That will erase tens of billions in interest payments that will now be freed up for other uses -- like dividend hikes.
Action to Take --> Certainly, there are other variables in play. But it's no accident that these five stocks have delivered an average total return of 45.5% over the past year -- with most of them still beating the S&P 500's impressive 31% gain.