In the 10 years following the 2007/2008 financial crisis, interest rates have been glued at historical lows. This has incentivized companies to load up on debt to fund growth, dividends, and buybacks. When you can borrow at 3-4% and almost guarantee to reinvest that money ay 7-8% returns, it is good corporate management to take that risk, assuming you keep your borrowing level within reason. This partially explains why non-financial corporate debt has ballooned from 3.4 trillion in 2008 to 6.2 trillion in 2018. During the same time period GDP has only grown from around 14.7 trillion to ~20 trillion.
There are a few issues with maintaining a large debt load. Refinancing puts a strain on earnings. During any slowdowns, over-leveraged companies are at risk of not being able to find financing and needing to cut their dividends or sell off crucial assets. Kinder Morgan, General Electric, and Anheuser-Busch are examples of fundamentally sound companies that took on too much debt and as a result had to cut the dividend after running into hiccups. Mind you these weren’t 2009 financial collapse type of issues, these were things that could reasonably be expected to occur in the course of a business cycle. Because of high debt levels, they were not able to navigate the issues without a dividend cut.
Now that rates have risen are are expected to stay (relative to recent history) high, companies with high floating debt or fixed debt coming due in the near future will have considerably fewer financial options. When debt is cheap, it makes sense to borrow to invest in new and continuing operations, make acquisitions, repurchase shares, or raise the dividend. Many companies took advantage of the cheap debt of the past decade and did just those things. One of the main reasons I expect overall annual stock market returns to be nearer the 5-6% range going forward rather than the recent 8-10% we have been seeing is the inability to lever up to improve returns. Companies are rightly wary of taking on debt when it will potentially lower their credit rating and in turn increase their cost of borrowing and many companies are near that line now.
This is why companies with large cash hoards have such an advantage in a high interest rate environment. The benefit is two-fold. Flexibility is the obvious benefit. Management can still invest in promising opportunities as they see fit, without the added stress of taking on debt to do so. It gives them more options to find value. They don’t have overextend to cut costs, which while helpful for hitting short-term numbers, is almost always a long-term negative for the company. The second benefit is mostly passive. With higher rates, cash hoards earn more interest. This takes pressure off of management to deploy the cash in a (potentially) negative manner. Shareholders are right to pressure management to find an effective use for cash when rates are low. I can think of a lot better ways to utilize $10 billion when it is only earning 1%. With higher rates, the opportunity cost for that money goes down, as you need higher quality, higher returning investments beat the risk-free rate.
While I’m not advocating going out and blindly buying all the companies with the highest cash hoards right now, I would be willing to bet that on average companies with high cash balances will do better going forward than companies with high debt balances, assuming you are able to buy them at similar valuations.