The Dash for Cash: This story is the second of a three-part series examining the changing shape of company balance sheets in the wake of the coronavirus pandemic.
As the world was turned on its head by the coronavirus pandemic in 2020, so was the traditional logic that companies holding a lot of cash perform more poorly for investors.
S&P 500 companies have been scrambling to shore up balance sheets since mid-February, when it became clear that the U.S. was headed for an economically disruptive lockdown.
That dash for cash has been met with approval by investors. Companies that have bolstered their cash positions, or were already in a strong liquidity position, delivered higher returns than those with relatively low cash ratios in the first five months of 2020, according to Alpha Factory Library, a proprietary collection of global equity selection signals, or alpha factors, available on S&P Global Market Intelligence's Capital IQ platform.
The Alpha Factor Library — which includes more than 570 alpha factors for over 50,000 companies in 94 countries — divides stocks in each sector into five quintiles according to their cash ratios. The return spread is calculated as the difference in returns for stocks in the quintile with the highest cash ratio minus the returns of stocks in the quintile with the lowest cash ratio.
Companies with cash ratios in the upper quintile outperformed in 10 of the 11 sectors that comprise the S&P 500 over the first five months of 2020.
A strong cash position has been particularly decisive in predicting the returns of real estate companies, with a 38.0% difference in performance between the first and fifth quintile.
The second most sensitive sector to cash ratios this year was communications services, with a 22.9% spread, followed by healthcare at 19.2%. Only in the utilities sector did companies with the lowest cash ratios perform better, with a return spread of negative 12.5%.
It is not typical for companies with elevated cash ratios to outperform.
In 2019, returns were higher for companies with low cash ratios in seven of the 11 sectors in the S&P 500. The trend was most marked in materials, where the bottom quintile outperformed the top quintile by 12.7%, followed by consumer discretionary with a 12.0% spread, and industrials with 8%.
"Having a large cash balance means you have an unproductive asset sitting on your balance sheet earning [zero percent]," Temilade Oyeniyi, vice president of quantitative equity strategies at S&P Global Market Intelligence Quantitative Research, said by email. "However, this ratio may be important in a crisis as investors are concerned about which companies will still be around at the end of the crisis and cash becomes a valued asset."
That rule has held since the global financial crisis of 2008 and 2009. Companies with relatively low cash ratios outperformed those with higher cash holdings in the majority of sectors in the decade through the end of 2019, a period when the S&P 500 rose 189.7%.
The return spread was most pronounced for the financials sector, negative 57.4%, followed by real estate, negative 47.1%, and utilities, negative 45.2%. Although as the function of banks is to take deposits and lend, the cash ratio metric is less relevant in the financial sector.
However, relatively high cash ratios were beneficial in some sectors.
In consumer staples and healthcare, the spread is positive over the decade at 34.8% and 32.2%, respectively. Information technology companies with a lot of cash outperformed those with relatively little by 21.9% in that period, reflecting the tremendous cash generation of the segment's giants, such as Apple Inc. and Microsoft Corp.
The wisdom of holding stocks with the strongest balance sheets has increased this year as equity markets went on a rollercoaster ride. The S&P 500 closed at a record high Feb. 19 before sliding 33.9% by March 23 and recovering 70.2% of that decline by the end of May. The benchmark U.S. equity index was 9.8% below its peak as of the close June 29.
U.S. large cap companies saw the need to increase cash holdings soon after it became clear that the pandemic had arrived on American shores.
S&P 500 companies — excluding financials — increased their cash holdings by $250 billion in the first quarter to a record $1.8 trillion, S&P Dow Jones Indices data show.
That helped push up the average cash ratio for the companies on the index by 3.3 percentage points to 17.1% by the end of March, the highest level in at least 16 years, according to data compiled by S&P Global Market Intelligence.
"Hoarding of cash is a replacement for revenues over the coming months," Simon MacAdam, senior global economist at Capital Economics, said in an interview. "The risk we're worried about is the cash running out rather than the cash being held."
S&P Dow Jones Indices and S&P Global Market Intelligence are owned by S&P Global Inc.