Since the onset of the global financial crisis in 2007-08, the administration and the Federal Reserve have implemented policies explicitly designed to spur investment, grow GDP, and reduce unemployment. These actions haven’t worked — certainly not as expected.
The weapons of choice to boost the U.S. economy have been low interest rates, deficit spending, and increased money supply through the Fed’s balance-sheet expansion to over $3 trillion. Yet almost five years later, GDP growth has been anemic at below 2% and at times negative, and aggregate domestic investment is about where it was in 2004, and considerably below the 2006-2007 level.
Optimists believe it’s still too early and that we have spent too little. More of the same would eventually produce good fortune — at least, that’s the hope.
S.P. Kothari is deputy dean and professor of accounting at the MIT Sloan School of Management. He is the author, with Jonathan Lewellen and Jerold Warner, of ”The Behavior of Aggregate Corporate Investment”.
In the wake of the economic crisis, many companies these days seem to be undervalued. The current earnings-to-price ratios are high and often market commentators argue that these ratios reflect good opportunities to invest. However, the emergence of undervalued stocks comes at a time of high market uncertainty so it’s more important than ever for investors to identify strong investment opportunities based on a company’s fundamentals. Read More »
Academic studies have shown that over the past few decades, public firms are increasingly holding large amounts of cash. Curiously, much of this build up in cash savings can be attributed to cash saved from seasoned share issues, which are sales of equity by already public companies.
I examined the share-issuance cash savings of a large number of U.S. firms over a 38-year period. In the 1970s, $1.00 of issuance resulted in $0.23 of cash savings, yet in more recent years, that same $1.00 of issuance resulted in $0.60 of savings. Over my sample period, the amount of cash saved from share issuance increased at an average rate of 2.5% per year.
So what is going on here? My initial reaction was that the firms were issuing shares because their stock was mispriced, thereby taking advantage of naive investors. However, after digging deeper, I found that this was most likely not the case. It turns out that there are good economic reasons for firms to hold onto cash and even to issue shares for the purpose of cash savings.
Consider an emerging pharmaceutical company with a promising pipeline of projects. The company is still early in its lifecycle so its profits are marginal and its cash flows are volatile. The company spends a large amount on R&D and plans to continue doing so in the future. Because the company generates little cash flow, it depends on capital markets to finance its R&D spending.
When a U.S. company owns a subsidiary overseas, it has a big decision to make when it comes to the earnings of that subsidiary. Does it send the money back to the parent company in the U.S. and pay U.S. corporate taxes or does it avoid the U.S. tax by permanently reinvesting the money abroad?
Given that the U.S. has one of the highest corporate tax rates of any country in the world, it’s not surprising that many companies choose not to repatriate the money.
Our current system in the U.S. — known as the worldwide tax system — is one where U.S. companies’ earnings are taxed in the U.S. even if earned overseas. However, companies are not required to pay the U.S. taxes on operating income of foreign subsidiaries until they bring cash home to the U.S. parent company.
My latest paper* focuses on the difficulties that rating agencies face in setting a credit score that accurately reflects the credit quality of a borrower, but also takes into account the effect that score will have on the borrower’s credit quality in the future. When a rating agency cuts a given company’s credit rating, investor confidence in that company’s ability to meet its debt obligations is undermined, making it very difficult for the company to raise cash. The downgrade often becomes a self-fulfilling prophecy.
In my paper I talk about the ideal accurate credit rating environment. It’s important to note that there may be several possible ratings that are accurate for a particular firm or country at any point in time, but some of these ratings lead to more distress than others. I believe rating agencies ought to be careful to select the best rating: one that provides an accurate portrayal of the company’s credit worthiness, but also takes into account the continued existence of the company in question. These ratings – where the agencies have a small bias towards the ultimate survival of the companies they evaluate – allow the companies to borrow money at a lower interest rate and therefore improve their chances of withstanding any financial shocks that may arise.