Reward shareholders, invest or just hold

In post-COVID India, economic and political risks would continue to shape corporate policies regarding cash holding, distribution of earnings, acquisitions and investment. An analysis of S&P BSE 500 companies by proxy advisory firm Institutional Investor Advisory Services Ltd (IiAs) recently identified 45 companies that have the potential to generate an additional Rs 68,900 crore for shareholders. This estimation is based on the financial statements of 2021-22, after adjusting for acquisition requirements and capital expenditures which have been announced after the balance sheet date.

The purpose is to focus attention on the fact that a significant amount of excess cash is available for distribution. How should companies return the excess cash to shareholders is the key question. The standard answer is, if the company cannot earn a return which is more than what the shareholder can get elsewhere, often called the ‘hurdle rate’, then it is better to return the money. Normally, this hurdle rate is a little more than the cost of capital.

Distributing Cash

The process of this distribution can differ from one company to another. Dividends are often perceived as some kind of a commitment, a certain degree of ‘stickiness’ gets attached to it irrespective of the future performance of the company. Lowering the dividend rate in subsequent years is always a difficult proposition. Stable dividend payout with a possible step up is becoming the norm. From that point of view, a special dividend or a share buyback are less sticky options. In the case of share buyback, the financial ratios like Return on Equity (RoE) and Return on Assets (RoA) improve.

The next question which arises is, do high payouts and buybacks hinder innovation and investment? For argument’s sake if one assumes that Rs 68,900 crore is given away in the form of payout and buyback, will it not disappear in ostentatious consumption? Cross-country empirical evidence tends to suggest otherwise. Majority of the shareholders are professional investors who switch funds from one sector to another or from one firm to another. There are several shareholder groups in India, these are promoters – both domestic and foreign along with their holding companies and trust, institutional investors – both domestic and foreign, government ­– both central and state, and finally high net-worth investors and retail investors. The bulk of the equity in India belongs to professional investors, retail investors own around 7 percent of it. Once professional investors get the buyback-related amounts, they can switch from an ageing (mature) industry to investing in a promising growth-oriented industry or innovation-driven startup. There are a number of existing industries where the trend in cash generation is much higher than the rate at which it can be utilised. Buybacks and payouts from industries like IT, pharma and FMCG can help the holding company or promoters to invest in new-age industries which could be cash guzzlers initially.

Buying Back

Some Indian companies have been buying back shares consistently in the recent past, these include TCS, Wipro, Balrampur Chini, Aarti Drugs and Jagran Prakashan. There are other operators too, however, they are less consistent and alternate between high dividend payout and buyback. Tax norms can influence the decision too, the dividend distribution tax has been removed but the payout is taxable in the hand of the recipient shareholder. In the case of buyback, the company is taxed and the shareholder doesn’t have to pay. Ownership structure plays an important role in the choice of buyback as a payment option.

Interestingly, PSUs have not been lagging behind in the area of buyback. In 2020-21, Hindustan Petroleum, NTPC, NMDC, Gail India, Nalco and Engineers India participated in the buyback process. The cash transfer through the buyback process helps the government to garner additional non-tax revenue. Further, it also helps the government to meet the disinvestment target.

Managing Uncertainty

Cash holdings have lower returns, so high cash holdings can depress financial ratios like RoE, return on capital employed (RoCE), etc. So, the question that is asked most often is – Why do companies hold cash? Apart from the generic answer that cash is being held for transactional purposes or precautionary purposes, there are some home truths in an emerging economy. The MSME sector often has problems accessing funds, particularly when the availability of liquidity becomes a constraint and rates are high. Secondly, there are some cyclical sectors (e.g., metals, infrastructure and realty) that too have liquidity constraints like MSMEs and prefer to use internal funds when available. Thirdly, given the volatility in the economic environment like the threat of El Niño and recession in advanced countries, the transportation and logistics sectors can get affected adversely in the near future. For these sectors, it is better to use internal funds than pick up a debt obligation. 

Excess cash holdings has two theoretical underpinnings (i) precautionary motive and (ii) agency theory. We have discussed the first one earlier. So far as agency theory is concerned, there could be a conflict between the corporate management and shareholders in the area of excess cash holdings. There may not be many opportunities of deploying the excess cash but corporate management, for purely self-serving purposes, can use the cash for value-destroying acquisitions or unwanted capacity creation and not return it to the shareholders. Indian business history is replete with examples where companies have gone for acquisitions at the height of business cycles or commodity cycles. Basically, at a time when stocks are overvalued.  Hopefully, with increasing shareholder awareness things would improve in the future.

Siddhartha Roy is the former Economic Advisor of the Tata Group. Views are personal, and do not represent the stand of this publication.