Bridge over ocean
1 August 2017 CFA Institute Journal Review

Precautionary Savings with Risky Assets: When Cash Is Not Cash (Digest Summary)

  1. Imrith Ramtohul, CFA
US industrial firms tend to invest significantly in noncash risky financial assets—for example, corporate debt, equity, and mortgage-backed securities. Such risky assets make up 38% of the firms’ financial portfolios, or 6% of total book assets. These assets are held mainly by financially unconstrained firms and by poorly governed firms. Nonfinancial firms may thus be operating in a “shadow” asset management industry subject to minimal regulation and disclosure requirements.

How Is This Research Useful to Practitioners?

A common assumption is that industrial firms invest in cash or risk-free securities. The authors investigate the composition, determinants, and implications of financial assets held by nonfinancial firms. They find that firms hold large portfolios of a variety of financial assets and that the total value of the firms’ financial asset portfolios is about 25% higher than the traditional measure of corporate cash holdings. This finding is attributable to the inclusion of long-term financial assets. Firms also invest heavily in noncash securities, which are both risky and illiquid. The traditional measure of cash holdings consists of at least 23% risky assets, on average.

The authors also show that risky securities represent around 38% of firms’ financial portfolios, or about 6% of the total book value of industrial firms in the S&P 500 Index. Nearly 80% of the risky assets are considered illiquid. Examples of these risky assets include corporate debt, equity, asset-backed and mortgage-backed securities, and government debt (other than US Treasuries). Such trends imply the existence of an important “shadow” asset management industry with minimal regulation and disclosure requirements.

The authors find that investing in illiquid or risky financial assets is suboptimal for financially constrained firms. Moreover, firms with larger portfolios invest more in risky assets. The authors also note that disclosure requirements for financial asset portfolios are limited and that firms are not required to disclose their portfolios’ asset composition or the performance of their investments.

Portfolio managers, analysts, and investors will find the authors’ conclusions useful. Because US nonfinancial firms tend to invest heavily in risky financial assets, the valuation of their investment holdings may register volatility. Managerial overconfidence may also result in firms’ increasing exposure to risky investments. Because disclosure requirements are limited, more analysis is needed to properly assess the risk of the investments being held.

How Did the Authors Conduct This Research?

The authors hand collect data on firms’ financial assets from the footnotes of annual reports (10-Ks) in the US Securities and Exchange Commission’s EDGAR database. Statement of Financial Accounting Standards (SFAS) No. 157 requires firms to disclose the process used to calculate the fair value of their assets. The authors’ sample includes all firms that were members of the S&P 500 at any point between 2009, when SFAS No. 157 became effective, and 2012. All financial firms (SIC 6000–6999) and regulated utilities (SIC 4900–4999) are excluded. The final sample includes 446 firms and 1,727 firm-year observations over four fiscal years. Monthly stock returns are obtained from CRSP, and all other firm-level accounting data are from Compustat.

The authors focus on firms’ nonoperating financial assets, which comprise the balance sheet accounts “cash and cash equivalents” and “short-term investments,” which are typically considered the standard measure of cash holdings, and any additional assets reported as “long-term investments” or “other assets.” Excluded are restricted assets, pension assets, and deferred executive compensation. Risky securities represent 38.3% of the combined financial asset portfolios, or 5.8% of the aggregate book value of industrial firms in the S&P 500. About 79% of risky securities are illiquid, including corporate debt (23.6%), equity (8.6%), asset-backed and mortgage-backed securities (8.4%), and government debt excluding US Treasuries (15.3%). Using a model to assess the motivations and optimality of such behavior, the authors find that both risky and illiquid financial asset holdings increase substantially as a firm becomes more financially unconstrained and holds a larger financial asset portfolio. Risky financial assets tend to be concentrated in large, low-cash-flow-volatility firms with only average investment opportunities. The authors also find that poorly governed firms invest more in risky financial assets.

Abstractor's Viewpoint

Many investors tend to assume that industrial firms invest their surplus cash in low-risk securities, but that is not always the case. Many such firms have important exposures to risky assets, as is evident in the case of financially unconstrained firms and poorly governed firms. That the data used in the analysis cover a very short period (2009–2012) and relate only to the largest listed firms in the United States is concerning. Investors may be unaware of the true risk of holding shares in such industrial firms and thus may be unable to properly assess the strategy and performance of the companies they invest in. Therefore, there might be merit in regulators’ requiring better disclosures of both corporate financial asset portfolios and the performance of the investments held. Moreover, investors could debate whether these firms should focus on their core business rather than invest in risky securities. Shareholders might favor receiving cash dividends instead of being overexposed to risky investments.

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