Business leaders are often asked, how are you going to grow? Where is the growth coming from? Do you plan to make acquisitions? There is a lot of pressure to keep expanding, keep moving forward.
This stems from a ‘growth for growth’s sake’ mindset that can end up damaging companies’ returns, making them less capital-efficient and pushing them toward overpaying on mergers and acquisitions (M&A).
Part of the mindset is the way they think about the company’s cash. Traditionally, managers (and board members as well) have imagined that it's their money they are using, and that returning it to investors is an admission of failure.
But that’s wrong. Companies are allocated a certain level of capital on the basis that they use it to produce a return that’s better than its cost. Sometimes managers have to ask themselves whether it's better not to use the capital and give it back to investors instead. Holding on to large amounts of surplus capital doesn't make sense by itself.
Investors allocate capital to companies because they think that the companies can do more with their money than they can -- otherwise they wouldn't hand it over in the first place. So managers should only accomplish inside the firm, what people outside the firm can’t. If investors could build their own factories, they would do it themselves. I only invest in you, because I think you can earn more than the cost of capital, the required rate of return.
If you can find investment projects with high profits and growth, that's great. But at some point, a manager may just run out of things to do that will meet the required rate of return. And that's the point where they should stop growing, stop investing, stop doing M&A and think about returning money to investors.
“Traditionally, managers and board members have imagined that it's their money they are using”
Even if share buybacks are running at record levels in the US after President Trump’s tax cuts, there may well be room for more. Investors elect board members and board members hire CEOs. A CEO should listen to the board, and the board should listen to investors, and if they don't know what to do with the money they should give it back. However, this is easier said than done.
If corporate governance worked properly, the money would be disgorged to shareholders. If CEOs didn’t act, the board would fire the CEO. Mechanisms should be in place to make this happen. But sometimes the board is either captured by the CEO or believes in the story that the CEO tells them that there is still growth to be had.
No board member wants to sit on the board of a declining company, any more than the CEO wants to lead one, and so the growth-for-growth’s-sake mindset is perpetuated. This suggests that CEOs’ incentives aren’t always properly designed. If they were, they’d be penalised for keeping excess cash in the company, something they would obviously try to avoid.
Make no mistake: growth is a good thing. If you can grow and earn a return above the cost of capital, that's the best outcome. But the second-best outcome is for managers to be open and have the confidence to say, ‘Okay, we've run out of things to do’, and give the money back.
“Even great managers will at some point run out of things to do. It is okay, there should be no stigma attached to it”
Sometimes it is difficult to adjust if you've been growing quickly and then you reached the stage in the business life-cycle where growth slows. It needs to be acknowledged there is a great temptation to hold on to money at this point.
Even great managers will at some point run out of things to do. It is okay, there's should be no stigma attached to it. For example, Apple has bought back around $250bn worth of shares since 2012. But it only increased its level of repurchases after pressure from activist shareholder Carl Icahn. Even Apple needed a nudge to continue the process.
CEOs don't want to run zero cash -- you do want to hold some money back. But there needs to be a good justification for it, and more cash is not always better. It has consequences, because money burns a hole in your pocket. There is some classic research showing that when firms are cash rich, they overpay in M&A.
If you've got all that cash sitting around, you have tons of flexibility. But that also means that you're not going to be so careful. It is much easier to spend money on acquisitions when you've got a lot of money lying around. It is much harder to be disciplined when you're rich. People believe cash is the ultimate insurance. If you've got all that cash sitting around, then no matter what bad things happen, you are going to be okay. If you crash your car, it’s okay, you can buy a new car. So as a result you don't drive the car as carefully, you don't pay the same attention to costs and you don’t run the car as efficiently as you could. The same effect can be seen in organisations. You have to be very careful that the cash cushion doesn't make your organisation lazy.
But that is exactly what’s likely to happen at some point in the cycle, when a cash-rich firm starts itching to boost its growth and earnings prospects. The problem is, no manager wants to face up to the fact that they have run out of good things to do. Some people may say, running out of ideas is not good enough, and sometimes that is true. But they need to be aware that to continue blindly down a route of ‘growth for growth’s sake’ is just as risky.
Henri Servaes is the Richard Brealey Professor of Corporate Governance and Professor of Finance at London Business School.