How much cash is too much? Looking at Apple

In the midst of lots of news about Apple - Steve Jobs taking a leave of absence and a 78% surge in profits reported today - I saw this news story in the Wall Street Journal. The gist of the story is that a portfolio manager who has about $700 million in Apple's stock feels that it should pay out some or all of its $ 50 billion cash balance to investors. I do not know the portfolio manager mentioned in the article, Mr. Bonavico, and I hope that he was misquoted because what he is quoted as saying borders on corporate finance malpractice.

Here is what Mr. Bonavico is purported to have said:"...they (Apple) are leaving money on the table by having such a large cash balance well below their cost of capital. The cash is earning near zero." That is an absurd comparison. Apple's cost of capital is close to 9% but that is for its operating investments in software, hardware and its iTunes store. Cash is invested in near-riskless, liquid investments and the appropriate benchmark (or discount rate) to compare it to  is therefore what you would make on riskless, liquid investment. The three-month T.Bill rate currently is yielding 0.16% and that is all that cash has to make to break even (or to be a zero net present value investment). Cash is not a good or a bad investment. It is a neutral one.

Does that imply that all companies should be allowed to hold on to as much cash as they want to? Not at all. Clearly, some companies accumulate too much cash and their investors would be better off, if that cash were returned to them. The question of how much cash is too much cash is  a debate worth having.  To resolve this debate, though, you have to start off with a clear sense of how or why cash balances affect equity investors in a company. No investor in a company is ever hurt by cash being invested in low return, riskless assets (commercial paper, treasury bills). What investors should worry about is what the company may do with the cash: take bad investments or overpay with acquisitions. I would rather that the cash earn 0.16% in T.Bills than be invested in projects earning 6%, if the cost of capital for those projects is 9%. To make a judgment on whether to attach a "stupidity discount" to cash, investors should look at a company's track record. They should discount cash balances in the hands of companies that have a history of over reacting, poor investments and bad acquisitions. They should not discount cash balances in the hands of companies where managers are selective in their investments and have earned high returns (on both projects and for their investors). In fact, over the last decade, there have been several studies that have looked at how the market prices cash balances and the results support this proposition.

In the case of Apple, a company that has seen its market cap rise almost thirty-fold over the last decade while generating a return on invested capital that exceeds 30%, this debate to me is a no-brainer. Do you trust Apple's managers with your cash? In fact, the real question should be if you don't trust Apple's managers with your cash, what company would you trust with your cash? As an Apple investor (albeit with a lot less than $ 700 million invested) since 1999, I have no complaints and here are the three scenarios relating to cash that I can see unfolding:

a. Do no harm scenario: In this scenario, which is the one that Apple has practiced for the last decade, it invests, when it feels that it has a good product (iPod, iPhone, iPad etc.) to promote and holds on to cash when it does not. Continuing with this scenario does not hurt me, as long as they keep the hits coming. I don't get dividends, but who needs them when you get that price appreciation?
b. Dream scenario: In this one, Apple finds a way to invest its entire cash balance of $ 50 billion right now and manages to earn a 30% return on capital on this investment. While this would clearly jump start and increase value, it does not strike me as viable. A company, even one as good as Apple, just cannot create new products and investments out of thin air and then staff them successfully.
c. Nightmare scenario: In this one, Apple decides that the return on cash (less than 1%) is too low and decides to take operating investments or acquisitions that generate returns that are higher than 1% but lower than the cost of capital. This would be devastating for value. If Apple goes on an extended buying spree, acquiring companies at outrageous premiums, I would join Mr. Bonavico in demanding my cash back.
d. Listen to Mr. Bonavico scenario: In this one, Apple returns $ 50 billion in dividends immediately. As an investor, I will get a big check in the mail (for dividends) on which I will have to pay taxes, but the stock price will decline by roughly the dividend. In fact, there is a very real chance that a big payout could be viewed by the market as a negative signal of future prospects and that the stock price could drop by more. (If the alternative is a stock buyback, the same problems exist though they will manifest themselves in a different way)

I have an extended paper on the value of cash and cross holdings (another widely misunderstood asset) that you can access at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=841485
Have a go at it!