Predicting Payouts

Research by Gerard Hoberg and Nagpurnanand Prabhala

After once competing almost exclusively with other computer makers, Apple has had to battle a more diverse group of rivals since launching its extensive line of music players, phones and tablets.

Despite the skyrocketing popularity of the products and Apple’s financial success, some major investors have criticized the company for holding onto too much cash.

A pair of Smith researchers found the kind of dynamic pressure applied by Apple’s emerging competitors might be one reason some public companies are more likely to hold cash and less likely to pay dividends or repurchase stock.

Finance professors Gerard Hoberg and Nagpurnanand Prabhala developed a new measure that uses SEC descriptions to identify new challengers that impact “product fluidity.” Their research, titled “Product Market Threats, Payouts, and Financial Flexibility,” appeared in the February 2014 issue of The Journal of Finance.

Computational linguistics allowed Hoberg and Prabhala, along with Gordon Phillips of the University of Southern California, to identify companies most at risk for market encroachment — and predict which ones would be most likely to adopt conservative cash reserve policies.

“People should really understand that the financial world is far more dynamic and changing than it once was,” Hoberg says. “You want to understand where it’s going next.”

The researchers examined nearly 43,000 documents, using keywords to count how many new competitors were entering an existing product space. Products in markets where firms are most rapidly revising their product vocabularies are considered highly fluid.

The researchers found gambling to be an industry in flux in the late 1990s, as online threats, legal changes and Native American casinos brought in more competition. Likewise, biotechnology firms in 2008 faced fluidity as health care regulation and government approvals changed.

Today, communication and media companies are working in multiple arenas, and many of their product lines invite competition. “Anything that you do is copied very quickly,” Prabhala says.

He compares the team’s research process to combing through social media feeds to determine who has the most activity and new friends. The research also easily identifies stagnant products and industries, such as lumber, chemicals and supermarkets.

“Managers in those areas probably don’t need to hold a lot of cash,” Hoberg says. He cautions, however, that it is not necessarily easier for investors in these stagnant areas to demand payouts because managers might have personal incentives to keep cash in reserve.

“Companies that hold more cash are better able to respond to threats,” Hoberg says. “They could tap their reserve to innovate or add to a product line, or they might acquire companies that can improve their existing products and services.”

The cash might also be an incentive to unrelated companies who develop complementary products. As an example, Prabhala mentions an eyewear maker whose product works with Google Glass, knowing that Google is a solvent company with the ability to defend its market share.

In total, nonfinancial businesses in the United States doubled their cash balances to about $1.3 trillion during the course of Hoberg and Prabhala’s study from 1997 to 2008.

“Holding stockpiles of cash definitely affects the market as a whole,” Hoberg says. “That has to change the decision-making of the rivals. You also have to ask if investors understand why the cash is there. And, second, are managers taking this too far?”

Ideally, the researchers say, firms should be more willing to return cash to investors when their product stabilizes.

In the case of Apple, the company initiated a quarterly dividend and a $45 billion buyback program in 2012, and billionaire investor Carl Ichan recently abandoned his proposal to get Apple to buy back even more stock. 

Guidance for Investors

The Hoberg and Phillips Data Library, updated in March 2014 to include data through 2011, has had more than 24,000 page views from more than 50 countries — an indication of the competitive insights available. Investors can apply the research in two ways:

• Visit the online library and check the fluidity scores of specific firms. High scores suggest competitive threats — a strong incentive to hold cash and delay dividend payouts.
• Follow industry trends in real time to identify fluid product markets in which rivals frequently add new features. The cellphone industry, for example, has had this feel of constant change as smartphone technology has emerged.