Merits of Being Cash Rich
One reason companies chose to increase their liquidity was so that they could weather the economic storm (i.e. recession). This is important because if your liquidity is too low, you will not be financially solvent and are in a precarious position if there are immediate cash demands. Here is an example you may be familiar with. Financial expert Dave Ramsey built a $4 million dollar real estate portfolio before he was thirty. Unfortunately, he was ill-liquid and completely over-leveraged. As soon as the Tax Reform Act of 1986 was passed, his primary mortgage holder requested he give them $1.2 million in cash in 90 days. This request forced him into bankruptcy. As many know, this is why he runs his businesses and lives his life debt-free.
In an effort to increase liquidity, companies also aggressively focused on decreasing expenses (i.e. cost-containment). Consequently, profits increased some 27% in the second half of last year. In some cases, this meant changing their existing business model to accommodate changing consumer sentiment regarding discretionary purchases. For luxury real estate developer Toll Brothers, this meant that they lowered their cost of goods sold (COGS). In 2009, the average home they sold was $623,300 plus $126,000 in options. In 2010, they predict that the average home will be $540,000-$560,000. Thus, Toll Brothers has effectively reduced their carrying costs (market exposure) by developing more affordable models. Hopefully, this strategy will be profitable, as McMansions have lost their appeal to some people. Still, McDonald’s huge success with McCafe shows that launching products with better perceived value can be very profitable. Note McDonald’s recently posted solid sales growth, which they partly attributed to their premium coffee offering.
There is yet another reason that businesses have increased their liquidity: to capitalize on newly available opportunities. For those of you who heeded the warning of expanding your cash reserves and deleveraging your life and who have a relatively stable financial foundation, now is the prime time to be looking for some tremendous deals on real estate and stock, mutual funds, etc. In fact, I am finding more and more every day. This is a unique window of opportunity where there are plenty of offerings that are below market value, and you don’t have to be a big business to capitalize on it. You merely have to be prepared. John Paulson is the perfect example of someone who was prepared. He bet against homeowners and shareholders because he knew that prices were too high. This is why he just accumulated cash during the boom, waiting for his opportunity to buy at a discount. In 2007, while the rumblings of a recession were getting louder and the market was teetering, his hedge fund increased a whopping $15 billion and his personal wealth increased by $3.7 billion. David Tepper did the same last year and increased his wealth a whopping $7 billion.