Relationship between cash holdings and expected equity returns: evidence from Pacific alliance countries.
| Autor | Garavito, Judith Vergara |
| Cargo | Cash holdings |
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Introduction
After the financial crisis of 2008, both academics and professionals have focused their attention on the cash holdings of firms as these are thought to affect the investment prospects, the risk, and therefore, the expected profitability of the stocks in the future (Rao et al., 2013). While there are studies on the determinants of cash holdings, as well as studies on their relationship with the value of the firm, those about the relationship between cash holdings, risk and expected equity return are very scarce. Also, the findings serve as a reference for firms in developed economies such as those of the US and Europe, whose capital markets are deeper and more developed, and therefore, do not present agency problems and information asymmetries, as is the case with markets emerging economies (Deloof, 2003).
According to Uyar and Güngörmü s (2013), emerging markets differ from developed markets in the following aspects, namely, weak regulatory framework, fragile corporate governance, weak protection of minority shareholders and poor disclosure of information. These factors have consequences for firms operating in emerging markets, generating agency problems and an increase in the costs associated with external financing. Therefore, the degree of information asymmetry affects the levels of cash holdings, which means that firms that operate in countries where the levels of information asymmetry are higher have lower levels of cash holdings (Chung et al, 2015). Hence, it was expected that the negative relationship between information asymmetry and cash holdings found for emerging countries would impact the relationship between cash holdings and expected equity return.
Despite being a subject of such importance, few studies address this problem, the works of Palazzo (2012) and Simutin (2010) are clear exceptions. These studies have provided empirical evidence that firms with higher risk, i.e. those that have a greater correlation between their cash flows and the performance of their stocks, generally have higher cash levels, as they are more susceptible to experience cash deficits in the future (Palazzo, 2012). Accordingly, a high level of corporate liquidity will signal financial constraint risk and will be associated with a higher expected return (Wang, 2012). Therefore, if the level of cash holdings indicates various sources of risk such as cash flow volatility and financial constraints, it is expected that those firms that accumulate more liquid assets do so because they have more volatile cash flows, and therefore, high risk is associated with a higher expected equity return (Simutin, 2010).
Nevertheless, these studies are concentrated exclusively in North American firms, whereas, for emerging economies, especially in Latin America, studies are scarce and information on the relationship between cash holdings, risk and expected equity return has not been researched. Given the above, there was a need to observe these relationships in emerging markets, where agency problems and information asymmetry are more pronounced because their capital markets are less developed (Deloof, 2003). In other words, economic and financial structures vary considerably in emerging countries compared to developed countries, and the results of most of these studies for developed countries are not fully replicable and generalized in the context of Latin American economies.
This paper is divided into five sections. Section 2 presents the literature review of cash holdings and expected equity return. Section 3 contains the methodology and provides a deep understanding of the relationship between cash holdings, expected equity return and risk. Section 4 contains the results of the research. Finally, Section 5 concludes and provides recommendations for future research and explains the implications from a perspective both theoretical and practical.
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Literature review
Cash holdings have been a subject of particular interest in corporate finance for the past 20 years. The seminal work of Opler et al. (1999) supports this idea. While it is true that in the literature the study of the determinants of cash holdings accounts for the great majority of contributions, the topic has also been studied concerning other important concepts in the field of corporate finance such as the value of the firm, financial risks and corporate governance. However, few works have studied its relationship with the expected equity return. The search process evidenced that the studies are few and very recent, mainly after the crisis of 2008, when corporate liquidity began to be incorporated as a risk factor capable of predicting expected equity return. The first study to address this relationship corresponds to that of Simutin (2010), in which it was established that there is a positive relationship between the excess of corporate cash and the expected equity return, arguing the firms with more cash in excess have higher market betas and lower yields during market crises. Also, firms with high excess cash invest much more in the future than their low-cash peers but do not experience a higher expected equity return was said by the author. In general, this evidence is consistent with the notion that excess cash holdings represent risky growth options (Brick and Liao, 2017).
Afterwards, Palazzo (2012) carried out a study using a sample of firms such as Simutin (2010) in which he developed and empirically tested a model that highlights how the correlation between cash flows and a source of risk affects the optimal cash holdings policy of a firm. In their model, riskier firms (i.e. firms with a greater correlation between cash flows and risk) are more likely to use external financing to finance their growth option exercises, and thus, gain greater savings. This saving motive, as a precaution, implies a positive relationship between the expected equity returns and the cash holdings; in addition, this positive relationship is stronger for firms with less valuable growth options (Palazzo, 2012).
Similarly, Wang (2012) examines the effect that corporate liquidity has on stock returns of the firm and found that firms with more cash have higher expected equity returns because they engage in higher risks. In general, firms with greater corporate liquidity tend to be smaller, have a higher beta, more volatile cash flows and more financial constraints. He also established that corporate liquidity contains risk information different from that of the size and value factors of the Fama French model, suggesting that corporate liquidity can serve as a proxy for cash flow risk and the risk of the financial constraint of firms (Wang, 2012). Nevertheless, and in contrast to previous studies, Sodjahin (2013) tests the positive relationship between these two variables using a new measure of cash holdings, indicating that, different to Simutin's (2010) and Palazzo's (2012) proposal, it is the changes in the level of cash holdings, not the cash holding alone, which has a greater power to predict the expected equity return. However, their results are in line with the above. Likewise, this relationship was tested by Rao et al. (2013), who concluded that cash holdings can predict the future performance of a firm's stocks and that firms with higher cash holdings, on average, experience higher returns, suggesting that investors should pay close attention to cash holdings when making investment decisions. More recently, Chen et al. (2016), using a real option component of cash holdings, concluded that stock returns of firms with higher cash holdings have a positive correlation with the shock to the real option component.
The literature review process reveals that while the issue of cash holdings has been studied from different approaches, these studies have not addressed the relationship between cash holdings and expected equity return in emerging countries, which are characterized by having a high degree of asymmetry of information. This condition implies the need to theoretically validate the proposed relationships in a scenario characterized by information asymmetry such as the firms that belong to the Pacific Alliance. Thus, as the literature review does retrieve studies for emerging economies, but only a few whose scope only includes developed economies, this condition indicates that there is a gap in the literature in terms of asset valuation models, therefore it becomes the motive for the development of the present research.
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Methodology
3.1 Sampling frame
To examine the relationship between cash holding, risk and expected equity return, we constructed a panel of Pacific Alliance firms. We selected this sample for different reasons. On one hand, on the macroeconomic level, the Pacific Alliance represents a critical trade bloc in Latin America. As Table 1 reports, the Pacific Alliance population represents 3% of the total population of Latin American and the Caribbean. Concerning economic growth, Pacific Alliance countries represent 36% of the total gross domestic product of Latin America and the Caribbean. Similarly, in 2018, the countries of the Pacific Alliance received 45% of total foreign direct investment in Latin America and, as a whole, the four countries make up the eighth largest economy in the world (Alianza del Pacífico, 2020).
Additionally, the stock exchanges and depositories of these four countries represent the largest capital market in Latin America since 2011. This market is named The Latin American Integrated Market, which had a market capitalization of USD 763,573 MM to February 2020 (Mercado Integrado Latinoamericano [MILA], 2020). Table 1 displays some economic indicators of the countries considered in this study.
3.2 Data
We obtained the data used for this research from DataStream. We take quarterly data from the financial statements of the listed firms of the Pacific Alliance countries for the period ranging from 2010 to 2016. Following...
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