Use it or lose it

During my university days, I became intimately familiar with the “use it or lose it” mentality when dealing with public funding. Essentially, the university got a certain amount of funding from public sources and if it didn’t use these funds by the end of the year, it risked a cut in its allocation the following year. This obviously meant that if there was money left towards the end of the year, people scrambled to find ways to spend it, whether that spending made sense or not.

One may count this as wasteful government spending, but it seems something very similar is going on in the supposedly efficiently run businesses in the private sector. But if you think about it, CEOs and CFOs are in a similar situation at the end of the year. If they had a successful year and free cash flows are high, they can decide to bank it and show high net profits and increases in cash holdings, or they can try to spend it on investments.

Normally, one would think they would bank the excess cash flows, but that puts executives at risk of being pressured by shareholders to increase their dividends or share buybacks. And if cash flows are a one-off, they run the risk of having to cut dividends or share buybacks in the future. So, rather than keeping the cash in reserve, they decide to invest it in future growth. The problem is now that they have little time to decide where to invest the cash. After all, by the end of the year, the cash has to be invested in order to reduce free cash flows for the year.

All of that implies that if a company invests a lot in the last quarter of the year compared to the previous three quarters, these investments will probably not be as well thought-out as other investments.

Michela Altieri and Jan Schnitzler have noticed a significant spike in investment activity in the last quarter of a company’s fiscal year and shown that companies that are particularly prone to these last minute investment sprees tend to underperform companies with better investment discipline. The chart below shows the difference in returns between US companies sorted into three terciles based on the relative spike in investment activity in Q4 of each fiscal year. The companies with low investment spikes at the end of the year managed to outperform companies with high investment spikes by about 4% per year with particularly strong outperformance between 1999 and 2004 and again an increasing outperformance since 2015.

Performance of US companies by size of Q4 investment spike

Source: Altieri and Schnitzler (2021).