Is Your Fund a Cash-Flow Champion or Convert?

As the stock market went into a death spiral this year, many fund managers found religion, and the religion's creed goes something like this: "We only invest in companies with strong balance sheets and consistent free cash flow." It's a good religion to believe in considering that 2008 saw a shut-down in corporate debt markets. But, more importantly, any equity investment contains risk, and investing in companies that generate loads of excess cash should reduce risk. Many large-cap fund managers in particular sold battered financial stocks in favor of blue-chip consumer-goods stocks like  Coca-Cola (KO),  Procter & Gamble (PG), and  Colgate-Palmolive (CL), which have long been big cash-flow generators.

It could be that some of these managers' conversions to cash flow are of the "death-bed" variety and should be treated with caution. Managers who haven't relied heavily on that metric in the past may be less mindful of cash flow as an investment criterion when the market stabilizes, so it's important to recognize which managers have used strong cash flow as a top investment requirement no matter the market's cycle.

Take a Look at the Past
To tell whether your fund managers have made cash flows king of their portfolios, depend not just on their words but on their portfolios' histories. For example,  Tweedy, Browne Value (TWEBX) has stuffed its portfolio with big-cash flow generators, like  Diageo (DEO) and  Comcast (CMCSA), for years, so it came as no surprise to read in their third-quarter market commentary:

"We constantly ask ourselves whether the businesses we own have good fundamental economics and the financial resources to get through a very difficult economic environment and prosper ..."

We'd like to highlight three fund managers that have consistently focused on cash flows, especially because their responses play out differently from one another in their portfolios. First is a fund that holds itself up as the poster child of favoring cash-rich companies:  The Yacktman Fund (YACKX). Since 2004, some of the fund's largest holdings have been in consumer-goods giants, like Coca-Cola and  Kraft Foods (KFT), as well as in cash itself. The portfolio had more than 20% of assets in cash as of Sept. 30, 2008. With investors fleeing stocks of companies whose fortunes are dependent on economic cycles and the commercial paper market, this fund has lost less than 90% of its large-value category rivals for the past 12 months through Nov. 18, 2008. Keep in mind that the Yacktman investing style also has resulted in the fund lagging peers in strong bull markets.

On the cash-focused manager scale, you have a happy medium in  Loomis Sayles Value . Manager Warren Koontz is fond of saying "cash is king" when looking for candidates for his portfolio. The fund's top holdings are classic cash-flow titans like  ExxonMobil (XOM) and  AT&T (T), but the fund doesn't sacrifice its tough balance-sheet standards in its smaller contrarian bets. For example, Koontz recently bought homebuilder  Pulte Homes (PHM) because he expects the company to have $2 billion in cash by year-end 2008. He says Pulte will be able to use its cash to its advantage when the economy recovers. So, even if some names in this portfolio look dicey at first glance, there is bound to be a strong balance-sheet story attached.

Then there are managers who are now emphasizing strong cash flow in their stock picks more than they did before. Some of these managers couple their adaptive stock-picking strategies with enough risk management to be successful in different market cycles.

Take  Federated Capital Appreciation , run by Carol Miller. Miller has always used cash flow along with earnings growth and macro considerations to pick stocks. She emphasizes the three perspectives to different degrees depending on the market's cycle. Recently, the fund has been taking big positions in noncyclical stocks such as  Kroger (KR), the supermarket behemoth that had 2007 earnings before interest and taxes that were 4.9 times its interest expense. While her emphasis on cash flow may not always be evident, her attention to macroeconomic trends led her to avoid financials starting in 2005, when her portfolio was less-defensive looking. Consequently, under Miller's tenure, the fund's three-year annualized return is in the top decile of the large-blend category.

What's the Level of Commitment?
Finally, other managers may have defensive-looking portfolios now, but these funds look like sheep in wolves' clothing.

For example, the team at  Hotchkis and Wiley Mid-Cap Value (HWMIX) said that in response to the credit crisis, it has been adding positions in stocks that it describes as having fortresslike balance sheets with little or no net debt because, in this market environment, it is critical to invest in companies with strong sources of funding. That may be so, but this is also a fund that continued to hold Washington Mutual even after its subprime-related implosion. Thus, it's important to look at the fund's portfolio history to see how committed the manager has been to "fortresslike" balance-sheet strength.

We should add that all managers (and mutual fund analysts) make mistakes, and even Yacktman had a stake in  American International Group  (AIG) through the second quarter of 2008, only months before the government bailed out the company. Just the same, you'll be better off knowing just how committed portfolio managers are to their "cash is king" mantra before investing in their funds.