7 Stocks That Are Swimming in Cash

Some say cash is king.

And today, many (The Economist, for example) are saying it loudly.

According to The Wall Street Journal, 64,000 companies bit the dust and filed for bankruptcy protection in 2008. Even more terrifyingly, credit markets are bracing for significant increases in corporate default rates in 2009.

For those companies that survived this first wave, the really bad news is that debt will still require repayment, employees will still want their paychecks, and electricity bills will still fall on their doorstep every month. Companies need cash -- and the ones holding a lot of greenbacks should do quite well.

I've found seven companies that have tons of cash, but that doesn't really matter. Let me explain why.

Cash helps, no doubt
I think we can all agree that an adequate amount of cash on the balance sheet is an excellent defense for a company facing complete financial destruction. Without cash on hand, not even the most iconic of companies, from IBM (NYSE:IBM) to Starbucks (NASDAQ:SBUX), could survive. Bear Stearns went under not because of insolvency, but because it had no liquidity.

But there's a bigger problem.

You may be looking at the cash line on a company's balance sheet with the belief that companies with lots of cash will be able to avoid bankruptcy, and therefore be properly positioned to succeed in the future. You might be tempted to buy shares of these companies. Not so fast.

I agree -- to some extent. These companies probably won't file for bankruptcy (in the near term, at least), but it has nothing to do with how well the company can or will do in the future. That train of thought will steer investors into a classic mistake.

Show me the money!
I've selected seven companies with market caps larger than $500 million and cash in excess of 20% of that market cap (which is a lot of cash!) to illustrate a simple point:

Source: Capital IQ, a division of Standard & Poor's.

These are relatively some of the "richest" companies in the world. But that fact alone doesn't have any bearing on whether they make for good investments.

Market beaters? Maybe.
These companies could be burning through cash faster than a teenager with your gold card -- or they could be tossing lots of money into that expensive new pet project that may or may not work. You just can't tell from these figures alone. The financial picture remains incomplete.

A tale of two opposites
Take Apple and Sprint Nextel, for example. Both have lots of cash. But Apple has more than $25 billion in cash, no debt, a ridiculous haul of $9.5 billion in free cash flow in the past 12 months, and an impressive 19.8% return on invested capital.  

Sprint, on the other hand, has $3.7 billion in cash, carries a whopping $22 billion in debt, earned a modest $2.3 billion in free cash flow, but still returned negative 1.2% on invested capital. Oh, and Sprint paid $4.4 billion to its creditors over the past 12 months (including interest payments). Those are two different companies in two remarkably different places.

I'm not saying that Apple is a much better investment than Sprint. (OK, it is.) I'm simply trying to illustrate why looking solely at cash figures can be misleading.

Just one piece of the puzzle
Instead of simply highlighting companies with huge bank vaults, ask yourself whether a given company will be adding to that stockpile in the future or taking away from it. And most important, identify just what the company intends to do with that cash.

Companies sporting generous coffers can't guarantee that their products will sell in the future, or that their industries are sustainable for the long term.

Companies need cash to avoid bankruptcy in the short term, and to operate properly in the medium term. In fact, we Fools like our stocks to support healthy cash cushions in the (likely) event of an emergency. But cash can only get you so far. Companies still need to have a plan -- a good plan -- for that cash.

Truth is stranger than fiction
There is another thing you should know about cash and the people who hold it. According to research confirmed by several different sources, the best managers of cash tend to be, ironically, the same companies that regularly redistribute it back to shareholders in the form of dividends.

As the master of your own money, you can probably appreciate how a dividend-paying company with limited resources must be more disciplined with its spending, because it knows it'll have to pony up a dividend to shareholders on a regular basis. Over the long run, these institutions generally become better stewards of capital.

The difference isn't marginal, either. Research has shown that from 1972 to 2006, S&P 500 dividend-paying stocks actually performed significantly better than their non-paying peers -- by a sizable margin of six percentage points per year! That outperformance can be at least partly explained by the burden (a blessing for shareholders) of having to pay a dividend regularly.

Foolish bottom line
Cash is a good thing. Most companies can sidestep total collapse with lots of the green stuff. But having cash today won't help you navigate the difficult waters of business tomorrow. And it doesn't mean that you, as a shareholder, will ever see a dime of it.

That's why the Motley Fool's Income Investor service not only looks for companies with strong balance sheets -- so they can avoid bankruptcy in the present -- but also demands that their companies develop the long-term fiscal discipline promoted by paying a regular dividend. The strategy works: 83% of our active recommendations are beating the market.

Want to take a free look? Click here for a 30-day trial to the market-beating service.

This story originally ran Feb. 1, 2009. It has been updated.

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Nick Kapur owns shares of Apple and Microsoft and wishes he had more cash. Starbucks, Apple, and UnitedHealth are Motley Fool Stock Advisor recommendations. Sprint Nextel, UnitedHealth, and Starbucks are Inside Value selections. The Motley Fool owns shares of Starbucks and UnitedHealth. The Fool has a disclosure policy.