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 in 2008. And, terrifyingly still, credit markets continue to brace for significant increases in corporate default rates throughout 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 it 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 like Microsoft (NASDAQ:MSFT) or 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 the companies that can 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 go bankrupt (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 12% 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 don't know with 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 $24 billion in cash and no debt, it hauled in a ridiculous $10.2 billion in free cash flow in the past 12 months, and it returned an impressive 19.0% on invested capital.  

Sprint, on the other hand, has $4.6 billion in cash, carries a whopping $21 billion in debt, earned a much more modest $3.5 billion in free cash flow, but still returned negative 1.1% on capital. Oh, and Sprint had to pay $2.7 billion of that free cash to its creditors over the past 12 months (excluding 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 (it probably is); I'm simply trying to illustrate why looking 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 are going to sell in the future or that their industries are sustainable for the long term.

Cash is necessary -- necessary 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.

The 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 is why the Motley Fool's Income Investor service looks not only 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 that is promoted by paying a regular dividend. The strategy works: 83% of our 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.

Nick Kapur has no positions in any stocks mentioned above. Starbucks, Apple, and United Health are Motley Fool Stock Advisor recommendations. Microsoft is an Inside Value selection. The Motley Fool owns shares of UnitedHealth Group and has a disclosure policy.