Considering Cash Flow, These Stocks Look Strong.

Over the years, I've made a lot of good stock picks in this column. But some stocks I recommended a year ago aren't among them.

At the end of August last year, I chose eight stocks that looked cheap based on the price-to-cash-flow ratio. Of the eight, six have declined. Only one -- Cordant Technologies Inc., which was acquired by Alcoa Inc. for a 39 percent gain -- has beaten the 15 percent return on the Standard & Poor's 500 index since Aug. 31, 1999 (including reinvested dividends). The average result was a loss of 2.6 percent.

Sorry for the clunkers. I am coming back for a second try because I still believe that the price-to-cash-flow ratio is a good stock-picking tool. It deserves a place in a value investor's arsenal, along with more-familiar tools such as the price-earnings ratio and the price-book ratio.

So today we'll try a few fresh picks of stocks that look good based on cash flow, and then revisit some of last year's selections.

Cash flow is corporate earnings plus such non-cash charges as depreciation and amortization. One thing I'll try to do differently this year is to give more weight than I previously did to "free cash flow."

Definition of terms

The Bloomberg database defines free cash flow as cash flow minus capital expenditures. Instead of actual capital expenditures, some analysts use "maintenance cap ex," which is their estimate of a reasonable annual minimum capital expenditure. Still other analysts subtract dividends.

No matter which definition you use, the basic concept is the same. Free cash flow is money that a company can use to pay (or increase) dividends, to fund (or increase) capital expenditures, or to buy back stock.

Blockbuster Inc., the No. 1 video-rental chain, looks very attractive on a cash-flow basis. The company reported a loss of $69 million last year. But that loss reflected more than $1 billion in depreciation charges. Operating cash flow was positive, to the tune of $1.1 billion.

Blockbuster shares are cheap because everyone is afraid it will be run out of town by various forms of video-on-demand. The stock hit a high of $16.88 a share last November, and has recently been trading at almost half that level, or $9. Maybe the doomsayers are right about Blockbuster, but I think people will continue to rent videos for a long time to come.

Another stock that looks good on a cash-flow basis is USEC Inc., a Bethesda, Md. company that produces enriched uranium for nuclear power plants. I own this stock in some client accounts, and have lost money on it so far.

I hope for a recovery, partly because the stock is cheap by a slew of measures. It sells for 3.5 times recent earnings, 0.3 times revenue, 0.4 times book value (corporate net worth per share), 1.9 times last year's cash flow and 2.4 times last year's free cash flow.

Agco Corp., a Duluth, Ga. company that makes and sells agricultural equipment including combines and tractors, is a third possible bargain. It sells for 2.8 times last year's cash flow and 3.4 times last year's free cash flow.

The entire agricultural-equipment business remains depressed. I recommend Agco for long-term, investors, but it is hard to guess when the stock will perk up. Right now it sells for $11 a share, down from about $36 in the middle of 1997.

My fourth and final new pick is Yellow Corp., the parent of Yellow Freight. I'm not a big fan of the trucking industry, but then neither are most investors. That's why Yellow sells for 7 times recent earnings, 0.9 times book value, 0.1 times revenue, 1.6 times last year's cash flow and 4.3 times last year's free cash flow.

When a stock is so cheap, it doesn't take too much to move it up. Yel1ow, based in Overland Park, Kan., earned a decent if unspectacular 13 percent on stockholders' equity last year. It has an OK balance sheet and has been doing a good job of cost cutting.

Now for a few words about last year's picks. In addition to Cordant, they were Alaska Air Group. Inc., CCB Financial Corp., Delta Air Lines Inc., First American Corp., Lafarge Corp., Liberty Financial Cos. and Reinsurance Group of America Inc.

For better or worse, I put my money where my mouth was. At various times, I have owned Cordant, Alaska Air and First American in client accounts. Dreman Value Management, another firm with which I'm associated, has owned CCB Financial.

The two airlines

Alaska Air and Delta both look cheap on cash flow, but Alaska Air currently has negative free cash flow, and Delta sells for 65 times free cash flow.

The best performers in the group were Cordant, up 39 percent, and First American, up 13 percent. The worst were Alaska Air, down 41 percent, and Reinsurance Group, down 12 percent.

CCB Financial was down 18 percent when it was acquired by National Commerce Bancorporation for stock in July. As of early this month, the value of the holding was still down 0.1 percent.

A year ago I said I was puzzled by the dirt-cheap valuations on Liberty Financial. Since then, the stock has drifted 8.1 percent lower, while earnings have inched a little higher. With mediocre profitability but good brand names (such as Colonial Group and Stein Roe & Farnham Inc.), I figure Liberty Mutual would normally be a takeover target. But nobody thinks of it as one because Liberty Mutual Group, a mutual insurance company, owns 71 percent of Liberty Financial.

Lafarge (which makes construction materials), Reinsurance Group of America and First American Financial still look good to me by most measures. But Lafarge sells for 21 times free cash flow (not cheap on that measure), and free cash flow was negative in 1999 for First American.

John Dorfman, president of Dorfman Investments in Boston, is a columnist for Bloomberg News.