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Where Cash Flow Is King | And the Victor Is...

FUND MANAGERS Richard Cervone and James Wiess righted the stumbling Putnam Investors Fund (ticker: PINVX) three years ago, by focusing on quality stocks undone by scandals or short-term concerns. Regional bank Commerce Bancorp (CBH) and search engine Google (GOOG) have been big winners. Cash flow is king to these stockpickers. A close second is Billy Beane, general manager of the Oakland A's. Cervone explains.

What's the allure of Billy Beane?
We try to see value where others don't. Beane is trying to spot players that are better than other scouts think they are. Beane builds a winning team with players that don't cost much, that are, in effect, "undervalued." We're doing the same thing in the stock market -- and we do that by focusing on long-term cash flow.

Warren Buffett remains a strong influence, however?
Yes. We study the great investors and, if appropriate, incorporate what we learn into our investment process. Buffett, quoting Benjamin Graham, says: In the short term the market is a voting machine. In the long-term, it's a weighing machine. That means it's cash flow in the long run that'll determine the value of a business.

How do you get cash-flow estimate right?
We try to quantify how much a business would be worth under different scenarios, assigning probabilities to each. We buy stocks that are trading at the lower end of our fair- value range, building a margin of safety into our purchase price. We always ask: If we were a private investor, how much would we pay for that business?

Where Cash Flow Is King

FORGET WARREN BUFFETT. Investment pros are channeling baseball executive Billy Beane as much as the Oracle of Omaha these days when they go scouting for stocks. The Oakland A's general manager has struck a chord on Wall Street with his ability to build a winning team on a shoestring budget by using unconventional methods to spot talent.

The Beane way has found a natural home with baseball fans and money managers Richard Cervone and James Wiess, who have driven their Putnam Investors (ticker: PINVX) large-capitalization blend fund to the top of the three-year performance rankings by, like Beane, finding value where others don't. To unearth their diamonds in the rough, they look for stocks they believe are selling below the estimated value of the companies' free cash flow. Just as Beane argues that Major League Baseball owners overpay for certain talents, such as strikeouts for pitchers, while underpaying for others, such as a hitter's ability to draw walks, Cervone and Wiess believe investors tend to pay too much for, say, short-term earnings momentum. The managers' 99-stock portfolio includes companies that have been undone by scandals, such as insurer American International Group (AIG), and gold-plated brand names tripped up by passing concerns such as declining consumer spending. In that camp: Nike (NKE) and Harley-Davidson (HDI).

"We don't pay any price for growth," says Cervone. "Free cash flow is what creates value. We put all our efforts in what free cash flow will look like in a few years."

The laser-like focus, reinforced by fundamental and quantitative analysis, propelled the $4 billion fund to a 12.96% annualized return in the three years through Aug. 31, putting it ahead of almost 80% of its peers and slightly in front of the S&P's 500 Index. In an overall lackluster market, Putnam Investors has posted a 4% return this year, through Aug. 31, versus the S&P's 2%. Big winners this year: office-supply retailer Office Depot (ODP), up 73%, and oil and gas producer Amerada Hess (AHC), a 61% gusher. Fannie Mae (FNM), off 29%, has been a downer. The managers' flexibility to pick among growth and value stocks and their measured move into the hot energy sector with recent bets on gas producer Occidental Petroleum (OXY) could boost Putnam Investors' performance sharply by the end of the year, especially if an uptick in consumer spending unleashes the power of holdings such as home-improvement giant Home Depot (HD).

James Wiess, left, and Richard Cervone have drawn inspiration from the talent-acquisition philosophy of the Oakland A's general manager, who believes Major League Baseball is overpaying for some skills while undervaluing others. For the managers of Putnam Investors, Wall Street tends to overvalue growth and undervalue free cash flow.

"We're finding a lot of good ideas," especially in financial and consumer cyclical, says Cervone. Enough, evidently, to share with the Putnam Tax-Smart Equity fund (PATSX), to equally glowing effects. That $285 million offering, also managed by Cervone and Wiess with similar investment strategy, has returned almost 13% over three years through Aug. 31.

Putnam Investors might, itself, qualify as an undervalued asset. Despite its solid three-year performance, the fund is getting little love from investors and Chicago-based Morningstar, which gives Putnam Investor a low rating of two stars, in part because of its sorry five-year record. Over that span, the fund has posted an annualized loss of 8%, dropping it in the performance basement in its category.

The fund's size has shrunk from $8 billion in assets at the end of 1999 and inflow has been flat this year. Investors have soured on Putnam offerings in general, yanking out more than $10 billion out of Putnam's funds during the first half of the year, despite the relatively solid performances of many funds. In contrast, T. Rowe Price (TROW) has pulled in $8.3 billion.

Many Putnam funds crashed after the bull market, and in 2003 some managers at Boston-based Putnam Investments, a division of Marsh & McLennan Cos. (MMC), were accused of market-timing. The firm agreed to pay fines, though it admitted no wrongdoing. Chief Executive Officer Charles Haldeman is trying to repair Putnam's image by, among other things, keeping funds' expenses low (Putnam Investors' 1.05% expense ratio is below the category's 1.21%) and creating funds that "deliver consistent and dependable performance."

Putnam Investors represented much of what plagued Putnam's offerings. During the 1990s, it made outsized bets on growth stocks; it paid dearly when they misfired. In 2001, the fund slumped 25%. The next year, Haldeman installed Cervone, now 39, and Wiess, now 45, two managers whose appreciation for risk and astute reading of quantitative and fundamental analysis mirror his own. One of their first steps was to jettison the fund's growth tilt in favor of more modest sector bets. "Before," Cervone explains, "the fund tried to hit home runs all the time. We try never to have a terrible year." Apart from 2002, when the fund lost 24% in a brutal market, Putnam Investors has been firmly in the black.

Haldeman is counting on the flagship fund to pull investors back to Putnam. "Large-cap core," underscores the CEO, "is a big area of interest for investors."

Morningstar analyst Laura Pavlenko Lutton is warming to the revamped offering. "The fund has performed admirably since the April 2002 transition with reasonable volatility," she says.

Cervone, a Boston native, "fell in love with investing" while working as an architect in New York City and decided he'd prefer designing portfolios to buildings. After getting an MBA from Columbia University, he worked for two years as an equity analyst with Loomis Sayles before joining Putnam in 1998.

Wiess has 18 years in the business, spending eight as portfolio manager at J.P. Morgan Investment Management before joining Putnam in 2000. The New York City native is also chief investment officer of Putnam's U.S. Core team.

Cervone and Wiess have recently been taking profits in some winners to load up on what they call "mispriced" gems. They've trimmed their stake in Amerada Hess, though they remain fans, expecting earnings to increase about 50% next year. Up 65% over the past year, Amerada trades for around 134, well above the managers' average cost in the mid-60s, but still well off the 150 they estimate is its intrinsic value.

They also more than halved their holdings in highflier Google (GOOG) in recent months. After doubling over the past year, Google is trading for 286. The managers' average cost is 190, but Cervone says, "It's not difficult to see fair value in the 350-400 area." Adds Wiess, "We still get a lot of skepticism when we talk about Google." And for good reason: The shares sport a forward price-earnings ratio close to 40. But they believe the Web's top search engine will benefit mightily from increased Internet ad spending.

Apple (AAPL) has also been on a tear. But, like Google, it's still a favorite of Cervone and Wiess, who peg its intrinsic value at 50 to 60, versus the recent 46. Apple commands a forward P/E ratio of 29, which isn't as expensive, notes Cervone, if you strip out its $8 a share in cash. Apple is more than the iPod digital music player. The fund managers see a company unveiling a broader product line at lower price points and with the power to double its 2% share of the PC market over the next several years.

In loading up on Occidental Petroleum, the managers are betting the producer's Middle East operation will boost production beyond expectations and continue to fire up the stock, which is up 59% to 84 in the past year.

Another recent buy, Bank of America (BAC), has seen its shares slide 8% this year, to 43, on concerns about bank earnings and the flat yield curve. But Cervone thinks the bank's acquisition of credit-card issuer MBNA will create long-term value. "The stock is worth around $62 on a base-case forecast," says Cervone.

Such a recovery in Bank of America could help Putnam Investors post its third straight year of positive gains. That would be a winning season for Cervone and Wiess, even if their beloved Red Sox and Billy Beane's A's end theirs on a losing note.

And the Victor Is …

CLOSED-END FUNDS have won a concession that gives minority shareholdlers a greater say when funds try to change managements.

"This will increase the value of all closed-end funds and allow retail investors to be heard rather than having deals simply rubber-stamped," says Thomas Herzfeld, president of Miami-based Thomas J. Herzfeld Advisors. Herzfeld and other minority investors had written to securities regulators, objecting to the proposed $437 billion deal under which Citigroup (ticker: C) will swap its fund unit for Legg Mason's (LM) retail-brokerage network. The objections hinge on how the deal affects management of about $8 billion in 24 closed-end funds, almost half of which trade at discounts of at least 9% to the value of their securities holdings.

THE BOTTOM LINE: With a 12.96% annualized return over three years, beating almost 80% if its peers, the fund has been paring back on big winners like Google and adding "mispriced" gems.

"Unless the change in management is coupled with measures to narrow or eliminate persistent discounts to net asset value in several of the funds, we will have to oppose the new management agreements when they come up for shareholder vote," Herzfeld had warned. For some of the funds, the vote comes up Oct. 21.

Herzfeld learned of his victory obliquely, when Cecilia Gondor, a principal in his firm, noticed it in an SEC filing connected with the swap. So far, Citigroup and Legg Mason have done little to sweeten the lot of the investors in the discounted funds. The New York Stock Exchange usually lets brokers vote their customer proxies at "routine" shareholder meetings.

The precedent-setting reversal has generated a new rule, said a Big Board spokesman. It makes transactions such as a change in a fund investment-advisory contract non-routine, assuring that brokers can't vote without instructions from shareholders.