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The famous value investor Ben Graham was an advocate of investing in "net-nets." These are companies that are trading at less than what the cash, receivables and inventory are worth, minus total liabilities. There are not a lot of net-nets to be found, but you can find a few.

The problem is that often when you invest in a net-net, management spends down the cash in succeeding quarters. So when you revalue your stock, the company has less cash. And unfortunately, the stock reflects this fact.

Case in point: 4 Kids Entertainment ( KDE). 4 Kids produces several cartoons for Fox Television ( NWS) and repurposes these cartoons into trading cards and games for children. Last September, the stock was at $15, and the company held $122 million in current assets and no debt. The market value was about $200 million.

Unfortunately, 4 Kids has burned through $45 million in current assets and now is trading at half of what it was last year. On top of that, management instituted a shareholder rights plan, a "poison pill," to prevent shareholders from gaining access to that cash. That is the hard part of net-nets. Investors can't ever access the cash, because management puts in too many safeguards.

Another company with a similar situation is IDT ( IDT). IDT started off selling long-distance telephone cards. When that business got too competitive, it spread into new enterprises such as animation, debt collection, ethnic groceries and a hodgepodge of other stuff.

Use Free Cash Flow to Avoid Value Traps

Three years ago, IDT was trading at $11 a share and had $10 a share in cash and no debt. Putting a stock like this in front of a value investor is like putting a piece of steak in front of a German shepherd. Marty Whitman of Third Avenue, Bruce Berkowitz of the Fairholme Fund ( FAIRX) and Mason Hawkes of Southeastern Asset Management together own over one-third of IDT. These are the best investors out there, but they've gotten soaked. The stock is below $1!

As with 4 Kids, investors can't get their hands on the cash before it disappears. There are different voting classes of stock at IDT, and guess who holds the share class with the most votes? Management.

Companies like these can drag on forever while management waits for a home run. They often don't have debt, and if they don't have debt, they probably aren't going out of business. You probably won't ever get back to your cost basis in the stock, though.

Another value trap was Handleman OTC ticker: HDLM . Handleman is a jobber. The company would go into retailers such as Wal-Mart ( WMT) and shelve compact discs and assemble displays. Ever hear of MP3 downloads? Talk about a company that was making buggy whips for horse-drawn carriages.

Unlike other companies, the management of Handleman is not going to wait until the last dog dies. It is actually doing the honest thing and returning cash to shareholders.

So what can an investor learn from all of this? Cash and current assets are nice, but they are not the be-all and end-all of investing. Warren Buffett studied under Ben Graham at Columbia and later worked for Graham at his firm, but you don't see Buffett doing many net-nets.

Free cash flow is more important. This what the company keeps after adding back depreciation to net income and subtracting out capital expenditures. TV: Warren Buffett's Investing Philosophy

Alice Schroeder, author of the new Warren Buffett biography 'The Snowball,' details the Oracle of Omaha's investing methods and explains why he recently invested in Goldman Sachs (GS).

To watch the video, click the player below:

Management can take the cash left over and buy back shares, increase the dividend, buy other companies, pay down debt or let the cash accumulate. A stock's price will eventually respond favorably if these five things are taking place. Following this method allows investors to find growing companies, not ones that are bleeding cash.

Let's look at the free cash flow king, Warren Buffett. He is either looking for companies that are at the bottom of a cycle and are going to come up in flows, or companies that are always progressively increasing cash flows.

One of Buffett's newer holdings is Kraft ( KFT). The world won't stop eating cheese, and the company does not have too much debt. Its free cash flow has been about $2.3 billion over the last few years. Buffett obviously believes that this flow will increase in the future and that the stock's price will respond.

GlaxoSmithKline ( GSK) and Sanofi Aventis ( SNY) are two examples of his holdings that have not done much over the past few years. However, they have a ton of drugs in late-stage development. He must believe that the sales from these drugs are going to manifest into free cash flow and, ultimately, an increase in the stock's price.

Remember Buffett's two rules for investing. Rule No. 1: Don't lose money. Rule No. 2: Don't forget Rule No. 1.

This was originally published on RealMoney on Sept. 30, 2008. For more information about subscribing to RealMoney, please click here.

At the time of publication, Osborne owned shares in IDT, Third Avenue, Fairholme, GlaxoSmithKline and Sanofi Aventis. He does not own the other companies mentioned.

Holmes R. Osborne III is a private money manager, founder of investment newsletter and frequent author of financial columns. He has a degree in finance from the Martin J. Whitman School of Management at Syracuse University and is a CFA charter holder. Osborne is a member of the Pacific Council on International Relations, Malibu Rotary, Business Forum International and was formerly on the board of the L.A. National Association of Business Economists. He spoke this year at the fifth annual Value Investor Conference.

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