Personal view: In troubled times, cash is king

With slow growth and inflation, the prospects for the UK economy are poor. The key to successful investing now, says one professional investor, is to focus on firms with a strong cash flow.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Martin Cholwill, manager of the Royal London Equity Income Trust.

The immediate prospects for the British economy look distinctly unappealing, due to the threats of significantly slower growth, or even a recession, and the potential re-emergence of cost-push inflation. The Bank of England's latest report suggests inflation will accelerate and stay above its targeted range for several quarters. So what's driving these threats?

There has been plenty of newspaper coverage of housing-market woes here and in America. In Britain, consumer spending is coming under pressure from higher food, utility and energy costs. Mortgage payments are also rising the credit crunch is just starting to bite as the banks make loans more expensive and harder to come by. If by the autumn business leaders decide that the economy is set for a difficult 2009, then we may see unemployment starting to edge up yet more bad news, which currently isn't fully reflected in share prices.

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Cost-push inflation is also starting to re-emerge, having been dormant for many years. Oil and other commodity prices have been strong for a while, but more recently food prices have also been climbing. Poor harvests haven't helped, while American policy on biofuels has compounded the problem by linking the price of food to oil in a way that has never been the case before. For America and Western Europe, the disinflationary tail winds that came from moving manufacturing to low-cost, low-wage economies may well have blown themselves out for now.

So what does all this mean for equity investors? A strategy of holding lots of mid- and small-cap shares, which has worked pretty well since 2003, is unlikely to be as effective over the next couple of years. I believe the key to successful investing will be a focus on firms that can offer growing and sustainable dividends. Here it's strong cash flow, not profits, that matter as it is cash flow that pays dividends.

When it comes to individual tips, I advise caution on cyclical consumer stocks. For many consumers it will feel like we are in recession, even if technically we are not. I'm also wary of firms with low cash and big debts, as these are particularly vulnerable when they have to renew their bank facilities. Even some traditionally defensive sectors, such as food manufacturing, will flag as firms struggle to pass on cost increases.

That said, selective financial stocks currently offer some value. One example is Cattles (LSE:CTT), a specialist provider of consumer credit to non-standard customers, which has recently undertaken a rights issue. This should enable it to take advantage of one of the most favourable environments for lending it's seen in many years as mainstream banks retreat from subprime lending. But do remember that when financial shares go wrong, they often go spectacularly wrong, as shareholders in Northern Rock, London Scottish and Paragon will testify.

There's also good value in large-cap stocks, such as Vodafone (LSE:VOD) and AstraZeneca (LSE:AZN). Both offer a growing dividend yield backed by cash flow. Their international diversity protects them from UK consumer woes. Finally, oil majors, such as BP (LSE:BP) and Shell (LSE:RDSB) offer attractive yields backed by resilient cash flow.