Tom Gardner developed the Rule Maker investing strategy in the 1990s for investors who didn't want to risk money on speculative upstart companies. Owning shares of Rule Makers -- large, well-known companies that lay down the laws in their markets -- increases your chances of long-term outperformance. Today, we revisit the Rule Maker strategy to see what it has to offer.
The Rule Maker strategy is built upon the idea that individuals should have at least a portion of their portfolio dedicated to rock-solid companies that they do not plan to sell for five to 10 years or longer. This buy-and-hold model limits the commission-, tax-, and opportunity-costs of investing.
The quintessential Rule Making company is one that manufactures products and provides services bought every day or every week by tens of millions of people the world over. This repeated sale of the same profitable item, over and over, results in the methodical accumulation of a mother lode of cash on a Rule Maker's balance sheet.
But a Rule Maker is more than just an industry leader. Certain industries don't yet (and may never) offer the sort of company that would attract a Fool's investment money. For instance, as an investor, the leading maker of sewing machines is likely far less attractive than America's third-best pharmaceutical business. Some industries will create zero Rule Makers, while others may house a half-dozen. Finding Rule Makers is more about finding the appropriate business model for long-term investment than it is about picking the leaders in each category.
There are 10 characteristics that we look for in a worthy Rule Maker investment candidate:
1. At least one sustainable competitive advantage
Companies with sustainable advantages are sheltered from competition. They have powerful brands, a deep-seated corporate culture, low-cost processes, de facto monopolies or standards, patents, or unduplicable distribution systems.
2. Dominant in its given industry
Think of how difficult it would be for another soft drink company to muscle in on Coca-Cola (NYSE: KO ) . Or how much money it would take for a company to duplicate the distribution network of one of the pharmaceutical giants like Merck (NYSE: MRK ) and Pfizer (NYSE: PFE ) . Or to knock Microsoft (Nasdaq: MSFT ) off its perch as operating system leader. A Rule Maker must, in fact, rule. The narrower the industry, the more dominant the company must be.
3. Dominant for more than a decade
This eliminates many different kinds of companies, most notably newer ones. We do not want to assume that companies that have recently ascended to power will stay there forever, because a market changing that rapidly does not generally settle down all at once. We want a company to show that it possesses good economics through a full market cycle. That means having access to 10 years' worth of financial data.
4. Strong free cash flow
The advantage of measuring profits with free cash flow is that cash flow isn't as easily manipulated as net income. We're looking for Rule Makers that generate lots of the green stuff. Coca Cola, for example, generated $4.5 billion of free cash flow on $24 billion in sales in 2006. Microsoft generated $11.9 billion in free cash flow on $46 billion in sales. Strong cash flow allows these companies to pay dividends, buy back shares, and fund new projects.
5. Efficient working capital management
This item is nearly universal. There are very few businesses where the need to pay out money faster than it comes in is a positive attribute. How a business manages the dollars that flow through its daily operations is of critical importance. We want our companies to bring money in quickly, but to pay it out slowly. More cash coming in today, less cash going out today.
6. Sales above $4 billion per year and growing revenues at 10% plus rates
We want big companies, and we would like them to be in industries that have promising futures, evidenced by above-average growth today. Be wary of a company that is growing at slower rates than its competition. Sales growth is the most fundamental indication of an expanding business.
7. Best-of-class management
We won't know everything about a company, and sometimes managements perceived by the public as great turn out to be anything but (example: Enron). Still, you want to try to own companies run by managers who are honest and who show above-average skill at increasing the value of people's investments in good times and in bad.
8. High Return On Invested Capital
Return on Invested Capital (ROIC) measures the amount of money a company creates using its capital base. A company that produces anything below 11% is not providing enough return to compensate investors for the added risk of buying individual equities rather than simply buying an index fund comprised of the S&P 500. Starbucks' (Nasdaq: SBUX ) return on capital of 23% in 2006 blows away most of its competitors.
9. Strong balance sheet
This one is important. Only under extraordinary circumstances would an investor want to buy a company that is being financed by enormous amounts of debt. Some debt is good; bunches of debt introduce an enormous risk to investors. Investors can measure debt using the debt to capital ratio or interest coverage ratio (this article explains more).
10. A reasonable purchase (or holding) price.
We'd like to be able to buy a company at a discount to our calculation of its intrinsic value with the intention of holding until it reaches that value. Some companies might grow and NEVER make it to 100% of fair value -- the prospects for future business might be improving along with the stock price.
Ready to learn more about Rule Maker investing? Great! Stay tuned to Fool.com as we single out our top Rule Maker picks over the next few weeks.
Rule Makers often find their way into our Foolish newsletter services. Coca-Cola, Microsoft, and Pfizer are Motley Fool Inside Value recommendations. Starbucks is a Stock Advisor recommendation. Merck is a former Income Investor recommendation. Try any one of our investing services free for 30 days.
Fool sector editor Joey Khattab updated this article, which was originally part of the Rule Makers Port. He does not own any of the shares mentioned. The Fool has a disclosure policy.