Dueling Fools: Rule Makers

The foundations for Rule Maker investing can be found in one of the earlier passages in Benjamin Graham's The Intelligent Investor, which we at The Motley Fool consider to be among the top investing books of all time.

That passage reads: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

Graham had a very narrow definition of what he thought it meant to be investor, and his protege, Warren Buffett, has evolved into one of the most successful investors of all time by first focusing on preservation of capital. Do anything else, and you might as well head to the casino, because speculating isn't much different from gambling with your money.

Investing intelligently is based on a number of guiding principles, and Rule Maker investing helps Fools translate those principles into a coherent investing plan of attack. In a nutshell, Rule Making consists of a strategy to identify companies whose share prices are likely to outperform the stock market over the long term. To best summarize what we're looking for, I offer a quote from a Motley Fool writer from back when I first became an avid Fool reader:

"A company's raison d'etre is to take financing from given sources and generate returns that exceed the overall cost of that financing."

Specifically, that means finding a firm that is consistently able to earn a return on invested capital, or ROIC, above its cost of capital. That's referred to as weighted average cost of capital, which, ahem, is also tracked and explained by the Motley Fool Rule Breakers team if you're interested in checking out what they're about -- I'll introduce them shortly.

To dig beneath the surface even further, a Rule Maker investment:

  • Has a leading brand that becomes increasingly relevant in our lives.
  • Makes mass-market products or services that are purchased repeatedly.
  • Makes products that are easily accessible and convenient to consumers.
  • Has at least a 10-year track record of strong financial performance, including a strong balance sheet and low debt.
  • Consistently generates strong cash flow and consequently posts a double-digit ROIC.
  • Is expected to continue as a Rule Maker and even increase its dominance.

Rule Maker candidates have made their way onto Motley Fool newsletter recommendation lists. Coca-Cola (NYSE: KO  ) is an Inside Value selection, while Starbucks (Nasdaq: SBUX  ) made the Stock Advisor cut a while back. Other industry leaders include PepsiCo (NYSE: PEP  ) , Cisco (Nasdaq: CSCO  ) , and Intel (Nasdaq: INTC  ) and are arguably Rule Maker-worthy.

A final key ingredient to Rule Maker investing is determining the appropriate price to pay for a company identified as possessing a sustainable competitive advantage. Benjamin Graham weighed in on this subject as well -- he recommended that investors calculate an appropriate margin of safety below their estimate of what a company is worth, also referred to as its intrinsic value.

At this point, you may be asking yourself how Rule Maker investing compares with Rule Breaker investing. I'll leave it up to my Dueling Fools counterpart to fill you in on the specifics, but I like to think of Rule Breakers as Rule Makers in training. In other words, companies aren't magically born as dominant, profitable entities but must identify the key products and conditions necessary to grow into industry leaders. The problem is, to Rule Makers, those younger companies qualify as speculation; we'd rather invest in firms that have already fought their way to the top and better ensure preservation of our capital. If you're interested in more details on Rule Maker investing, this article will shed some more light.  

Go back and read the rest of the arguments. Then vote for the winner.

Coca-Cola is anInside Value recommendation. Check out our value-hunting newsletter service free for 30 days.

Starbucks is a Stock Advisor pick.

Fool contributor Ryan Fuhrmann is long shares of Starbucks and Cisco but has no financial interest in any other company mentioned. The Fool has an ironclad disclosure policy. Feel free to email him with feedback or to discuss any companies mentioned further.

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