When I began investing, I was starting from a knowledge base of zero.
One of the first books I read was The Motley Fool's Rule Breakers, Rule Makers. In it, Motley Fool co-founder Tom Gardner laid out specific criteria for crowning a company a "Rule Maker," i.e., a large, mature, consumer-facing company that's king of its market space, and an investment that can be confidently and profitably held onto for years with only quarterly check-ins.
His step-by-step process for analyzing a business was an easily understandable way for a beginner like me to quickly get up to speed, but its back-to-basics methodology will benefit even advanced investors. Today we're going to run organic-foods retailer Whole Foods Market (Nasdaq: WFM ) through Tom's merciless gauntlet and see whether it has what it takes to make the Rule-Maker grade.
1. The mass-market, repeat purchase of low-priced goods
You don't get much more "mass market" than a supermarket. Even if you're a confirmed bachelor, you're still going to hit a supermarket at least once a week to stock up on everything from fresh produce to prepared food and household goods.
As for "low-priced," anyone who's bought anything organic knows it's always more expensive than non-organic. But relative to, say, automobiles and refrigerators, the consumables at Whole Foods can be considered low-priced. As such, Whole Foods easily makes our first Rule-Maker grade.
2. Gross margin
Gross margin indicates manufacturing efficiency, brand power, and, therefore, pricing power. Per Tom Gardner, the ideal gross margin for a Rule Maker is 60%. However, the supermarket business is unusually cutthroat, and margins are much less robust than in other industries.
Still, Whole Foods' gross margin is at the top of its class, at 35.03% for the trailing 12 months. Strip-mall perennial Safeway's (NYSE: SWY ) TTM gross margin, in comparison, is only 28.16%. Kroger's (NYSE: KR ) is a meager 21.48%, and SUPERVALU's (NYSE: SVU ) is just a hair better at 22.21%. Even Wal-Mart (NYSE: WMT ) can claim only 25.02%. Given its size and resulting economies of scale, you would expect Wal-Mart to have the best of all of them -- which just goes to show how brand appeal, like Whole Foods has, can translate into better margins and, therefore, better profits.
3. Net-profit margin
Net-profit margin dictates how many pennies a company gets to keep from every dollar of sales. Tom Gardner likes to see net-profit margins of 10% for his Rule Makers, but again, in the supermarket business, you'll rarely ever see margins that fat.
Whole Foods' TTM net-profit margin is 3.55%. Safeway's is 1.18%. Kroger's is just 0.67%. (Ouch!) SUPERVALU is actually running in the negative, at -2.88%. Here Wal-Mart is the most competitive against Whole Foods, with a net-profit margin of 3.51%.
4. Sales growth
Year-over-year sales, or revenue, growth counts even for big companies, for which it will naturally slow with age since it's an indicator of business momentum. Top-tier Rule Makers grow their sales by 10% every year, and here Whole Foods fits the bill, having grown its quarterly revenue at 12.9% year over year. At 6.2% YOY, Safeway's quarterly revenue growth was respectable. Kroger did even better, growing its quarterly revenue by 7.6%. SUPERVALU's quarterly revenue, as you might have guessed, declined, by 5%. Wal-Mart, though, grew its sales by a decent 5.8%.
5. Cash-to-debt ratio
Rule Makers should be cash-heavy and debt-light, ideally having at least 1.5 times as much cash as debt. Whole Foods has $849.2 million in cash and $19.33 million in debt, for an impressive cash-to-debt ratio of 44.7. Safeway has $786.2 million in cash and $5.41 million in debt, for a not-so-impressive 0.14.
Kroger has $188 million in cash and $8.21 billion in debt, for an even less-rousing 0.02. SUPERVALU: $157 million in cash and $6.26 billion in debt, or 0.25. Wal-Mart, surprisingly, isn't much better here, with only $6.55 billion in cash and $53.5 billion in debt, for a depressing ratio of of 0.12.
6. The Foolish Flow Ratio
The Foolish Flow Ratio measures how well a company manages its inventory and cash. Specifically, a company should be keeping its inventory and accounts receivables low and its accounts payables high -- strong indicators of market-space dominance.
To calculate the Foolish Flow Ratio, take current assets minus cash, cash equivalents, and short-term investments, and divide by current liabilities. The best companies have Foolish Flow Ratios of 1.0 or less. Whole Foods' is a beautiful 0.82. Kroger and Wal-Mart both come in at a happy 0.78. SUPERVALU? A jolly 0.95. And at 0.69, Safeway beats them all. All of our companies are doing a good job managing their inventories and cash.
7. Your familiarity and interest
What's in a name? A lot. Your familiarity and interest with a company help you understand exactly what it does and how it makes money, thereby lowering your overall investing risk.
Whole Foods' business model really couldn't be easier to understand. Most of us are familiar with how a supermarket works and exactly how it makes money. As for your "familiarity and interest" with Whole Foods itself, if you're part of the organic-foods movement, chances are you've heard of the company. If you're not, you've still probably heard of it.
The Motley Fool's top stock for 2012
Factoring in the extraordinary competitiveness of the supermarket industry, Whole Foods easily meets all of our benchmarks, making it the king of its market space and an undisputed Rule Maker investment. But companies and markets are constantly in motion, so please remember to check in with your Rule Maker investments regularly. Of course, Whole Foods isn't the only easy-to-understand stock you can profitably and confidently hold onto for the long term. Learn about the stock The Motley Fool is calling its top pick for 2012 in this special free report: "The Motley Fool's Top Stock for 2012." Get it while the stock is hot.