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 on to 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 Harley-Davidson (NYSE: HOG ) through Tom's merciless gauntlet and see if the classic American motorcycle manufacturer has what it takes to make the Rule Maker grade.
1. The mass-market, repeat purchase of low-priced goods
While you certainly don't buy a new motorcycle every week, or even every few years, as with cars, if you like the brand well enough you're going to keep coming back to it when you do need a replacement. Harley-Davidson has crazy brand loyalty and, as such, its customers will come back again and again.
And motorcycles, particularly Harleys, aren't necessarily low-priced, but even the highest-end bikes are more affordable than a comparable high-end car. Harley-Davidson doesn't score tops on this first metric, but well enough that we can say it makes our first Rule Maker grade.
2. Gross margin
Gross margin indicates manufacturing efficiency, brand power, and therefore pricing power. The ideal gross margin for a Rule Maker is 60%. Not all manufacturing sectors are created equal, however, and to be realistic we have to take these differences into account, even for Rule Makers. And since there's no perfect, apples-to-apples comparisons for Harley-Davidson, we'll get as close as we can.
Harley-Davidson's gross margin is 36.88% for the trailing 12 months. Heavy-machinery maker Caterpillar's (NYSE: CAT ) is only 26.16%, Ford's (NYSE: F ) a meager 14.5%, and General Motors' (NYSE: GM ) and Toyota's (NYSE: TM ) an even more meager 13.03% and 13.85%, respectively.
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. At 11.28% TTM, Harley doesn't disappoint on this metric. Caterpillar comes in at an admirable 8.19% here, Ford at a big 14.83%, GM at a decent 6.12%, and Toyota at an almost unbelievable 1.07%.
4. Sales growth
Year-over-year sales, or revenue, growth counts even for big companies, where it will naturally slow with age, because it's an indicator of business momentum. Top-tier Rule Makers grow their sales by 10% every year. Harley grew its revenue by a big 9.3% YOY, Caterpillar by a whopping 34.6%, Ford by a less-than-whopping 6.6%, and GM and Toyota by even less, at 3% and 4.1%, respectively.
5. Cash-to-debt ratio
Rule Makers should be cash-heavy and debt-light, ideally having at least 1.5 times more cash than debt. With $1.1 billion in cash and $5.73 billion in debt, Harley has a cash-to-debt ratio of 0.19. Caterpillar has $1.83 billion in cash and $34.6 billion in debt, for a C/D of 0.05. Ford has $22.75 billion in cash and $99.5 billion in debt, for a C/D of 0.23. GM has $31.65 billion in cash and $13.84 billion in debt, for a C/D of 2.28. Toyota has $36.19 billion in cash and $144.42 billion in debt, for a C/D of 0.25.
None of our companies, except for GM, did very well on this metric. Way to go, GM. The only consolation for any of these indebted companies is that money, for the moment, is cheap.
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. On this metric, Harley comes in at a rule-making 0.75, Caterpillar at a slightly sloppy 1.23, Ford at a super-sharp 0.23, and GM a rule-making 0.58. All of our companies, except for Caterpillar, are running a tight ship according to this metric.
7. Your familiarity and interest
What's in a name? A lot. Your familiarity with and interest in a company help you understand exactly what it does and how it makes money, thereby lowering your overall investing risk.
Harley-Davidson is one the world's most famous and most distinctive motorcycle brands. People who know motorcycles, and many who don't, know Harley-Davidson. And the business model is about as straightforward as you can get -- i.e., the company makes and sells big, loud motorbikes. No mystery here, and that's the way a good investment should be.
Three cheers for Rule Maker Harley
Harley could do a bit better on its C/D, but so could just about every other company listed. And while gross margin could be better, Harley is still the best of the bunch. As such, there's no doubt Harley-Davidson makes the Rule Maker grade. Remember, though, that businesses and markets are always in flux, and business positions therefore are subject to change. Check in on all of your Rule Maker investments every quarter.
In Rule Breakers, Rule Makers, Tom Gardner goes into even greater depth and detail about what exactly makes a Rule Maker a Rule Maker. So I suggest you pick up a copy for yourself and get the whole story from the man who, literally, wrote the book on it.
Of course, Harley-Davidson isn't the only easy-to-understand stock you can profitably and confidently hold on to 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 by clicking here now.