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; that is, 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 The Hershey Company (NYSE: HSY ) through Tom's merciless gauntlet and see if the American chocolate giant has what it takes to make the Rule-Maker grade.
1. The mass-market, repeat purchase of low-priced goods
Whether it's a bag of foil-wrapped chocolate Kisses, the company's classic chocolate bar (with or without almonds), or a squeeze bottle filled with chocolate syrup just waiting to be poured over your favorite ice cream, Hershey spells chocolate for the masses. Its products can be found in supermarkets, convenience stores, and gas stations all over the developed world.
As it is chocolate for the masses, it always has been affordable. And after that bag of Kisses disappears over a few successive 3:00 AM kitchen raids, you are certain to go buy another, ad infinitum. Hershey 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%. Not all manufacturing sectors are created equal, however, and to be realistic we have to take these differences into account, even for Rule Makers.
As such, with the industry average for gross margin in Hershey's sector at 21.97% trailing twelve months, Hershey, at 42.38%, comes in solidly above that and solidly above peer Kraft's (NYSE: KFT ) 34.98%. Nestle (OTC: NSRGY.PK) manages a little better than Hershey on this metric, coming in at 47.32%. Looking at H.J. Heinz (NYSE: HNZ ) and Campbell Soup (NYSE: CPB ) , two more food conglomerates, they come in respectively at 35.92% and 39.46% on gross margin. Well done, Hershey.
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 10.34% trailing twelve months, Hershey does not disappoint on this metric, nor does Nestle, at 11.33%. Kraft comes in at a decent 6.49%, Heinz at a reasonable 8.46%, and Campbell's at a very good 9.84%.
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. Hershey grew its revenue a big 13.3% year over year, Kraft a reasonable 6.6%, and Heinz a decent 7.2%. Campbell saw -0.70% revenue growth year over year. Well done again, Hershey.
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 $694 million in cash and $1.89 billion in debt, Hershey has a cash-to-debt ratio of 0.37. Kraft has $2.06 billion in cash and $27.5 billion in debt, for a C/D of 0.07. Nestle has $9.55 billion in cash and $24.75 billion in debt, for a C/D of 0.38. Heinz has $883 million in cash and $5.03 billion in debt, for a C/D of 0.17. Campbell has $332 million in cash and $2.97 billion in debt, for a C/D of 0.11.
None of our companies did very well on this metric. Taking out debt is always, in some ways, a bet. The only consolation for any of them 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 receivable low and its accounts payable 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, with 1.25 being the accepted upper end. On this metric, Hershey comes in at a healthy 1.15, Kraft at a very nice 0.77, and Heinz and Campbell at a happy 0.92 and 0.74 respectively. You need to tighten up the ship here just a bit, Hershey, like your peers have done.
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.
Hershey is a big name in chocolate. Again, it's chocolate for the masses, and isn't just confined to the high-end confectionary shops. Everyone knows Hershey, and it's easy to figure out how the company makes money -- it sells chocolate. Easy. No mystery here, and that's the way we like it. As such, Hershey scores as high as is possible on this metric.
Three cheers for Rule-Maker Hershey
Hershey could do a bit better on one or two metrics -- and all of these companies should increase their cash and lessen their debt -- but there's no doubt Hershey makes the Rule-Maker grade. Remember though, businesses and markets are always in motion, 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, Hershey 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 by clicking here now.