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 MasterCard (NYSE: MA ) through Tom's merciless gantlet and see if it has what it takes to make the Rule Maker grade.
1. The mass-market repeat purchase of low-priced goods
MasterCard processes electronic payments. When you swipe your credit card at your favorite coffee shop, or buy a book from your preferred online seller, MasterCard is the behind-the-scenes interface that makes it all possible. The company makes its money by taking a percentage of each sale.
As money moves more and more from being a physical thing you hold in your hand to a burst of data sent between a merchant and your bank account, services that companies like MasterCard provide are going to be more and more in demand. As such, MasterCard easily makes our first Rule Maker grade.
2. Gross margin
Gross margin is an indicator of manufacturing efficiency, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%. With a gross margin of 100% over the trailing 12 months, MasterCard blows this metric away. Rival Discover Financial Services (NYSE: DFS ) also turns in an astonishing 100% TTM gross margin.
Visa (NYSE: V ) turns in the next best performance, with a TTM gross margin of 84.02%. Last in line, but by no means turning in a poor performance, is American Express (NYSE: AXP ) , with a TTM gross margin of 76.37%.
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 29% TTM, MasterCard crushes this metric. Discover comes in at an even better 37% TTM, Visa at a superb 43% TTM, and American Express at a very healthy 17% TTM. Well done to all our companies here.
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.
At 22% year over year, MasterCard is on top of its game, as is Visa, at 14% YOY. Discover knocks this metric out of the park with revenue growth of 45% YOY, while American Express managed 9%.
5. Cash-to-debt ratio
Rule Makers should be cash heavy and debt light, ideally having at least 1.5 times more cash on the balance sheet than debt.
- With $5.18 billion in cash and zero debt, MasterCard is in the best situation possible.
- Visa has $2.96 billion in cash and zero debt, for a perfect C/D of "zero."
- Since Discover and American Express are lenders as well as transaction networks, they have much bigger debt positions than this Rule Maker criterion looks for. With $6.38 billion in cash and $18.76 billion in debt, Discover has the unenviable C/D of 0.34. American Express has $28.15 billion in cash and $60.6 billion in debt, for an almost equally unenviable C/D of 0.46.
6. 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 then divide by current liabilities. The best companies have Foolish flow ratios of 1.0 or less. As of the most recent quarter:
- MasterCard has a Foolish Flow Ratio of 0.57 -- the best of the bunch.
- Visa has a solid F/F of 0.85.
- American Express has an excellent F/F of 0.75.
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.
You know MasterCard very well because, chances are, you use a MasterCard-branded credit card quite regularly or have at some time in the past. Again, as electronic payments have become more and more common worldwide, familiarity with MasterCard and companies like it have become the norm.
Three cheers for Rule Maker MasterCard!
Why MasterCard and not Discover? When Discover performed better on so many of our metrics? First, Discover failed -- big -- on a very important metric, i.e., cash-to-debt ratio, which MasterCard soared on. Second, MasterCard is a much older, more established company than Discover, which is one of the things we're looking for in a Rule Maker. As older, more established companies, Rule Makers don't have to hit every number out of the park. Their beauty lies in their longevity, and their ability to steadily generate revenue and profit quarter after quarter, year after year.
At this point in its development as a business, Discover is more prone to big increases in revenue and earnings growth, as well as big decreases. Slower and steadier is what wins the Rule Maker race. And as MasterCard hit well above all our benchmarks, that's really all we need.
In Rule Breakers, Rule Makers, Tom Gardner goes into even greater depth and detail about what exactly makes a Rule Maker a Rule Maker. 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, MasterCard 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.