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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 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 supermarket chain Whole Foods (Nasdaq: WFM ) through Tom's merciless gauntlet and see if it has what it takes to make the Rule-Maker grade.
1. The mass-market, repeat purchase of low-priced goods
Well, you don't get much more mass market than a supermarket, do you? From fresh food to prepared food to household items, supermarkets cover a wide range of items that we can't seem to go without for very long.
Whole Foods' new twist on this old concept is, of course, that everything in their stores is organically sourced, naturally derived, or proven not be damaging to the environment. You do pay more for just about everything at Whole Foods, but the goods they carry are still relatively low-priced consumer staples. As such, Whole Foods easily makes our first Rule-Maker grade.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%, but industries vary, and the supermarket business has lower overall margins than most. The industry average is 24% in the trailing 12 months, which Whole Foods easily beats with a gross margin of 35%.
Pure play grocers Kroger (NYSE: KR ) and Safeway (NYSE: SWY ) come in at gross margins of 21% and 28% respectively. Target (NYSE: TGT ) and Wal-Mart (NYSE: WMT ) also come in below Whole Foods on this metric, with respective gross margins of 30% and 25%.
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, industries vary. And supermarket margins have notoriously low margins, as mentioned before. Thus, Whole Foods' net profit margin only comes in at 3.7% in the past 12 months, but easily beats Safeway's 1.29% and Kroger's O.66%.
Target actually beats Whole Foods on this metric, with a net-profit margin of 4.15%, as does Wal-Mart, at 3.52%, but these last two aren't apples-to-apples comparisons, as both stores sell a much wider range of products.
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.
On this key metric, Whole Foods comes in at a rule-making 13.6% year over year, versus Safeway's 2.4%, Kroger's and Targets 5.8%, and Wal-Mart's 8.5% sales growth.
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:
- $1.06 billion in cash and $19.23 million in debt give Whole Foods the very enviable C/D of 55.1.
- $181 million in cash and $6.68 billion in debt gives Safeway the very unenviable C/D of 0.03.
- $511 million in cash and $8.14 billion in debt give Kroger almost as poor a C/D as Safeway, at 0.06.
- $690 million in cash and $17.52 billion in debt gives Target a similarly depressing C/D of 0.04.
- Finally, $8.13 billion in cash and $54.82 billion in debt gives Wal-Mart a relatively good, though in absolute terms poor, C/D of 0.13.
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, then divide by current liabilities. The acceptable upper limit for the Foolish flow ratio is 1.25, but the lower the number, the better:
- Whole Foods comes in at a very healthy 0.78.
- Safeway comes in at an also healthy 0.84.
- Kroger does likewise, with a F/F of 0.76.
- Wal-Mart does very well on this metric as well, with an F/F of 0.71.
- Target, the worst of the bunch, still comes in below the upper limit, with an F/F of 1.20.
7. Your familiarity and interest
What's in a name? Quite a bit. 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 doesn't have the name recognition of Safeway yet, or Kroger or Target, but it's getting there. As mentioned previously, the company has a respectable 324 stores and is even in the U.K. now. Whole Foods scores well on this metric, then.
Three cheers for Rule Maker Whole Foods
Barring some industry-specific challenges on margins, Whole Foods meets or exceeds all of our Rule-Maker standards. But remember to check in on Whole Foods or any other Rule Makers you have positions in at least once a quarter, and run them through this simple checklist.
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, 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 by clicking here now.