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": a mature, consumer-facing company that's king of its market space, and an investment that can confidently and profitably be 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 approach will benefit even advanced investors. Today we're going to run luxury handbag and accessories manufacturer Coach (NYSE: COH ) 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
Coach, low-priced? Hardly, but it's widely available at least. And items like shoes, handbags, watches, jewelry, and fragrances (all in Coach's bailiwick) wear out or get used up, and need to be replaced. As such, Coach is solid in this first Rule Maker metric.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%.
- With a gross margin of 73% in the trailing 12 months, Coach blows away our first metric. You rarely see a gross margin like this.
- High-end yoga-gear retailer lululemon athletica (Nasdaq: LULU ) , at 56%, does well here, but not as well as Coach.
- High-end jewelry perennial Tiffany (NYSE: TIF ) does exceptionally well on this metric, with a gross margin TTM of 58%.
- Limited Brands (NYSE: LTD ) -- owner of effortlessly elegant brands like Victoria's Secret, Bath & Body Works, and, of course, The Limited -- needs to tighten up its ship here, with a gross margin TTM of only 46%.
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.
- Our hero-in-waiting, Coach, hits a giant 21.81% TTM net-profit margin.
- No slacking here, Lululemon comes in at 18.48% TTM net-profit margin.
- Tiffany also has its house clearly in order, with an 11.88% TTM net-profit margin.
- Limited comes in with a solid, if not exceptional, 7.05% TTM net-profit margin.
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 12% YOY sales growth, Coach lets its investors sleep happily at night.
- So can Lululemon's, with YOY sales growth of 33.1%.
- Tiffany's investors might need some sleep aids after reading this: 1.6% YOY sales growth.
- But everyone beats Limited here, with YOY sales growth of -2.4%.
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:
- $917 million in cash and $23 million in debt give Coach the beautiful, and rarely seen, C/D of 40.
- $444 million in cash and zero debt give Lululemon the best cash-to-debt position of all.
- $367 million in cash and $939 million in debt give Tiffany the unenviable C/D of 0.39.
- Finally, $1.2 billion in cash and $4.6 billion in debt give Limited the even more unenviable C/D of 0.26.
6. The Foolish Flow Ratio
The Foolish Flow Ratio measures how well a company manages its inventory and cash. 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:
- At 1.23, Coach is pushing the FF limit about as far as it can go, but still makes it.
- Lululemon breaks right on through the barrier, with an unacceptable FF of 2.12.
- Tiffany is even worse, with an FF of 5.23.
- Limited finally brings us back into Rule Maker territory, with an FF of 1.09.
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.
Coach sells luxury handbags and accessories: a dead simple business model. And ask any woman if they know of Coach, and you'll likely see their eyes light up like a kid's on Christmas morning. Coach easily hits our final metric.
King of the handbags
The only metric Coach is less than stellar on is the Foolish Flow ratio, but it still hits it: It just doesn't blow it away, like it does most of the others. As such, Coach is easily crowned a Rule Maker.
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 wrote the book on it.
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