RULE MAKER PORTFOLIO

<THE RULE MAKER PORTFOLIO>

Back to Basics, Part 2
Qualitative Business Analysis

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (July 7, 1999) -- Last night, I introduced the 10 investment criteria that are most meaningful to a Rule Maker investor. In case you missed it, here are the Rule Maker Essentials:

  1. Dominant brand
  2. Repeat-purchase business
  3. Convenience
  4. Expanding possibilities
  5. Your familiarity and interest
  6. Sales growth of at least 10%
  7. Gross margins of at least 50%
  8. Net-profit margins of 7% or greater
  9. Cash no less than 1.5x long-term debt
  10. Efficient use of cash (Flow Ratio below 1.25)

Picking up where I left off yesterday, let's dive into criteria #1 - #5. These five, largely written by Tom Gardner, cover some of the important qualitative aspects of a business.

1. Dominant Brand

True Rule Makers are looking to establish a direct connection with billions of consumer minds, day in and day out. And they'd like to consistently draw a clear distinction between their product and the generic, competing brand. For example, when you ask for a tissue during allergy season, there's a good chance you'll call for a Kleenex. And when you head out to buy a pair of jeans next month, you might tell a friend, "I'm going to buy some Levi's."

When a product achieves that instant recognition, that consumer habit, it is Foolishly said to have mindshare. It has burrowed a small home into your cerebellum. And when this happens en masse -- when you, your neighbors, your colleagues and your enemies all say, "Haaa-choooo! Ugh. Eeew! Do you have a Kleenex, Joe?" -- you have an increasingly defensible business. Having one product with mindshare, or better yet several, is the first sign of a true Rule Maker business.

2. Repeat-Purchase Business

We love these businesses because every time a sale is made, the customer is reminded once again of the value of the company's product. The more often this free advertising occurs, the better. A product that is used often but purchased infrequently, such as software or an automobile, benefits from frequent (and hopefully positive) customer contact. However, future income is more predictable when the product or service is actually repurchased often.

Not surprisingly, the more people that know and appreciate the product, the better chance the company's stock will reward shareholders. Because in business it's much harder to reverse the purchasing behavior of millions (or billions) of consumers than it is to reverse the purchasing behavior of a few large, wealthy buyers. If, for instance, one of the five corporate buyers of your $10 million video technology takes its business elsewhere� you just lost 20% of your business! Ouch. Much better is a mass-market base that doesn't shift and that doesn't have an ability to shake the foundation of your business in an instant.

This stability is best accomplished by driving product popularity, consistent branding, the repeat purchasing of low-priced stuff, and a focus on reaching more and more buyers across the planet.

Please note that this should not be interpreted to mean that software or technology companies can't be Rule Makers. On the contrary, Microsoft and Intel, for example, are Rule Makers, in our opinion. Their high gross and profit margins make it easy to overlook any disadvantage that comes from the relatively infrequent purchase of their products, especially since most buyers of their products use them almost daily. One can imagine, also, that in a networked world, we might be buying services from these providers every week or month online.

3. Convenience

To establish Rule Maker authority, a business must position its products as the most accessible and convenient in its industry. History shows that in virtually every consumer sector, there are few ways to underrate the value of being the leader in convenience for customers. Whether it's buying midlevel shelf space in a supermarket, placing the gas station fifty yards closer to the exit ramp, delivering books right to the doorstep, selling coffee on the corner, or preloading software on a computer, convenience for the customer is crucial to a company's long-term success.

To be sure, rating a company's convenience is a highly subjective endeavor and relies on your ability to make a judgment call comparing a company to its lead competitors. Try to determine if a given company provides the most accessible products or services in its industry. The gold star only goes to companies with best-of-class convenience.

The software industry provides an example of a company that excels in convenience. Its name begins with M and ends with T. Microsoft (Nasdaq: MSFT) certainly provides the most conveniently placed software for individuals and corporations. Flip on any computer, a Dell or Gateway, a Compaq or Apple, and preloaded Microsoft icons will peek out at you. Redmond, Washington's software giant committed early on to trying to provide the most accessible and most visible applications for desktop computing.

4. Expanding Possibilities

In the public markets, even more important than the past is the future. We're looking for companies with a direction that's even sweeter than their present location. Sure, historical performance leads us to some great companies, but it doesn't correlate perfectly with future results. Instead, we need to think seriously about a company's future prospects. Is the world going to be buying Beanie Babies in 2010? Does Coca-Cola's brand name have staying power? Are video rental stores going out of business?

Now, the most common mistake an investor can make (financial reporters are particularly prone to this) is to be pessimistic about everything. Gloom-and-doomers can find potential calamity in the cards for any business. You can imagine them taking the following positions:

  • With Coca-Cola -- caffeine will be its eventual undoing.
  • General Electric, they lost Seinfeld at NBC; those guys are toast.
  • Microsoft? When the Justice Department breaks up that monopoly, it'll fall apart.
  • The Gap... they're in a fad business. They can't possibly have staying power.

We're not saying that making these determinations is easy, nor that you shouldn't be skeptical. You'll want to probe your own habits, your own thoughts, read through the company's statements, and ask questions on the message boards to figure if the business you're studying has staying power. And because this one isn't quantifiable, you'll want to return to it again and again. When in doubt, try asking yourself the following questions:

  • Do my friends know about and use the company's products?
  • Is worldwide expansion believable for their stuff?

Strange musings, yes, but you don't typically have to think for more than ten minutes.

5. Your Familiarity and Interest

On the face of it, the last of our qualitative criteria for finding Rule Makers seems absurd. How does your interest and familiarity with a corporation improve its chances of excelling? It doesn't. This requirement, rather than being applied to public companies, is applied to you, the investor. Absent an understanding of what your businesses really do, you open yourself up to subpar returns. The likelihood that you'll understand whether the bumps and bruises along the way are minor nicks or life-threatening injuries for your company is very high if you can understand and follow its progress.

Thus, this criterion of the Rule Maker is that you find it easy to follow the operational direction of the business. It proposes that you'll dramatically improve your chances of scoring above-average investment returns if you weed out the unfamiliar and concentrate on companies whose products, marketing approach, management, and reputation with customers you'll enjoy following. Whether it's dedicated to the business of NASCAR racing, to selling sandwiches, or manufacturing personal computers, a company will more likely serve you well if you know it well.

Tomorrow, we'll look at criteria #6 - #8, which cover the most important metrics of the income statement.

If you'd like to discuss any of these concepts in greater depth, bring your thoughts and ideas to the Rule Maker Beginners or Strategy boards (linked below).

Finally, The Motley Fool Radio Show is holding a financial parodies contest in honor of Weird Al Yankovic's appearance on the program this Saturday, July 10. Check this link for details. You could win a one-year subscription to The Motley Fool Monthly, our newest print publication, plus a Fool ballcap, T-shirt, and a copy of Weird Al's new CD.

Have a great night!

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    07/07/99 Close
    Stock Change    Bid
    AXP   -2 1/4    135.75
    CHV   +1 3/8     99.69
    CSCO  -  7/16    66.25
    EK    +  1/4     70.63
    GM    -1 5/8     70.06
    GPS   -  1/8     49.63
    INTC  +  1/2     64.38
    KO    -  3/8     63.25
    MSFT  +2 3/4     92.31
    PFE   -  1/4     37.75
    SGP   -1 13/16   52.50
    TROW  -2 1/8     37.69
    XON   +  1/4     80.44
    YHOO  -8 1/16   167.06
    

    
                      Day     Month  Year    History
            R-MAKER  -0.78%   2.16%  16.20%  47.03%
            S&P:     +0.56%   1.68%  14.13%  41.14%
            NASDAQ:  +0.23%   2.14%  25.10%  65.96%
    
    Rule Maker Stocks
    
        Rec'd    #  Security     In At       Now    Change
        2/3/98   48 Microsoft     39.13     92.31   135.89%
       6/23/98   68 Cisco Syst    29.21     66.25   126.84%
        5/1/98 82.5 Gap Inc.      22.91     49.63   116.58%
       2/13/98   44 Intel         42.34     64.38    52.05%
        2/3/98   66 Pfizer        27.43     37.75    37.61%
       2/17/99   16 Yahoo Inc.   126.31    167.06    32.26%
       5/26/98   18 AmExpress    104.07    135.75    30.45%
        2/6/98   56 T. Rowe Pr    33.67     37.69    11.92%
       8/21/98   44 Schering-P    47.99     52.50     9.39%
       2/27/98   27 Coca-Cola     69.11     63.25    -8.48%
    
    Foolish Four Stocks
    
        Rec'd    #  Security     In At     Value    Change
       3/12/98   20 Exxon         64.34     80.44    25.03%
       3/12/98   15 Chevron       83.34     99.69    19.61%
       3/12/98   20 Eastman Ko    63.15     70.63    11.84%
       3/12/98   17 General Mo    72.41     70.06    -3.24%
    
    Rule Maker Stocks
    
        Rec'd    #  Security     In At     Value    Change
        2/3/98   48 Microsoft   1878.45   4431.00  $2552.55
       6/23/98   68 Cisco Syst  1985.95   4505.00  $2519.05
        5/1/98 82.5 Gap Inc.    1890.33   4094.06  $2203.73
       2/13/98   44 Intel       1862.83   2832.50   $969.67
        2/3/98   66 Pfizer      1810.58   2491.50   $680.92
       2/17/99   16 Yahoo Inc.  2020.95   2673.00   $652.05
       5/26/98   18 AmExpress   1873.20   2443.50   $570.30
        2/6/98   56 T. Rowe Pr  1885.70   2110.50   $224.80
       8/21/98   44 Schering-P   2111.7   2310.00   $198.30
       2/27/98   27 Coca-Cola   1865.89   1707.75  -$158.14
    
    Foolish Four Stocks
    
        Rec'd    #  Security     In At     Value    Change
       3/12/98   20 Exxon       1286.70   1608.75   $322.05
       3/12/98   15 Chevron     1250.14   1495.31   $245.17
       3/12/98   20 Eastman Ko  1262.95   1412.50   $149.55
       3/12/98   17 General Mo  1230.89   1191.06   -$39.83
    
                                  CASH     $70.09
                                 TOTAL  $35376.53
    
    

    Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.

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