Step 10: Understand the Rule Maker Investing Philosophy

The Rule Maker investing philosophy begins with the same premise that all Foolish investment philosophies do: You are the best manager for your money.

The Wall Street Wise want you to think you don't have the time or the skills to manage your money profitably. They are dead wrong. In fact, with enough curiosity, discipline, and elbow grease, you have a good shot at generating strong returns over the long haul. In short order, if you make your selections properly, you can acquire a portfolio of roughly 10 gigantic companies that make the rules in our economy. And although these companies are not immune to business cycles, they are extremely unlikely to evaporate. We call these companies Rule Makers.

Leading brand
The criteria for identifying Rule Makers begin with looking for the No. 1 brand name in an industry. And not just the No. 1 brand here in America -- we're talking king of the world brands. What companies come to mind when you think of soda, diamond rings, and microprocessors? We suspect that most people will name Coca-Cola (NYSE: KO), Tiffany (NYSE: TIF), and Intel (Nasdaq: INTC).

Mass-market purchases
Repeated mass-market purchases also characterize Rule Maker companies. People who aren't NBA stars don't buy many automobiles in a year, so General Motors (NYSE: GM) fails this test. Think instead of things you routinely use, either because you like to or you have to: soda, blood-pressure pills, shampoo. Coca-Cola, Pfizer (NYSE: PFE), and Procter & Gamble (NYSE: PG) may come to mind.

Strong historical performance
When searching for Rule Makers, you need to crunch a few numbers. We're not talking about logarithmic progressions -- just a few basic measures of financial performance combined with disciplined research. Start by looking for strong historical performance from the company. Check out the 10-year record. You're buying with the intention of holding for an extended period of time, so you must be certain you're getting a company that richly rewards its owners.

Profitable and growing business
Rule Makers make money, and they're still growing. We look for Rule Makers that have a gross margin (gross profit divided by revenue) above 50%, a net margin (net income divided by revenue) of at least 10%, and sales growing by more than 10% per year.

Cash is king
These companies have been around for a while and have been making loads of dough for years. By now, they should have a nice big vault of cash, with which they can expand their operations in the future and not have to borrow money from anybody else. You can find out how fat a company's coffers are by reading the balance sheet. Looking for a low Foolish Flow Ratio is a special metric of Rule Maker investing. The Flow Ratio reveals whether a company is managing cash flow effectively by demanding payment from its customers quickly (an indication of strength) and paying its obligations slowly.

Strong financial direction
Even more important than past performance, however, is the future. In what direction is the company heading? Since a stock's price will always be tied to the current value of future cash flows -- and how the market views this scenario -- you want the present to look better than the past. Hunt for rising margins, a company that's generating boatloads of free cash flow, and low debt. Compared with industry peers, the Rule Maker candidate should sit at the head of the class.

Long-term buy and hold
Rule Maker investments are meant to be long-term ones. Once you identify and invest in these powerful companies, you should, for the most part, be able to leave your money invested for a decade or longer. This means you won't be making many buy and sell decisions, and you won't be forking over capital-gains taxes to Uncle Sam as a result. You should sell these companies only if they become ridiculously overvalued (a la Cisco in 2000) or if you detect severe financial deterioration.

With some deep-discount brokers charging trading commissions of around $10, a Fool could buy 10 Rule Maker stocks for less than $100, starting with an initial investment between $5,000 and $10,000. Doing so would meet the Foolish aim of keeping commission costs below 2% of the invested principal.

There's a lot more involved in identifying and investing in Rule Makers, but these are some of the core principles, and they should help you decide whether you want to devote a little more time to the strategy.

Your goal when investing in Rule Makers is to beat the market by a few percentage points annually. Beating the market over a 10-year period isn't easy, but picking quality companies with lots of cash, powerful brand names, and proven management is a good place to start.

The Rule Maker strategy hunts for dominating giants, but it's not the only strategy that will find winning stocks. Check out Step 11, where we introduce some other winning approaches. And don't forget to consider checking out our well-regarded newsletter services -- some of the ideas they present will be Rule Makers, too.

Coca-Cola, Intel, and Pfizer are Motley Fool Inside Value recommendations. Pfizer is also an Income Investor pick. The Motley Fool has a disclosure policy.