Belly up to the bar, Fools! We're laying a foundation of criteria that should help serve us in finding an excellent high-growth investing prospect.
The initial six criteria that we seek in a high-growth company are: Endless new business opportunities; boundless opportunities for the company's existing business(es); a very likely 17-year period of significant growth for the company, not just the industry; management who will speak with us regularly; annual sales growth of at least 20%, or the promise to exceed that; and finally, strong working capital and cash flow along with a Cash King Margin of 20% or more, and a Foolish Flow Ratio of below 1.4, or the promise to exceed these numbers.
Now we present the rest of the criteria. As you read them, think about how you can help us improve them and then post your thoughts at the end. If you haven't read part one yet, however, then skip along, amigo, and read that first. If you're ready for part two, off we go!
High-Growth Company Criteria, Part 2
-- Alongside sales growth of at least 20% year-over-year, the company must have projected five-year earnings per share growth of at least 20% annually. If a company is not yet profitable, it must promise to soon become so, and then grow earnings much more than 20% annually for many years. Remember, our goal is 20% to 25% earnings growth the first four years, 16% to 18% the next five years, and 11% to 12% growth the next eight.
-- We must see tangible evidence that the company's business is not only growing, but that its rate of expansion in the world at large (beyond the business numbers alone) is accelerating. This means that we must see momentum in the signing of new business contracts, in value-adding partnerships or acquisitions, in new product launches when applicable, and in media coverage about the company's progress and rising place in the world. In other words, we want to find a business that is beginning to ride the crest of a rising wave as its products grow in utility and need worldwide.
-- The company must have a lasting sustainable advantage. Taking a page from the Rule Breaker criteria, a sustainable advantage can be gained by patents or inept competitors, for instance. A sustainable advantage can also be gained through the theory of increasing returns, a theory whereby the leading company signs more and more new customers for many reasons. This is especially true of technology companies. (More on this in the future.)
-- The company must have current assets that are at least 1.5 times long-term debt. We do not want to buy a company saddled with too much debt. The company must also have enough funds to bring it to profitability if it is not profitable yet, or it must be financed from operations, with funds to spare, if it is already profitable. We want a company that, although young and still investing heavily in its future, is now able to stand on its own feet financially.
-- The higher the gross margin and return on invested capital (ROIC), the better. However, we will not put a specific hurdle on these numbers today, or perhaps ever. Instead, we'll judge each company on its own merit.
To expound: Gross margin measures the money remaining from sales after the cost of goods sold is removed. A high gross margin, such as Yahoo!'s (Nasdaq: YHOO) or Microsoft's (Nasdaq: MSFT), which top 80%, signals a powerful business model. But, in the same breath, a lower gross margin doesn't by default mean a poor business model. Plus, the number is relative. Paychex (Nasdaq: PAYX), our community-vote leader, has a gross margin of 35%. Many investors consider this high.
We'll expect a software or pharmaceutical company to have a gross margin above 80%, partly because these companies design a single product and can sell it cheaply millions of times. Marimba (Nasdaq: MRBA), a software company on our high-growth list, has a 91% gross margin. With other companies, however, we may be comfortable with a 35% gross margin. We'll also consider return on invested capital on an individual basis.
-- We want to invest in a company that has a market capitalization of no less than $300 million and no more than $50 billion. I recognize that this is a giant range! I like the range because it allows us flexibility. We want to buy a company that is established but is only recently poised, or will soon be poised, to prosper greatly due to its past hard work. This means that the company may be only five years old, worth $500 million, and just beginning to sell its product; or it may be 20 years old, worth $50 billion with $5 billion in sales, but is only now beginning to hit its largest paydirt. The $50 billion company could be poised rise 500% in 10 years. We want to be able to consider both types (and everything in-between) of companies and sizes.
That said, we are capping the maximum market value that we'll consider, because it is easier for a company to grow steeply from a lower value, all things being equal. If you are able to buy a company that has $500 million in market value, by the time that it reaches $5 billion in value, if it does, you will have already made 1,000%. If it becomes a very successful company (and there are handfuls of examples already on our company list), and it rises to $50 billion in value, well... the math is easy. An investor's $10,000 becomes $1 million.
These criteria are and will always be open for modification and improvement. If you have suggestions for us right now, please post them! We'll implement good ideas immediately as we continue our study. Plus, next week we begin to pare down our company list based on these criteria. So, the big ax comes out! See you on Tuesday.
Fool on!
Jeff Fischer, TMF Jeff on the discussion boards.
Related Links:
Our High-Growth Criteria, Part 1, Drip Portfolio, 9/13/00
Our List of High-Growth Companies, Drip Portfolio, 9/12/00
Wanted: 25% Annual Growth, Drip Portfolio, 8/31/00
