<THE RULE MAKER PORTFOLIO>

Thoughts on the Rule Maker Ranker

By Phil Weiss (TMF Grape)

TOWACO, NJ (June 7, 1999) -- This week, our theme focuses on some of our favorite message board threads. We hope that this week's reports serve as a reminder that some of the highest quality information available in Fooldom is found on our message boards. There, you'll find intelligent contributions from Fools all over the world. For those who are strapped for time, the Post of the Day (along with the "runners-up" listed at the bottom) is a way to see the best that our community has to offer each day.

Tonight, I'm going to share some thoughts on four of my favorite threads:

The first two of these threads actually evolved from the posting of the latest Ranker results for Pfizer (NYSE: PFE) and Microsoft (Nasdaq: MSFT) on our companies boards. The third came from a question that arose after a Maker Spreadsheet was posted for Ford Motor Company (NYSE: F). The last is from our Rule Maker Beginner's Board. I'm discussing these threads in conjunction because they all address various aspects of the Rule Maker Ranker spreadsheet (free download links at bottom) that I think merit additional discussion.

Before delving into the specifics of the threads that I've highlighted above, I think it would be worthwhile to discuss the purpose of the Rule Maker Ranker. Just about every day, you'll find Fools posting analyses of potential Makers on our Companies Board. So far, more than 80 companies have been reviewed. Here's the current Master List.

This Foolish research is great and very informative. But let's not forget that the Ranker is not the be-all and end-all of Foolish stock analysis. As a starting point for research, it's a good categorization tool, but more work is required to really understand a company. The Ranker takes an objective look at the quality of a company's financial statements. Plus, it gives us a feel for how a company compares to its competitors. It also gauges some of the more subjective aspects of a company, such as your familiarity of the company's products or services.

For some more Foolish thoughts on the utility of the Ranker, check out this post from "spencersdada."

To my way of thinking, though, there are a few things missing from the Ranker. Personally, I track my own holdings in a spreadsheet that captures the additional quantitative measures that are of interest to me. But, there's no way a spreadsheet alone can give a complete understanding of a company's future prospects. The strength of a company's financial statements is a critical indicator of business quality, but the best way to get a sense of a company's future is to study its business both in terms of its current position as well as its potential for the future.

So, now that I've said the Ranker is not the be-all and end-all to Foolish research, does that mean we should stop using it or stop trying to improve it. ABSOLUTELY NOT! Anything that's helpful in the research process is worth improving and tweaking whenever we can. No model is perfect, but with experience and knowledge, we can make it better and better.

My concern about the Ranker is that although we say we're investing for the long haul, I sometimes wonder if we over-emphasize the Financial Direction score, which has a short-term focus. Currently, the Financial Location section earns a maximum of 12 points versus the potential for 21 for Financial Direction. We've often said that a company's direction is more important than its present location, but is it 75% (21 divided by 12) more important?

For me, one of the toughest parts of the process is assessing the companies that are at the far-right or far-left of the distribution curve for our financial metrics. For example, if Microsoft's Flow ratio increases from 0.30 to 0.31 and EMC's decreases from 2.25 to 2.18, which deserves more (or any) points? Using that example, each company's Flowie moved by 3%. Even though Microsoft's Flowie is well below our standard of 1.0, it earns zero points because its Flowie increased, albeit by a small amount. EMC, on the other hand, earns a point for the slight decline, even though it is well above our standard. Clearly, Microsoft operates with leaner working capital, but we are rewarding EMC for heading in the right direction, even though it has a long way to go. Is this right?

I see advantages in placing qualifiers on the numerical criteria under the Financial Direction category. Let me explain. I think we should consider setting some standards of excellence that reward a company with a top score (three points) for its Flow ratio, its ratio of cash-to-debt, its gross margins, and its net margins in the direction segment of the Ranker. (See Rule Maker Step 6 if you're unfamiliar with these terms.) As a corollary to this, I'd also automatically give some companies a score of zero even if these metrics were improving, if they were pretty anemic to start with. I've been toying around with some ideas of how I think this might work.

Here's what I've come up with so far:

Flow Ratio -- It's uncommon to find companies with a Flowie of less than 0.75. But I don't want to give companies a max score too liberally. Here's my proposal: If a company has a Flow ratio of less than 0.5 (50% less than our standard of 1.0) and a period-to-period change of less than 10%, it gets the maximum three points. A Flow ratio of more than 2.0 (100% above our standard) and period-to-period improvement of less than 10% gets a goose egg.

Cash to Debt (CTD) -- I don't want to mess with this one on the high-end at all -- zero debt for the top score. If a company has any interest-bearing debt, then it earns two points only if its cash position has improved in accordance with our existing standards (i.e., CTD above 1.5). On the low-end, companies with cash-to-debt ratios of less than 0.5 with period-to-period improvement of less than 10% get an automatic zero points.

Gross Margin -- More than 84% (40% above our standard of 60%) with a period-to-period change of less than 10% gives a company a maximum score of three points. I'm not sure what to do on the low-end as it could too easily lower the scores of the Merchant Kings. However, that may not be a big consideration, as those companies should be tested using different criteria anyway.

Net Margin -- More than 20% (100% above our standard of 10%) with a period-to-period change of less than 10% gets a maximum score of three points. As with gross margins, I'm not sure what to do on the low-end yet.

Another excellent suggestion about a way to approach this situation came from "RobinAllenson" in this post on our Companies Board. Robin made the following suggestion:

"Why not keep the scores the way they are now but also add a 'momentum' score based on the numbers of quarters that the Flowie is under a certain number (the same could apply to margins and cash-to-debt as well)?"

This was suggested as a means of rewarding those companies that have had sustained excellence and efficiency while also reducing the hurt for a little bit of a bad quarter. The proposal would involve more work because it would require looking at a number of quarters worth of data (4-8 would probably suffice), but it could be worth the effort. As an alternative to a quarterly test for sustained excellence, you could also substitute a yearly test with 5 sets of year-end data.

The basic premise is to add a category called either history or pedigree that would provide fewer points than the direction or location scores, but could round out the overall scoring system rather nicely.

What do you all think about the alternatives that I've discussed above? Let's continue the discussion over on our Strategy Board. I'll see you there.

Phil Weiss, Fool

06/07/99 Close

Stock Change    Bid
AXP   +2 3/4    128.00
CHV   +  1/2     92.06
CSCO  +  1/2    115.38
EK    +2 3/16    70.19
GM    +  3/4     69.13
GPS   -  7/16    67.31
INTC  +  1/4     53.44
KO    -2         67.75
MSFT  +  11/16   80.25
PFE   -4 1/8    111.00
SGP   -1 3/8     47.50
TROW  -  23/32   36.13
XON   +  3/16    80.88
YHOO  +4 7/16   151.88

                  Day     Month  Year    History
        R-MAKER  -0.06%   2.25%   7.06%  35.47%
        S&P:     +0.51%   2.51%   8.88%  34.69%
        NASDAQ:  +1.85%   2.17%  15.12%  52.71%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     80.25   105.06%
   6/23/98   34 Cisco Syst    58.41    115.38    97.53%
    5/1/98   55 Gap Inc.      34.37     67.31    95.85%
    2/3/98   22 Pfizer        82.30    111.00    34.87%
   2/13/98   44 Intel         42.34     53.44    26.22%
   5/26/98   18 AmExpress    104.07    128.00    23.00%
   2/17/99   16 Yahoo Inc.   126.31    151.88    20.24%
    2/6/98   56 T. Rowe Pr    33.67     36.13     7.28%
   8/21/98   44 Schering-P    47.99     47.50    -1.03%
   2/27/98   27 Coca-Cola     69.11     67.75    -1.96%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     80.88    25.71%
   3/12/98   20 Eastman Ko    63.15     70.19    11.15%
   3/12/98   15 Chevron       83.34     92.06    10.46%
   3/12/98   17 General Mo    72.41     69.13    -4.53%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   3852.00  $1973.55
   6/23/98   34 Cisco Syst  1985.95   3922.75  $1936.80
    5/1/98   55 Gap Inc.    1890.33   3702.19  $1811.86
    2/3/98   22 Pfizer      1810.58   2442.00   $631.42
   2/13/98   44 Intel       1862.83   2351.25   $488.42
   5/26/98   18 AmExpress   1873.20   2304.00   $430.80
   2/17/99   16 Yahoo Inc.  2020.95   2430.00   $409.05
    2/6/98   56 T. Rowe Pr  1885.70   2023.00   $137.30
   8/21/98   44 Schering-P   2111.7   2090.00   -$21.70
   2/27/98   27 Coca-Cola   1865.89   1829.25   -$36.64

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1617.50   $330.80
   3/12/98   20 Eastman Ko  1262.95   1403.75   $140.80
   3/12/98   15 Chevron     1250.14   1380.94   $130.80
   3/12/98   17 General Mo  1230.89   1175.13   -$55.77

                              CASH     $70.09
                             TOTAL  $32593.84

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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