Hey, Fools! Today's column is meant to answer a common question about Rule Maker investing, namely, "Where should I look to find some new Rule Makers?" Because our Rule Makers, by their very nature, are usually the overdogs of their industries, it's typically not that hard to find them. I mean, where is a company like Microsoft (Nasdaq: MSFT) going to hide?
On the other hand, as has been mentioned many times, size alone is not enough. Our companies must dominate and authoritatively make the rules in their respective industries. But even industry dominance alone is not enough. If dominance of a given industry were all that it takes, companies like Boeing (NYSE: BA), Disney (NYSE: DIS), and Gillette (NYSE: G) would be clear-cut Rule Makers. These companies are obviously big dogs in their kennels, but don't come close to achieving our Rule Maker criteria.
While Disney and Gillette could potentially become Rule Makers by virtue of improving their business results, I feel quite safe in saying that a company like Boeing could never become a Rule Maker, regardless of how efficient the company were to become. This is because Boeing competes in an industry that pretty much prevents any company from becoming a Rule Maker.
For Boeing, just being in the aerospace/defense industry means the company has several strikes against it. If you're looking for either established or emerging Rule Makers to add to your portfolio, you should consider the industry before you start to even consider the factors that the company can control. Let's ponder the defense/aerospace industry for a minute. First of all, Boeing's products carry hefty price tags. There's not a big base of potential customers standing in line with a squillion dollars clamoring to buy planes.
That's not to say that Boeing has trouble selling its wares, because the company consistently has a long backlog of orders. But, the limited number of potential customers that have the ability to pay for these products limits Boeing's pricing power. The company is simply not in a position to mark up its planes by 100% over the material costs of producing them, which is the bare minimum requirement -- gross margins of at least 50% -- for entry into the exclusive Rule Maker club.
At least Boeing is in the position of being able to market planes to commercial airlines, some large companies, foreign governments, and occasionally a wealthy individual. Other companies in the defense industry serve a market of one -- the U.S. government. Want to talk about being at the mercy of your customers! If the Pentagon or whoever decides to stop buying, or even decides that they will only buy at a certain price, well, that's the very definition of being between a rock and a hard place, because the company ends up with a case of severely squeezed margins (also known as "marginitis") in the case of the latter and a scenario too nasty to contemplate in the case of the former.
Another characteristic of the aerospace industry is that it's extremely capital-intensive. This means that for every dollar of earnings the company pulls in, a large chunk of that dollar will head back out the door to be invested in plant renovations or next year's design improvements. Year in, year out, the company has to compete not only with their competitors' new products, but also with their own older products. That doesn't help the company's pricing position one bit
OK, I think you get the drift. Some companies, no matter how big or how well run, are never going to be Rule Makers because they are competing in an industry that doesn't allow any. While I'm not saying that potentially good investments don't exist in these industries, investors are likely to be much better off concentrating their efforts elsewhere.
There are some industries that offer such attractive economics that there is sufficient room for multiple Rule Makers to profitably coexist. Contrary to intuition, it is precisely these industries that would seem to be already fully saturated with Rule Makers that are most likely to see even more companies reach the exalted status. If you are looking for companies that have the potential to be Rule Makers, you might want to start by looking at those industries that already feature multiple Makers.
Let's do a quick experiment. I'm going to name two industries that immediately come to mind when I think of Rule Makers: pharmaceuticals and software. Both industries feature an environment with very attractive economics. Let's look at the drug industry first.
Pharmaceuticals offer high barriers to entry, extended consumer monopolies, and long product cycles. I'll just list the first several companies that come to mind, and check them against our quantitative Rule Maker criteria. I came up with seven companies: Abbott Labs (NYSE: ABT), Bristol-Myers Squibb (NYSE: BMY), Eli Lilly (NYSE: LLY), Johnson & Johnson (NYSE: JNJ), Merck (NYSE: MRK), Pfizer (NYSE: PFE), and Schering-Plough (NYSE: SGP). As you can see in the table below, only one company (Schering-Plough) actually achieves all the criteria for a Rule Maker company. Interestingly enough, almost every other company on the list is close enough to be considered a strong candidate. Pfizer stands out as the only company falling short on our Cash King Margin, although I expect the company to be back over 10% in the future. Eli Lilly is just short in sales growth.
Sales Gross Net Cash/ Flow CK
COMPANY Growth Margin Margin Debt Ratio Margin
Abbott Labs 5.0% 54.6% 18.5% 0.32 1.57 14.8%
Bristol-Myers 10.6% 72.5% 21.0% 0.95 1.61 16.1%
Eli Lilly 8.8% 78.7% 26.9% 1.06 1.14 17.1%
J&J 17.0% 69.5% 16.7% 1.04 1.68 16.6%
Merck 21.6% 46.4% 18.0% 0.53 1.37 10.9%
Pfizer 20.9% 84.3% 19.0% 0.82 1.82 5.9%
Schering-Pl. 13.6% 80.3% 22.9% 2.58 1.22 14.7%
Let's build another table for software companies. Software has lower barriers to entry and faster product cycles, but compensates with the need for standardization, which again allows multiple consumer monopolies, and an ultra-light business model due to having essentially no inventories. Because I am not as familiar with the big software players, only three companies came immediately to mind. Here's the table:
Sales Gross Net Cash/ Flow CK
COMPANY Growth Margin Margin Debt Ratio Margin
Microsoft 21.4% 87.2% 40.2% ND 0.34 58.9%
Adobe 13.5% 90.6% 23.3% ND 0.47 24.5%
Oracle 13.1% 64.9% 14.4% 6.50 0.92 14.7%
Interesting. While I couldn't think of as many companies, the three companies that did come to mind easily o'erleap our Rule Maker hurdles in every category! Based upon this limited sample, one could make the hypothesis that the economics of the software business, at least once a company has achieved critical mass, are even more attractive than that of pharmaceuticals.
Finally, let's look at the aerospace/defense industry. First of all, I couldn't think of another company beyond Boeing, which is probably a bad sign. I was forced to do a little digging to find some other companies to run through our checklist. The results are interesting, and Boeing actually did better than I expected: I give a tip of my Foolish cap to Boeing management and employees for the company's strong Flow Ratio and decent Cash King Margin. On the other hand, the company isn't close in our other four metrics. The other two companies, Northrop Grumman (NYSE: NOC) and Raytheon (NYSE: RTN.B), share the same shortcomings as Boeing: low sales growth, very low gross margins, and tons of debt. Take a look for yourself:
Sales Gross Net Cash/ Flow CK
COMPANY Growth Margin Margin Debt Ratio Margin
Boeing 3.2% 11.5% 4.0% 0.51 0.95 8.3%
Northrop Gr. 1.0% 23.8% 5.2% 0.06 1.18 11.2%
Raytheon 9.6% 17.9% 2.2% 0.01 1.87 -10.8%
For those of you looking to add Rule Makers to your portfolio, my advice is to look to an industry in which Rule Makers are the rule, not the exception. If you're not sure how attractive the industry is, you might want to build yourself a little table like the ones above. You'll likely gain some immediate insight into the industry, and you may even find the Rule Maker you've been looking for!
Until next time, y'all stay Foolish!
NOTES TO TABLE: Abbott Labs, Schering-Plough, and Merck figures are for full fiscal year 1999. Eli Lilly and Bristol-Myers Squibb figures are for the nine months through September 30, 1999. Pfizer and J&J figures are for the nine months through October 3, 1999. Microsoft figures for the six months through Dec 31, 1999. Microsoft's Cash King margin has been changed to reflect tax benefits of options. Oracle figures for six months through November 30, 1999. Adobe figures for full year 1999. Boeing and Northrop Grumman figures are for fiscal year 1999. Raytheon figures are for the nine months ended October 3, 1999.
