And earlier this year we even added a new criterion -- Cash King Margin -- but we've always stuck with the target level we originally established for each of our criteria. We've always looked for sales growing by at least 10%, gross margins of at least 50%, net margins of 7% or more, a Cash-to-Debt ratio of at least 1.5, and a flow ratio less than 1.25.
Rule Makers are a rare breed, and as such should truly represent the best of the best. I'm a firm believer that there's nothing wrong with taking a model that works and making it even better. For the most part, I think that the financial criteria I mentioned above are set right around the right level, but there's one I think gives too many companies a free pass. It's also the one that makes it easier to argue that Dell (Nasdaq: DELL) is or is not a Rule Maker.
Personally, while I think Dell is one of the better run companies you'll find today, and one that has certainly provided a top return to its shareholders, I dont think there's a place for it in a portfolio dedicated to Rule Maker investing.
In my opinion, the bar that companies have to o'erleap to surpass our net margin standard is set too low. Before I tell you why and let you know what I think the standard should be, let's take a minute to review net margin.
Net margin is calculated by using this simple formula: Net margin = net income / sales. It's used to measure the percentage of sales dollars left over after all of a company's expenses have been accounted for. We like to see high net margins, as they provide evidence that a company's business model leaves it with a competitive advantage, one that can be seen in the form of superior products, friendlier service, more efficient delivery, or a powerful brand name that's in high demand. If a company has a net margin of more than 7%, then it's earning at least $0.07 on each $1.00 of sales. Most strong Rule Makers deliver net margins well above that level.
If you take a look at this table showing the net margin for each of our current Rule Maker holdings for its most recent fiscal year, you'll see how easy our target is to surpass:
Company Net Margin American Express (NYSE: AXP) 11.6% Cisco (Nasdaq: CSCO) 17.2% Gap (NYSE: GPS) 9.7% Intel (Nasdaq: INTC) 24.9% JDS Uniphase (Nasdaq: JDSU) NA Coke (NYSE: KO) 12.3% Microsoft (Nasdaq: MSFT) 41.5% Nokia (NYSE: NOK) 13.4% Pfizer (NYSE: PFE) 19.8% Schering-Plough (NYSE: SGP) 23% T. Rowe Price (Nasdaq: TROW) 25% Yahoo! (Nasdaq: YHOO) 10.4% Average 18.98%As you can see, most of our companies have as much trouble surpassing our net margin threshold as Michael Jordan would have scoring a key basket with me guarding him. Seven percent is just too low. If you disregard the impact of non-cash, acquisition related charges, the result is that each and every one of our current portfolio holdings easily surpasses the target. It's the only financial statement metric against which we measure our businesses that every company in our portfolio regularly passes.
I ran a screen on research site Multex for companies with a net margin of at least 7% over each of the last two fiscal years. The result was that just over 2,000 companies (more than 25% of the total number of companies screened) surpassed our target. That's just too many in my book.
We want a company's Cash King Margin to be at least 10% and equal to or greater than its net margin. There's no reason that we shouldn't look for its net margin to be at least 10% as well. When I ran the above screen with a 10% net margin, I found that the number of companies that met this target fell by nearly 600 (less than 19% of the total companies I screened). The number of companies passing this screen is still quite large, but it's certainly smaller than the one we get when screening for a net margin of 7%.
Rule Makers are dominant companies. They're companies that should be able to sell their products or services for an amount that's at least twice what it costs to make or provide them (i.e., have a gross margin of at least 50%). That means that these companies have a lot of money left to spend on research and development, selling and marketing their products, pay for all its administrative costs, all its corporate executives, and even provide for a nice holiday party for all its hard-working employees.
We expect Rule Makers to run their business efficiently, which means that they should be able to keep the cost of running the business low and even hopefully lower with the passage of time. Rule Makers have a dominant brand and a strong position in the marketplace. To a certain extent their products should sell themselves. All of these things help to keep costs low. Although it's true that not every company that might be considered a Rule Maker will surpass each of our criteria, they should at least be set at challenging levels.
I think that for purposes of the Rule Maker Essentials spreadsheet we should be looking for companies with a net margin of at least 10%. When it comes to the Rule Maker Ranker spreadsheet (you'll find it on the same page), a company should have a net margin of at least 13% to receive a top score.
Take this poll and let us know what you think on our Rule Maker Strategy discussion board.
In related Rule Maker news, optical networking components company JDS Uniphase reports Q4 earnings after the bell tonight. Look for Phil Weiss to dig deep into the company's performance next week.
