"...John D. Rockefeller, the archetypal capitalist, betrayed a special affinity for accounting and an almost mystic faith in numbers. For Rockefeller, ledgers were sacred books that guided decisions and saved one from fallible emotion. They gauged performance, exposed fraud, and ferreted out hidden inefficiencies. In an imprecise world, they rooted things in a solid empirical reality."

- Ron Chernow, Titan: The Life of John D. Rockefeller, Sr.
Like the legendary oil titan, I'm an avid believer in the power of numbers. Business decisions -- and, by consequence, investment decisions -- should be controlled by reason, not emotion, intuition, or anecdotal evidence. Yet, in the spirit of honest self-evaluation, every month here in the Rule Maker port, we add $500 to our account based on a fairly random selection process. I don't think we can be faulted for a bad job allocating our monthly savings, but I do think we may have fallen short on our mission to educate you the reader.

Perhaps, then, the Rule Maker port should develop and implement a quantitative approach to our monthly buy decisions. (What do you think? Let us know in the poll at bottom.) In that vein, below is my first-draft attempt to piece together and quantify the drivers behind our investment selection process for adding cash to existing holdings. (Note that this process varies somewhat from our approach to selecting new investments.)

I've come up with a fairly simple system that evaluates all 12 of our existing Rule Makers on nine success metrics. As a comparative analysis, all 12 companies are compared to one another and assigned a score of 1-12, with 12 being the best. The criteria are as follows
  1. Revenue Growth -- higher the better
  2. Gross Margins -- higher the better
  3. Net Margins -- higher the better
  4. Net Cash (Cash MINUS Debt) -- higher the better
  5. Foolish Flow Ratio -- lower the better
  6. Cash King Margin -- higher the better
  7. Percent Below 52-week High -- higher the better
  8. Relative Portfolio Position -- lower the better
  9. Market Capitalization -- lower the better
The first six are our usual RM financial criteria, applied to the trailing 12 months of operations. Those six metrics need little explanation beyond the in-depth descriptions on our Rule Maker Criteria page.

One slight twist to take note of, though, is that I tweaked number five to be Net Cash rather than the Cash-to-Debt Ratio. Net Cash (calculated as total cash minus total debt) measures which company has the greatest "war chest" of available cash -- for acquisitions, to ride out economic slumps, or to crush a competitor with price reductions. Since it's impossible to calculate a cash-to-debt ratio for a company with no debt -- such as Cisco or Yahoo! -- the net cash metric serves us better for this comparison. Beyond that little tweak, the first six are pretty straightforward.

The last three success metrics deserve a bit more explanation:

Number seven is the Percent Below 52-week High. With this metric, the question we're asking is, which of our companies has been most beaten down by the market over the near-term? This one may strike you as odd since the Rule Maker approach is generally price-insensitive. It's true that when we buy a new company for the portfolio, to be held for at least ten years, we see little need to raise a fuss over the current price. Why? Because large-cap Rule Makers tend to be priced fairly efficiently by the market, with a bias towards being undervalued rather than overvalued.

So, upon initially finding a Rule Maker, we don't hesitate to purchase it at the going price. But once we have a stable full of Rule Makers and we're looking to throw a $500 bone to one of them, we look for relative value. It's only one-ninth of the overall decision, but we like to be opportunistic with our monthly purchases by comparing how far each stock is trading below its 52-week high.

Number eight is the Relative Portfolio Position. Here in the Rule Maker port, Cisco is our top holding with a 22.8% position. On the other end of the spectrum, beleaguered Coca-Cola represents only 2.9% of assets. We're perfectly happy to let our top performers dominate the portfolio -- up to a 30% cap on any one investment -- but we do still believe in diversification. And thus, in our attempt to maintain a somewhat balanced portfolio, a lower relative portfolio position is more deserving of additional investment dollars.

Number nine is Market Capitalization -- the lower the better. As we've seen with Microsoft this past year, a high market cap invites government antitrust scrutiny. Plus, the law of large numbers makes it more difficult to grow a business that's already generating tens of billions of dollars in annual revenue. As such, we reward our smaller, more-emerging Rule Makers.

So, there you have it -- a starting point for quantifying our monthly Rule Maker investment decisions. I ran the numbers for all twelve of our holdings, and found the results to be quite interesting. The two companies that tied for the highest score happened to be the two I was most inclined to select from the get-go: Yahoo! and Microsoft. Here's how their numbers turned out: 
                   Microsoft          Yahoo!
                Result  Points    Result  Points
Revenue Growth   16.3%     6      119.1%    11
Gross Margin     86.9%    12       85.1%    11
Net Margin       41.0%    12       23.7%     8
Net Cash ($B)    23.8     12        1.0      6
Flow Ratio        0.49    11        0.34    12
Cash King Mar.   56.6%    12       44.2%    11
% off 52-wk Hi   41.1%    10       46.3%    11
Pos. in Por       8.0%     4       10.0%     3
Mark. Cap ($B)  371.7      3       73.7      9
TOTAL SCORE               82                82
Here's a link to the entire Rule Maker Comparative Analysis.

My personal conclusion is that this type of analysis is constructive as a solid starting point for analyzing such a wide range of criteria across many investment options. Even so, there are always a few intangible factors that can't be entirely captured in the numbers. For example, two reasons I like both Microsoft and Yahoo! as investments are their strong management teams and the network effects implicit in their business models. To some degree, those factors are captured in the numbers, but not entirely.

I'd love to hear your feedback on the usefulness of this system, and whether you find it instructive to see our monthly investment decisions structured in quantitative fashion. Please take a minute to evaluate the following question and vote for the response that best describes your opinion:

Compared to the Rule Maker portfolio's past monthly investment selection system, do you find the proposed first-draft quantitative approach to be more educational?
  1. Absolutely, it's much more instructive.
  2. Yep, it's somewhat more instructive.
  3. No better, but no worse.
  4. Verve, I'm more confused than ever.
Vote Here.

Oh, and my vote for this month's investment? Between Microsoft and Yahoo!, I have to give the edge to Yahoo!, as its execution to date has been flawless and its management continuously innovates new services for its global user base.

Fool on!

-Matt Richey, TMF Verve on the Discussion Boards

Related Link:
  • The Zen of Rule Maker, 3/3/00