About six weeks ago I wrote that the 7% net margin threshold we use in the Rule Maker Portfolio is too lenient. Since I was curious about what readers thought, I also created a poll. It seems many of you agreed with my point of view.

Recently your Rule Maker Portfolio managers got together and debated this issue for hours and hours. OK, I'm exaggerating. We didn't really do that (the rest of the group could have, but I know that if they did, that meeting took place without me). We exchanged a few e-mails and a couple of phone calls, though. Best of all, we made a decision. We're going to increase our net margin target.

Here are the revised net margin criteria for the Rule Maker Essentials spreadsheet: Any company that realizes a net margin of 10% or more gets a score of 2. If its net margin is less than 10%, the result is no points.

Moving on to the Rule Maker Ranker, things will look like this:

  • Net Margin greater than or equal to 13%: 3 points
  • Net Margin greater than or equal to 10%, less than 13%: 2 points
  • Net Margin greater than or equal to 7%, less than 10%: 1 point
  • Net Margin less than 7%: 0 points
There are those out there who may be wondering if we backtested the data in reaching this conclusion. No, we didn't. I'm also pretty certain we won't be doing that in the future. Personally, there are more interesting things to do with my time. As mentioned in my first article, I ran a net margin screen in which I determined that more than 25% of the companies traded on the NYSE, Nasdaq, and AMEX exceeded our old target. To me, any performance measure that easy to overleap needs to be raised. So, we're raising the bar.

We're looking for the greatest companies we can find. Based on our experiences studying and analyzing companies, we think that great companies can earn more than $0.07 for each dollar of revenue they generate. When a company has gross margins of at least 50%, it should have plenty left to reinvest in its current or future business success via either new product development (i.e., research and development), or in selling and marketing its products or services. There should also be more than enough left over to cover the administrative costs of running the business -- accounting, tax, legal, and cash management expenses.

We want our model to reward the companies that run their businesses most efficiently, which is one of the things net margin tells us. We like companies that have light business models. Again, these companies will typically earn higher net margins. We feel that raising our net margin target makes our model better reward companies that perform the best in this capacity.

This change also better aligns our net margin threshold with our Cash King Margin (CKM) target. We want the CKM to be equal to or greater than the net margin. It makes sense that the minimum targets for both are the same -- 10%.

There are a couple of other things that you should keep in mind as you look at this change in our criteria. The first is that not every company that you designate as a Rule Maker has to pass each of our criteria all the time. What's important for you to remember is that if a company doesn't meet one or more of our criteria, it's up to you to understand why and determine how comfortable that makes you as a potential investor and/or current shareholder.

One other thing we discussed was whether to just drop net margin from our criteria. After all, the CKM measures cash earnings, while net margin is a creature of accounting conventions that result from the application of Generally Accepted Accounting Principles (GAAP). We've talked many times about how much more meaningful cash earnings are than GAAP earnings. We still believe that. Does that mean we should stop measuring net margin? No way.

We like to keep things simple. Net margin is easy to calculate. All you have to do is pick two numbers off the income statement -- total revenues and net income. Then you divide net income by total revenues and you have net margin. That's it. I think the comparison of net margin and CKM is important, particularly in assessing the quality of earnings and conservative accounting. Since we have to make that comparison, we're calculating net margin anyway. The bottom line is that there's no reason to stop calculating net margins and rewarding those companies with the highest return. So, we'll be raising our net margin target on a go-forward basis.

Phil Weiss, TMF Grape on the Discussion Boards

Related Link:
  • The 10% Solution, Rule Maker Portfolio, 7/26/00