In the next five business days, the Rule Maker Portfolio will deploy its $2,111.80 of cash into shares of Yahoo! (Nasdaq: YHOO) and Nokia (NYSE: NOK). I made the case for Yahoo! on Monday, and Rich followed up yesterday with a vote for Nokia. But what about the rationale behind all the non-vote-getters? For nine of the companies in our portfolio, "Not gonna do it!" was our George Sr.-ish conclusion. Today, I'll explain why we're not buying any of our other nine Rule Makers.
1) A Flow Ratio that's going up, up, up
First among the candidates we considered and then rejected was Microsoft (Nasdaq: MSFT). On the pro side, there's deep management, the incredible software economic model, and scads of cash on the balance sheet ready to fund new initiatives. Plus, the former market-cap champ is down 55% off its all-time high to a relatively attractive $300 billion valuation.
But, the company's Foolish Flow Ratio is out of control, having risen each of the last seven quarters (on a year-over-year basis) to a current level of 0.67. As I've explained in the past -- remember the cash vacuum? -- a rising Flow Ratio is dilutive to cash flow and can be a warning sign that management is "stretching" to meet earnings estimates by extending ultra-favorable financing terms to its customers. We simply will not add money to a company with a constantly rising Flow.
By the way, another candidate that fell to the wayside for the same reason was Schering-Plough (NYSE: SGP). Its Flowie has also risen seven quarters in a row, although not as drastically as Microsoft's.
2) Need more information
Intel (Nasdaq: INTC) was another candidate on our short list. We like Intel's perennially excellent management, strong cash position, and commitment to being a relevant provider of technology to the computing world. Intel has some attractive expanding possibilities with its XScale processor and optical packet tracker.
But, after the recent bumps in the road -- revenue shortfall preannouncement, cancellation of the Timna microprocessor, and delay in the next generation of the Pentium -- we've decided to wait for more information in the upcoming Q3 earnings report before making any additional investments here. A secondary consideration was that Intel is already our second-largest holding.
Another company we're waiting for more information on is Pfizer (NYSE: PFE). Because of the hasty circumstances that led to the merger of Pfizer and Warner-Lambert, we want to give the combined company a few quarters to prove the merger's success.
3) Risky valuation
The operating performance at JDS Uniphase (Nasdaq: JDSU) has been nothing less than stellar over the past year. Revenues are soaring at a triple-digit pace, and the Flow Ratio has declined five quarters straight (on a year-over-year basis). We also know that JDS makes the critical optical components that are expected to be in increasingly high demand for years to come.
But, the valuation remains very high. When we make our initial purchase of a company, business quality is our sole concern. But, as we make additional investments, we take a closer look at valuation. We don't need a discounted cash flow analysis to know that a lot of growth is priced into this company, with its $87 billion market cap supported by only $1 million in trailing free cash flow.
4) Already a large holding in the portfolio
Cisco Systems (Nasdaq: CSCO) -- what more can be said? CEO John Chambers and the rest of management have been practically immortalized for building the networking empire that is Cisco Systems. The company continues to manage hypergrowth without a hiccup, even as it approaches annual revenues of $20 billion. Amazing.
But, the stock already makes up 23% of our portfolio. That's almost double the percentage of Intel, our second-largest holding. With such a large investment in the company, we really wouldn't consider buying additional shares unless it dropped to bargain-basement prices.
Another reason we're less inclined to add to our Cisco Systems position at this point is a combination of reasons #1 and #2. The last quarter revealed an upswing in the growth of receivables and inventory, both of which grew faster than sales. Fools, this is never good. The result was that Cisco's Flow Ratio increased on a year-over-year basis for the first time in three years. We'd prefer to wait for another quarter's performance to see if that was an aberration or the beginning of a trend.
As our largest holding, Cisco deserves our watchful eye, especially considering that the company faces immense competition in the increasingly blurred telecom and networking space. We'll be watching the financial statements very closely for any cracks in Cisco's armor.
5) Shortage of expanding possibilities
Coca-Cola (NYSE: KO): Is it a mature large-cap or a global mid-cap with growth a-plenty still to come? That's the debate that has kept us from investing any additional cash into the undisputed Rule Maker of the beverage industry. For the past few years, Coke has suffered from management upheaval, PR disasters, and an inventory glut. It hasn't been pretty. The most recent quarter showed signs of hope with decent profitability and a Flow Ratio of 0.99 -- the lowest since 1997.
But, revenue growth continues to be meager -- 4.5% in the most recent quarter and 6.1% for the past year. I don't know if Coke will ever again see revenue growth that meets our 10% criteria. For what it's worth, the company has called for 6-7% volume growth in the coming year. In years past, Coke could turn that type of single-digit top-line growth into double-digit earnings growth -- through rising net margins. But, net margins appear to have hit a plateau several years ago. As such, it'll be difficult for Coke to deliver the kind of growth that would make this investment interesting at current prices. Coke sells at nearly 60x free cash flow.
In contrast to all these no-buy situations, Yahoo! and Nokia have declining Flow Ratios, understandable businesses, at least somewhat reasonable valuations, modest representation in our portfolio, and clearly identifiable expanding possibilities. We'll split our cash proceeds evenly between the companies in the next five trading days.
Finally, one last call for our Biotechnology Investing Online Seminar, which starts this coming Monday. The deadline to enroll is tonight at midnight Eastern Time. This seminar will teach you how to use some biotechnology-specific analytical tools, like the Clinical Index, which can help you identify biotech opportunities while they're still in the emerging Rule Maker stage. I'll be there, and I hope to see you, too! Click here to enroll.
-- Matt Richey, TMF Verve on the Discussion Boards
