The Rule Maker Portfolio has really taken it on the chin this year, but I think the future is full of opportunities for Rule Maker companies because the financially strong survive.

Recently, orders for Intel's (Nasdaq: INTC) microprocessors have been cancelled. And, unable to get funding from traditional sources, telecommunication service providers are looking to networking equipment manufacturers such as Cisco (Nasdaq: CSCO) for financing. In the short term, this sounds like bad news for these technology stalwarts.

While a slower economy isn't necessarily good for business, Cisco and Intel have the resources to weather the storm.

As a matter of fact, Cisco's CEO and president, John Chambers, has said that the company has gained the most market share in times of market uncertainty or downturns. As detailed in my most recent report on Cisco for Motley Fool Research, its recent performance in the Asian market has been quite strong. One of the keys to Cisco's success has been its willingness to continue to invest heavily in Asia even when the region has experienced economic turmoil. By continuing to invest during tough times, or even stepping up its investments, Cisco has been able to acquire assets relatively cheaply. When the recovery takes place, it'll be better positioned for success.

Let's take a look at some of the ways that the financially strong can use their position to take advantage of down cycles in the economy:

  • They can acquire troubled competitors, potentially at cheap prices.

  • While they may be scaled back a little, capital budgets are less likely to be slashed.

  • They're less likely to cut off research and development efforts, so product development continues.

  • If margins are strong, there's room to cut prices, which can lead to new customers or stronger relationships with existing customers.

Financial strength allows strong companies to attack rivals at their weakest points. If your competition is awash in debt, or failing to generate positive free cash flow, it will have a much tougher time keeping up with the efforts of its stronger competitor to maintain or expand its market share and/or its product line. Once the good times return, it will be that much tougher for weaker competitors to make up lost ground.

There are three main ways a company can fund future growth:

  • Go to the credit markets and borrow.

  • Issue new shares of stock.

  • Utilize cash generated by existing operations.

My preference is to invest in companies that fund growth from current operations. Of course, that's something only the strongest companies can do.

If you're not generating enough cash from operations to grow, you have to raise it by other means. This can be tough when stock prices are falling. Issuing stock in such an environment means giving away equity at bargain prices. If credit isn't readily available, then you're forced to pay higher rates to borrow. Too much interest expense can cripple a business -- just check out AT&T (NYSE: T).

In the type of market we have today, a company's best source of cash is its own operations. Let's take a look at the ability of Intel and its top competitor, Advanced Micro Devices (NYSE: AMD), to generate free cash flow so far this year and over each of the last two years (figures in millions):

                     AMD                Intel

               9 mo     9 mo        9 mo     9 mo
               2000     1999        2000     1999
CFO             955      -79       9,449    8,447
Net Capex      -565     -492      -4,251   -2,423
FCF             390     -571       5,198    6,024


               1999     1998        1999     1998
CFO             260      142      11,335    9,191
Net Capex      -616     -868      -3,403   -3,557
FCF            -356     -726       7,932    5,634

While AMD's performance has improved year-to-date, it's generating much less cash than Intel. If the economic outlook continues to weaken, Intel will be able to take advantage of more opportunities than AMD. As such, one of the most encouraging aspects of Intel's warning last week was that it boosted year 2000 capital spending to $6.5 billion from $6 billion. I'm an Intel shareholder, and this means that Intel is running its business with the same type of focus that I have as an investor, i.e., the long-term is important. By investing in the future when current results are below expectations, Intel is enhancing its position for tomorrow.

Next let's look at Cisco's performance compared to rivals Nortel (NYSE: NT) and Lucent (NYSE: LU). (Note: Data for Cisco is for 12 months, as the most recent available data is for its fiscal year ended in July. Nortel data is for 9 months through September. Lucent data is for 9 months through June, as its 10-K has not yet been released.)

Cisco
               2000       1999  
CFO           6,141      4,325 
Net Capex    -1,530       -697  
FCF           4,611      3,628
               

Lucent 
            9 mo 00    9 mo 99
CFO            -378       -925
Net Capex    -1,737     -1,239
FCF          -2,115      -2,164


Nortel
            9 mo 00    9 mo 99
CFO            -921       -257
Net Capex    -1,127       -529
FCF          -2,048       -786

Cisco's business is generating positive free cash flow, so it still has available cash to invest in new opportunities. Lucent and Nortel, however, are unable to generate enough cash to fund their current operations. This could hinder their ability to take advantage of future investment opportunities. To this Cisco shareholder, Cisco certainly has a leg up in terms of its ability to expand its operations and market share.

The bottom line is that in the current market environment you should be looking for companies that are able to generate cash from operations, as that cash can be used opportunistically in the current market.

At the end of last week's column I mentioned the fact that my dog was ill. I've been overwhelmed with all the kind thoughts and stories many fellow Fools have sent to me via email. As for Amelia, it will still take some time before we know her prognosis.

Have a great night.

Phil Weiss, TMF Grape on the Discussion Boards