[This article, which originally ran December 28, 1999, teaches investors a simple but valuable business lesson. There are many profitable companies that operate in low margin industries, but we try to make the task of spotting winners easier by focusing on companies with light business models that operate in high-margin pastures. We set the bar high in the Rule Maker, and you can tighten your search by narrowing the field.]
Over the holidays, I visited friends and family back home (Tennessee, in case you're wondering), and -- as often happens -- I ran into a number of folks who'd never heard of The Motley Fool, much less the Rule Maker Portfolio. Typically, my 10-second explanation of a Rule Maker is something along the lines of the following: A company that dominates its industry, generates lots of cash, and holds the potential to continue its Rule Making ways for years to come.
The only drawback to my fast-and-dirty definition is that some people come away with the impression that any big, brand-name company -- like AT&T (NYSE: T) or Wal-Mart (NYSE: WMT) -- is a Rule Maker. Not so! Yes, both AT&T and Wal-Mart are big, have strong brand-names, and have handsomely rewarded shareholders over the years, but neither company qualifies as a Rule Maker due to their skinny profit margins and substantial debt.
By definition, the Rule Maker label only applies to a handful of great companies with a very specific business model. If you've read our investment criteria or Rule Breakers, Rule Makers, you already know that we require our companies to have rising sales, high gross and net profit margins, mucho cash, scant debt, and efficient cash management as measured by the Flow Ratio. All of that, plus a great brand, strong management, and a future direction that exceeds the current location.
Yes, we're pickier than a spoiled child at the dinner table. But we're not interested in diversifying for the sake of minimizing volatility. We're looking for the world's best companies, period.
In thinking about the type of financial model that we're looking for in our companies, one of the most distinguishing factors is a high gross profit margin, which signifies a business that's light in material costs. Gross margin is an easy metric to calculate. Using the income statement, simply take Sales minus Cost of Goods Sold (or COGS, or Cost of Sales), and then divide the resulting number by Sales. By requiring our companies to achieve at least a 50% gross margin, we're demanding that the material costs of the company's product be no more than half of what that product can be sold for. Or, to put it more simply, we want our companies to take a $0.50 widget and then sell it for $1 (or more). Make sense? If not, get a more in-depth explanation here.
The significance of a high gross margin is that it leaves a lot of room on the income statement for other important expenditures, such as Sales & Marketing and Research & Development, while still leaving a nice chunk of change for the bottom-line. In addition, one of the greatest consequential benefits to high gross margins is the potential for rising net margins. Whereas COGS tends to be a variable cost that increases proportionally with sales, other expenses tend to be of a more fixed cost nature, which means they grow more slowly than sales. When you combine fixed (or slow-growing) costs and growing revenues, the result is margin expansion on the bottom-line. Microsoft's (NYSE: MSFT) history as a public company serves as an excellent example of this phenomenon:
Fiscal Year: 1985 1990 1995 1999* 2000*
Gross Marg.(%) 78.6 77.0 77.8 85.7 86.9 Net Marg.(%) 17.1 23.5 23.9 39.4 41.0 * Net margins from 1999 and 2000 include gains
from investment income. Back this out and
Microsoft's net margins for 1999 and 2000 are
30.3% and 27.2% respectively.
Take a look at that table. If the margin comparison doesn't make you say, "Wow," get this: Between 1985 and 1999, Microsoft's revenues grew from $140 million to $19,747 million -- a 42% compound annual growth rate. But because expenses grew less quickly than sales, net income grew even faster, from $24 million to $7,785 million -- a 51% annual pace. When gross margins are high and other costs are relatively fixed, the bottom-line impact can be tremendous.
But finding high gross margin companies can be tough. Yesterday, I perused CFO Magazine's recent SG&A Survey Results, which showed that out of 42 industries studied, only seven met our 50% gross margin requirement. Consider the implications: In your search for potential investments, Rule Makers are like needles in a haystack. Well, it's not exactly that tough, but there's only a one-out-of-six chance that any company you analyze will meet our gross margin hurdle.
CFO's survey indicated that the following seven industries surpassed our gross margin goal: Beverages, Computer Software, Medical Products & Equipment, Network Communications, Pharmaceuticals, Soaps & Cosmetics, and Telecommunications. Now, is it any surprise that most of this portfolio's holdings fall into one of those categories?
In your search for Rule Makers, don't be surprised when most companies don't meet our stringent criteria. Only those industries that have the potential for a profitable competitive advantage will contain companies of Rule Maker caliber. But when you find companies that qualify as a true-blue Rule Maker, the results can be fantastic.