Cisco, Not Wal-Mart

Note: An earlier draft of this story contained an error in a compound interest example. The example has been removed. The updated story is accurate.

We're embarking today upon a nine-part journey through the six (only six!) financial statement criteria that have long served as the foundation of the Rule Maker investing approach. We're calling this series The Craft of Rule Maker, based on the concrete, objective nature of the financial side of Rule Maker investing. New Fool or old, we hope you enjoy this overview of the simple mathematical underpinnings of finding great long-term business franchises.

If you want to know what the Rule Maker approach is all about, let me tell you how I see its strengths, weaknesses, and risks. Then you can decide whether to camp here or seek new shelter. (We've got a good spot we think: flat ground, tall pines, running water.)

On the quantitative side, we look for leading companies that produce lots of cash and carry little debt. It's why we're invested in Cisco (Nasdaq: CSCO), which has more than $15 billion in investments and zero debt, but not Wal-Mart (NYSE: WMT), which has too much debt relative to the cash the company generates.

We don't mess around with unprofitable companies, which means we eschew startups and hopefuls. It's our way of saying we aren't smart enough to pick companies destined for greatness. They have to be there already.

On the qualitative side, we look for companies with room to grow and lasting competitive advantages, such as broad distribution networks or strong brand names.

It's why we're invested in Coca-Cola (NYSE: KO), which has the world's most valuable brand name and a network of bottlers that delivers soft drinks in more than 200 countries, but not Bed Bath & Beyond (Nasdaq: BBBY), a great company but one that participates in a smaller market, and with little in the way of brand power.

Identifying competitive advantages is much tougher than reading an income statement or a balance sheet. It's more art than science, which doesn't mean it requires intuition, just a lot of homework. Keep this in mind if you're thinking about investing in individual stocks: you should enjoy researching what makes a company tick. If not, why invest in anything other than an index fund?

If investing is like a trip down the highway, we want to drive solid, road-tested cars. We don't want to stop a lot for gas or repairs. We don't want to test drive the latest hybrid. We want to buy the best cars at reasonable prices to eliminate the headaches that come with less-stable models.

Let's look at a few of the pricey distractions we hope to avoid. We have a long time horizon for companies we purchase in the Rule Maker -- at least five years -- and this approach yields benefits that are a key part of our strategy. First, we don't get saddled with management fees fund managers charge, which often range from 1% to as high as 3%. Take a moment to consider the impact of this fee. Three percent of $10,000 is $300, which sounds small, but 3% of $100,000 is $3,000. This adds up fast.

Not only that, but consider, in terms of percentages, how much you're giving away to a fund that charges, say, 1.5% annually. The average real return (adjusted for inflation) on stocks from 1926 through 1997 was 7.2%. You have to think in percentages to realize 1.5% is 20.8% of 7.2%. One-fifth of your return goes to the mutual fund manager.

This doesn't mean there aren't any good mutual funds, or mutual fund managers who earn their 1.5%. Just make sure you aren't paying someone 20% of your annual returns to underperform an index fund that charges less. We skip these annual fees by picking stocks ourselves. 

Next, because we minimize trades we cut down on capital gains taxes and allow the buoyancy of compound interest to float returns. Keep in mind this is one of an investor's most powerful weapons. The frictional cost of trading and the cost of taxes erode returns more than you might imagine.

Rule Maker risks
If you're still on board, you understand the basics of Rule Maker investing. We yoke the returns generated by great companies to the advantages of low transaction fees, deferred taxes, and compound interest. It's pretty simple.

Simple doesn't mean easy, however, and there are traps you must avoid. We've been ensnared a few times ourselves. First, we're buying companies the market has already identified as champs. These companies come highly valued, sometimes valued to perfection, and investors must proceed with caution.

You can pay too much for a great company, just as you can pay too much for a great car. Rule Maker investors must be patient and choosy. Great deals don't come along everyday and you must be prepared to do nothing. Can you endure the sensation of doing nothing? 

Next, I want to steal a phrase picked up while reading Michael Maubossin, a sharp analyst at investment bank Credit Suisse First Boston. Rule Maker investors must avoid the twilight. This means we must avoid buying companies that have peaked, and it's not easy to do. Television maker Zenith had its day in the sun, and now it's ashes. Investors once paid top dollar for glittering shares of cosmetics company Avon (NYSE: AVP) and instant-camera manufacturer Polaroid (NYSE: PRD), only to watch the shares languish for years.

How do we separate the Ciscos from the Polaroids? We put the whole package together. We pool our qualitative and quantitative criteria, seek companies with competitive advantages and room to grow, and wait until the market gives us a price we think is reasonable. If we do our job well up front, we'll be right often enough to shine.

In the next eight installments of our Craft of Rule Maker series, we'll bear down on the quantitative side of Rule Maker investing. Then, upon this series' completion, we'll begin our 2001 Rule Maker online seminar on The Art of Rule Maker ($49), in which we'll cover the qualitative side of finding dominant businesses. With both the quantitative and qualitative methods in your toolbox, you'll be prepared to intelligently assess any Rule Maker candidate from a 360-degree point of view.

That's the direction we're headed. Next time: simple numerics -- why financials matter and how to find 'em.

Have a great day.

Part 2: Essential Investing Knowledge �

Richard McCaffery, a co-manager of the Rule Maker portfolio, lives near the horse-racing track in Laurel, Maryland with his wife Linda. You can view his stock holdings in his online profile. The Motley Fool is investors writing for investors.