Rule Maker manager Mike Trigg wrapped up his analysis of Tiffany & Co. (NYSE: TIF) in a story last week, concluding that it isn't a Rule Maker because it doesn't generate the kind of cash we like to see. 

Mike did a couple of things in this analysis worth noting. First, he took a close look at the company's working capital management to determine how well Tiffany handles cash running through its business. But he didn't stop with just a number. Rather, he tried to find out why inventory was throwing working capital management a little out of whack.

As is often the case with static ratios, they don't tell the whole story. There are business reasons for Tiffany's higher inventory, and some are mitigating factors. Tiffany, like the Gap (NYSE: GPS), deliberately stocks extra inventory as a convenience for customers. Rivals such as Zale (NYSE: ZLC) do the same thing. It's part of doing business in the jewelry trade.

That doesn't mean you don't have to be careful. Any manager can come up with plausible-sounding reasons for high inventory. It takes practice and context to be able to judge the issues for yourself. Just remember the companies you analyze are living businesses, not just a collection of numbers in a 10-K. My take is that it's unrealistic to expect Tiffany to meet our working capital management criteria (which we call the Foolish Flow Ratio), but that Tiffany's inventory is still too high. 

The second problem Mike looked at was Tiffany's Cash King Margin. This measure identifies free cash flow as a percentage of sales. Think of it as net profit margin, only it's based on cash accounting rather than accrual accounting. The cash numbers are more reliable.

Mike took a three-year look at the company's Cash King Margin and decided it just doesn't create the kind of profits we're looking for. Again, high inventory levels were the big culprit, which means, in one way, it's just a new name for the same criticism. Even without this flaw, however, Mike tells us Tiffany would have a hard time creating enough cash to meet our 10% margin requirement. Fair enough.

Before writing it off, though, I'd offer a couple words of caution, one specific to the Rule Maker and another outside the scope of what we normally talk about. First Mike made it clear we use that 10% benchmark as a starting point. It's just that -- a starting point, not a commandment. No way I'd cross a company off the Rule Maker list because it failed to meet one or two criteria, not if I thought there was more to the story.    

There is. We talk a lot about cash in this portfolio. Cash is good. But believe it or not, too much cash can be a sign that a company lacks options, that it lacks opportunities to invest cash in new areas that promise a good return. Consumer food giant Kraft (NYSE: KFT) probably fits into this category. It produces a lot more cash from operations than it's investing back in the business. This isn't a bad thing. It just means the business is aging.

This is the normal life cycle for most companies. By the time they generate enough cash to fully support operations, well, the sun is setting, at least on the faster growth days. That often means returns are moving back towards the industry average as well. Therefore, this Rule Maker criterion can be misleading if it gets you to focus too much on cash-producing companies. Microsoft (Nasdaq: MSFT) and Intel (Nasdaq: INTC) probably have enough snap in their sales growth to keep them from falling into this category for a while, but investors should be aware that cash, like anything else, must be viewed critically.

Fast-growing companies often generate negative or low free cash flow. On the one hand, the Rule Maker, which prizes a profitable track record, looks for companies generating lots of free cash flow as a kind of insurance policy. We don't want to invest in companies still figuring out how to make a buck.

On the other hand, not every company producing negative free cash flow is the same, and not every company should be eliminated from Rule Maker contention just because of the cash king margin criteria. For example, JDS Uniphase (Nasdaq: JDSU) produced a free cash flow deficit of more than $350 million through the first nine months of this fiscal year. That's not great, though it's not unexpected for a company getting cobbled together as fast as JDS. At the time we owned the company in the Rule Maker Portfolio, I was unhappy about the negative cash flow, but I was more concerned about the difficulty of understanding the business and picturing its growth path. I'm out of my depth knowing which way the optical components business will turn.

Now compare this to Wal-Mart (NYSE: WMT), which ran a free cash flow deficit through its fast growth years of the 1970s and 1980s. Al Ehrbar, business writer and partner at consulting firm Stern Stewart & Co., talks about this in his book EVA: The Real Key to Creating Wealth (an overview of Stern Stewart's valuation technique), and uses it to underscore an important aspect of capital allocation: negative free cash flow is a good thing if the investments creating the deficit earn a high rate of return. In fact, it can be a brilliant strategy provided expenses are carefully managed.

Wal-Mart's founder Sam Walton could have expanded slower and focused on generating free cash flow. But new stores earned 25% and Wal-Mart's cost of capital was just 12.5%, according to Ehrbar. In other words, Wal-Mart earned 25% on money costing half that. This is an important lesson. Ehrbar writes that free cash flow is not a useful measure of a company's current performance because it doesn't indicate what kind of return a company is generating on its investments. 

Where does this leave us in the Rule Maker? It isn't easy figuring out what kind of return a company is generating on its new investments, or figuring out a company's cost of capital. Those kinds of calculations are beyond the scope of what we talk about in the Rule Maker. That doesn't mean they don't exist.

The truth, for me, is that I like the Rule Maker's populist approach. I like that it focuses investors on high quality, profitable companies since so many investors get lured into penny-stock sucker bets. But there's more to investing than what you see in our quantitative criteria. The Rule Maker is a great starting point, an entryway to the wardrobe, but it's not the whole forest. Mike touched on this when he said Tiffany may well be a good investment even if it doesn't match our criteria.

Tiffany is priced too high for my tastes right now. I don't know if I'd like to see it in our portfolio at some point or not. But I know this: The company generates a pretty solid return on invested capital and marginal invested capital, about 17.3% and 21.9%, respectively. Return on invested capital (ROIC) is a measure of return relative to how much money is being invested in the business. Return on marginal invested capital (ROMIC) is a measure of the return on the most recent capital invested in the business. (I've listed a couple of stories in the related links box in the top right corner for anyone interested in knowing more.)

Very likely, its returns are above its cost of capital, which means the company is creating value as it grows. That's good business. While expanding quickly eats up a lot of cash flow, it may also be the best strategy for Tiffany long term, and for Tiffany shareholders. At the very least, it's too soon for me to say that it isn't. 

So use the Rule Maker criteria as a guide. Don't let them define all of your investing decisions, especially the margin requirements, which are just one component of profitability, not the final determinant.

Have a great day.

Richard McCaffery, co-manager of the Rule Maker portfolio, doesn't own any shares mentioned in this report. The Motley Fool is investors writing for investors.