Alright, we've defined what the Rule Maker is looking for in companies: pure unadulterated quality, which we'd like to get at a good price. We also talked about the power of a sustainable competitive advantage. We're going to come back to that one, because it is the single most important determinant in defining a Rule Maker. It is also the most difficult.

After all, Kodak (NYSE: EK) had the definitive sustainable competitive advantage for decades, and yet it is now but a shadow of its former self. Its low-margin camera/high-margin film strategy has been eaten alive, first by higher quality German and Japanese equipment manufacturers, then by competing film companies, and now by digital technology. The potential for sustainability is WAY different than the assurance of sustainability, and the single most difficult determination for investors to make is the difference between the two. Seriously, USX (NYSE: X) nearly dominates the U.S. Steel industry, but are investors really waiting for it to come back?

We're going to develop a framework for looking at companies here, but let me give you a few more resources. First, there is the classic Philip Fisher book "Common Stocks, Uncommon Profits," which contains Fisher's 15 steps for analyzing a company. These include such things as "Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?" I'd of course add to this the "Enron Corollary": When the company's management suddenly and aggressively begins crowing about how undervalued its stock is, look out. If you don't have this book, get it. The "15 steps" chapter is worth the price alone, though you could always go to the public library with a pocket full of dimes and photocopy it. Do copiers at libraries still take dimes?

The other resource is a document released by respected value investment management firm Tweedy, Browne called "10 Ways to Beat an Index." It's long, about 20 pages, but it contains some valuable information and an excellent checklist that any investor should seek to answer about a company in which he is interested --things like questions about anticipated changes in the competitive environment, what the company plans to do with retained earnings (those not paid out in dividends), and what the company plans to do to achieve projected growth rates.

Let's talk a little bit about setting some parameters for what we want our companies to look like. One of my favorite developments to come out of the Rule Maker portfolio over the last two years is the Cash King Margin. This, for review, is the total amount of free cash flow generated by the company divided by its revenues. So many people focus on "earnings," which to me is a completely bogus number, because it treats capital expenditures, well, like they came from the CapEx Fairy. A company can generate enormous paper profits and still be a total disaster because it requires more capital investment than it generates in free cash.

But as we've seen with some of the former (and perhaps future) darlings of Wall Street such as Cisco (Nasdaq: CSCO) and Yahoo! (Nasdaq: YHOO), regardless of these companies' abilities to produce free cash over the short term, when business cycles changed the companies have struggled mightily. Our mistake in this instance was that we took a short-term, cash-generating ability and we extrapolated it into a much longer period of time, which is a no-no.

After all, if this were 1988 and we were looking 'round for the best place to put our money, where would it be? If we looked at the previous five years it would have been one of two places: oil stocks or Japan. Neither of these were able to continue their torrid rates of growth into the 1990s because once the business cycle changed course, both got hammered. Japan, unfortunately, has yet to pull itself out, and I fully expect it to collapse in due course. Buying either of these based on their previous five years would have turned out quite badly. If we went back a bit further, with oil companies at least we would have seen a violent change in economics and a period of time in which the companies' ability to generate cash was really, really poor.

And so, for Rule Makers we want to ensure that our cash flow generation expectations are based on solid evidence. This means that we need to get approximately 10 years worth of financial statements. In most 10 year periods, you will find that at least one market correction (I mean goods and services market, not the stock market) has taken place. This extended period of operating history will give you a much better idea, on a historical basis, how well the company operates when things do not go so well.

Yes, I did say 10 years. I know that's hard to do, after all, in most instances only goes back to 1996. When I looked at one company, Coca-Cola (NYSE: KO) at random, though, FreeEdgar had 10-K's going back to 1994. Perfect, because if you look in the 1994 10-K, it also includes results from 1993 and 1992. If the company you want to review does not have financials going back that far online, well, on your desk there is this other crazy contraption called a telephone. Call the company and ask 'em for 10 years' worth of financials. They can mail them, or they can e-mail them, but get them. You could also go to the library and get the numbers in ValueLine (or buy it, but ValueLine is pretty pricey).

What this exercise would do is immediately eliminate such companies as Yahoo! or even Cisco for consideration as investments. Yahoo! first came public in 1996, and Cisco, though it is older, could not have been argued to have endured a full business cycle when the Rule Maker first bought it in 1998.

Let's look at Coca-Cola's reported free cash flow (operating revenues - capital expenditures) and revenues for the 10 year period of 1992-2000:

      Revenues   Free Cash Flow
1992   $13,074        $1,183
1993    13,963         1,708
1994    16,181         2,305
1995    18,018         2,178
1996    18,673         2,473
1997    18,868         2,940
1998    18,813         2,570
1999    19,805         2,814
2000    20,458         2,952
       (numbers in millions)

And then, in percentage, a Cash King Margin:

1992    8.6%
1993   12.2%
1994   14.2%
1995   12.1%
1996   13.2%
1997   15.5%
1998   12.9%
1999   14.2%
2000   14.4%

As you can see, through a considerable period of time Coca-Cola has generated excellent levels of cash generated from its revenues. That's an important signal, because through this time Coca-Cola's earnings and P/E ratio have been all over the map. At many points over the last decade, Coca-Cola would have been a stellar buy. It may be again now. We'll get into that later, but what this exercise shows is how a company has done generating cash though a full business cycle. Coke has been excellent at it.

Two things: First, we are not necessarily looking for perfect consistency. What we do want to see is a general long-term trend at creating cash from operations. It is by no means a knock if a company has negative free cash flow for a year or two. In fact, given the short-term view of much of the market, a company such as Applied Materials (Nasdaq: AMAT) has historically given investors wonderful opportunities to buy at the very moment it turned cash-flow negative due to violent cyclical turns. We would prefer them to be positive each year, but bear this point in mind before you simply toss out a company because it had a bad year.

Second, the Rule Maker criteria expressly states that we want Cash King Margins in excess of 10%. This is true, sort of. By setting this bar, we are eliminating certain industries, particularly some types of retailers. For example, Costco (Nasdaq: COST) is by all means a Rule Maker, but it will never, ever generate 10% cash on its revenues. It's not built that way. In fact, it's built on generating as much revenue as possible and just having a tiny bit stick on the bottom line. Do a 10-year free cash flow on Costco, though, and you'll see that they are really pretty consistent at generating free cash, even in years where they have aggressively expanded.

Ten years may seem like a lot of work. It is. But anyone who is not willing to do work in order to invest should likely just settle down with an index fund. This is not a knock; it is cold reality. The market has beaten up an awful lot of people who thought that the words "great company" shielded them from a stock ever dropping. It doesn't, but more importantly we want to make sure that a company really and truly is built for long-term greatness.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

For some reason, Bill could not convince the government to let him travel to Cuba to "observe the local stock market." Go figure. Bill owns shares of Applied Material and Cisco. The Motley Fool has a full disclosure policy.