We're trundling on along in our attempt to redefine the Rule Maker criteria. We have discussed the absolute need for sustainable competitive advantage and our preference that a company be generating good free cash flow from its revenues as defined by our Cash King Margin.
Let's file that second item under "preferable, but not required," because as we'll see, particularly with companies that are growing, sometimes capital expenditures to grow the business can throw things out of whack. It is for this reason that we are pushing for collection of a decade's worth of data on any company before we designate it a "Rule Maker." If a company makes money only in one type of economic environment, we should be quite careful not to extrapolate that cash production into any and all environments. The climate changes, so do businesses. Church & Dwight (NYSE: CHD), for example, has gotten into businesses as varying as baking soda and pregnancy detection kits. Likewise Sara Lee (NYSE: SLE), which makes coffee cakes and also makes shoe polish to insecticides. These companies have added new brands over time. Should we reward them simply for growth through acquisition?
No, not really. In fact, I think that as of late that investors have been too dependent on gaudy growth rates to inform their investment decisions. Coca-Cola (NYSE: KO) has been forecasting 15% growth consistently for years, and each year has not even come close to meeting this target. Seriously, if I were to ask you really quickly what the better investment is: Newell Rubbermaid (NYSE: NWL), whose CEO not that long ago predicted the company would grow earnings by 15% this year, or Clorox (NYSE: CLX), which grew this past year at less than 3%, what would you say?
I would fail anyone who bothered to answer with anything besides "not enough information," or more accusingly "misleading information." Comparing one company's past growth and another's projected growth as enunciated by the CEO is dirty pool.
There again, I get a sick feeling every time I see a CEO trumpeting that 15% per year growth, like it's something that is minimally acceptable. Last year Fortune Magazine did a fantastic article on the historic growth rates of the 150 largest companies in the Fortune 500 as of 1980. They found that, of these big companies, only 5 grew at more than 15% per year, and only 26 grew at greater than 10% per year. What were the 5? Fannie Mae (NYSE: FNM), Phillip Morris (NYSE: MO), UAL (NYSE: UAL), Merck (NYSE: MRK), and Abbott Labs (NYSE: ABT). Of these, four out of five have obliterated the S&P 500 over this time period, but only two of the five (Fannie Mae and Abbot Labs) have outperformed the S&P 500 over the past decade. And UAL, for its part, has not even managed to meet its cost of capital. In other words, for every additional dollar in revenues, UAL has managed to LOSE money.
Again, this is all much ado about nothing. The end result is that as investors we ought to use sales growth as a "would be nice" data point. There is nothing all that special about a company that is growing at 10% or more if the market expects it to continue growing at 10% or better and has priced it accordingly.
That said, since we are talking about Rule Makers, we want companies that have products in demand by wide swaths of the population. Big companies with big revenue bases that have wide and dominant usage among their target populations tend to remain that way. First Data Corporation (NYSE: FDC), for example, has hit the bull's-eye in network effects, with its market reach for processing credit card transactions exceeding 1/5th of the entire U.S. Gross Domestic Product. It is clearly the Rule Maker in its field, and yet its revenue growth rate over the last decade is a shade over 8% per year. The chance of a company pushing First Data out of its position of dominance is quite remote.
First Data also sports a massive revenue base, created by a large number of repeat purchases (even if the consumer does not directly make the purchase, each credit card transaction verification includes a small payment to First Data. Since we are looking for Rule Makers in important industries, I'd suggest making a floor on the level of revenues at about $4 billion. This is arbitrary, and we're not going to throw out companies that fall just shy of this level, but after all, Rule Makers are supposed to be BIG, right?
Compare First Data's results with Amazon.com (Nasdaq: AMZN). This is a company that grew by 188% per year compounded over the last five years. Should we ipso facto assume that Amazon is going to be a better investment than First Data over the next five years? I don't think so. For one, for the entirety of the last 10 years, First Data has been cash flow positive, and has a debt-to-equity ratio of 0.78. Amazon, on the other hand, has a shareholder's deficit, and more than $2 billion in debt. All the growth in the world may not be sufficient to help Amazon.
Over the next weeks we are going to be looking at a few more ratios, including return on equity next week. This will be a departure from the existing Rule Maker criteria, which has lacked any equity criteria, instead focusing on revenues, profit margins, and free cash flow. These all have their place, but ROE also has an important role.
Until next week!
Bill Mann, TMFOtter on the Fool discussion boards
Bill Mann's wife, for whatever reason, is opposed to his wanting to name his child "Milk." He owns none of the companies mentioned in this article. Check his online profile for current holdings, and see The Motley Fool's Disclosure Policy.