In the past six weeks, we've been talking about reconfiguring the Rule Maker strategy. We're about halfway done, so I thought I'd ease back a little bit and talk about where we're steering this boat. In the next few weeks, we're going to start getting into some valuation work, and some sell criteria, which are going to be sharp departures from the Rule Maker modus operandi that has been in place to date.
To review, in the first week we talked about the need for a sustainable competitive advantage. This is the end-all be-all for Rule Makers, and over time this concept will be where we do most of our analysis. The best way to picture these things is to conceive of a fortress. The first and foremost thing about a fortress that makes it useful is that it protects something that other people actually covet. Fort McHenry was built with the goal of protecting Baltimore Harbor, one of the best natural harbors on the Eastern Seaboard of the United States. To get to the harbor, attackers had to take the fort.
Moreover, we want a fort that has a moat filled with dragons, snapping alligators, and piranhas, is difficult to approach, armed to the teeth, and is packed full of ferocious warriors. The fort we want is one that no opposing general in his right mind would attack.
The companies we want to own have the same characteristics: monopolistic, duopolistic, or oligarchic dominance, gilt-edged brand name, technological superiority, economic scale, global reach, price dominance, massive war chest, patents, proprietary processes, and a pet alligator (you know, just in case.)
Our companies look like Switzerland, only bigger. What does the opposite of this look like? Belgium. Flat, small, unarmed, and otherwise undifferentiated. Don't invest in Belgium. Invest in Switzerland. (No offense to the Belgians, but the only thing you could do to make your country less defensible is pave the whole thing.)
A sustainable competitive advantage is mandatory, period. Don't leave home without it. It may be hard to find companies with the SCA (OK, let's work on an acronym or something, shall we?) at a price we like, but it's a sure thing that the less advantages a company does have, the cheaper it will ultimately be. And, although our "quality matters more" message has been strewn this way and that over time, I think the opposite is nearly universally true: "Cheap rarely is."
There is one more piece that I believe should be required for Rule Makers. The company must have 10 years or more of operating history as a public, audited entity. Ten years is an arbitrary limit, but the rationale for this is not. We want to ensure that the company has existed through at least one market cycle. It was awfully easy to see how well JDS Uniphase (Nasdaq: JDSU) was doing in the late 1990s -- they had the growth and the operating margins to prove it. But could investors make any knowledgeable presumptions at all about what would happen with JDS Uniphase in a market downturn? Nope, because the company hadn't ever gone through one. This limitation will likely cause us to take a pass on some pretty exciting companies in the future. I don't care. It is no tragedy to me if this investing methodology causes me to miss out on getting rich quick. I do not believe that the risks involved in buying the new new thing are worth it.
The last few weeks we discussed some numerical criteria. In the spirit of ensuring that Rule Maker does not come off as a mechanical process, I must once again emphasize that each and every one of these criteria are "strongly suggested," but not mandatory. If a company has NONE of them, I'd probably question its appropriateness as a Rule Maker, but by no means must a company display all of these characteristics.
The first is a Cash King Margin (CKM) above 10% per year. The CKM measures how well a company can turn its revenues into cold, hard cash. For some businesses, particularly in retail, a CKM this high is an impossibility. For Rule Maker software companies and pharmaceuticals, a CKM this low would be nearly inexcusable.
We also discussed sales growth. The original Rule Maker criteria called for annual growth of 10%. Again, this would be nice, and if we can find a company growing that quickly, great. But the companies we are talking about are huge, and some may be growing scarcely at all. As long as they are not being picked apart by smaller, more nimble competitors, this is OK. I do think that the rule of thumb of a minimum of $4 billion in annual sales is important not so much for the number, but for the concept.
Finally, last week we discussed Return on Equity (ROE). The more I think about it, the less happy I am about focusing on ROE for much of anything other than a "make sure the company HAS one" kind of check. There are a few reasons for this, but the main one has to do with a guy named Pacioli and another named Lev.
Luca Pacioli was a Venetian Monk who invented the modern accounting system in the 15th century. Baruch Lev is a professor at Stern School of Business at New York University who thinks Pacioli's system has finally outlived its usefulness. Lev has argued that modern corporations have assets that are unquantifiable under the current accounting covenants -- things like intellectual property, human capital, and trademarks/patents. These things are assets, and they have a value that for companies like Microsoft (NYSE: MSFT) or Schering-Plough (NYSE: SGP) distorts any notions of book value. I haven't figured out what to do here yet, but in thinking out loud I'll probably move more towards a Return on Invested Capital type calculation.
That's the recap thus far. Now why are we doing this? Simple. Because there are more than 9,000 companies listed on the three major U.S. exchanges, and there are only 24 hours in each day. By the time we run through these steps, ideally we will have eliminated all but about 200 companies. That's still way too many for one person to evaluate, especially one person with a day job. But we do have this amazing new contraption called the Internet, and we have each other -- a collection of several hundred thousand people who read these articles, and more importantly, the six of you who read all the way to the end.
We are a distributed computer, each with his or her own set of strengths and weaknesses. (My strength is geography. My weakness is chocolate.) Between us we can cover a tremendous amount of ground to explore these companies and determine which ones should rightfully be able to claim the mantle of Rule Maker. Guaranteed we won't all agree, but that's what makes a market.
Then all we have to do is value the dang things and see which ones offer compelling prices. Again, some management of expectations is in order. There is no way that I will ever, ever be able to pinpoint the exact value of a stock. No one can. All we can do is determine quite roughly whether a company is in the range of undervalue, fair value, or overvalue. These types of valuation exercises are crucial, even if they present a wide range. Warren Buffett once said, "In the first edition of Security Analysis, as I recall, Graham used the example of J.I. Case and said, 'Maybe it's worth somewhere between $30 and $110.' He said, 'That doesn't sound so great. How much good does that information do you?' Well, it may do you some good if it's selling below $30 or above $110."
In the next few weeks we'll be doing just this, with some discounted cash flows that I hope to raise above the level of "garbage in, garbage out." The title of this article was originally "The Rule Maker's 'Special Purpose'" in honor of Steve Martin's greatest cinematic creation, Navin Johnson of The Jerk, but my editor is leery of pop-movie references that people might misconstrue. Regardless, we are working toward our own special purpose, a way for investors to evaluate the staying power and value of some of the world's great companies.
Bill Mann's all bling-bling. He owns none of the companies mentioned in this article. The Motley Fool has a disclosure policy.