The Rule Maker Rules

We've gone through the full ration of the Rule Maker criteria over the last four months, retaining the things that we liked and altering things we didn't and jettisoning those that seemed to constrict or deceive us rather than help us make good investment decisions. I hope that one thing is clear: We are not returning to a point at which someone could go down the list and, if the answer were satisfactory at any price, just pull the trigger on a buy. If I can highlight one simple, important concept for Rule Maker investing, it is this: You must be willing to question everything. Question financials. Question growth assumptions. Question whether the company really has the type of competitive advantage that makes for a powerful Rule Maker.

If you come out of an analysis with no notion of risks to a company or to your investment, go try again and invest in NOTHING until you can spell out as many different risks that you can think of. Call it "eyes wide open" investing. You're not going to be able to catch everything, of course, but you should try to, because there is no one, repeat, no one waiting to restore your investment capital should you be caught surprised by a negative business development. This is one of the central tenets of investing only in businesses you understand. It makes it much, much easier to analyze and foresee threats, and then to quantify or discount them.

Our goal with the Rule Maker is to get great companies at good prices. That's not very complicated, but it is pretty difficult to practice, because it requires discipline. As the big bubble from the late 1990s will show, discipline is often in short supply in the stock market. Why try to remain true to core fundamentals when you can jump on the giant feedback loop of a company that has tripled in price in the last three weeks? Why indeed, because in most cases these companies have now lost more than 90% of their market value. So, let's highlight the most important part of our new Rule Maker creed:

A Rule Maker investor seeks to buy great companies at good prices.
Note the dichotomy. The most important thing about a Rule Maker is that it is a great company. Price is secondary, but in no way does this make it unimportant. Overpaying for a great company may not be as fatal as overpaying for a garbage company, but it does not portend great returns. Just the same, NOT selling a company when it has become absurdly overpriced can be just as bad a mistake. When Cisco (Nasdaq: CSCO) was valued at $500 billion (or even $300 billion, really), it was foolish of us not to say "Well, it doesn't get much better than that, folks," and move on.

The key, then, is to identify a great Rule Making company. There are two "must-have" characteristics:

1. The company must have at least one sustainable competitive advantage. The more, the better.
Companies with sustainable advantages are actually sheltered from competition. They have powerful brands, a deep-seated corporate culture, low-cost processes, de facto monopolies or standards, patents, or unduplicable distribution systems.

2. The company must be dominant in its given industry.
Think of how difficult it would be for another soft drink company to muscle in on Coca-Cola (NYSE: KO) and PepsiCo (NYSE: PEP). Or how much money it would take for a company to duplicate the distribution network of one of the pharmaceutical oligarchs like Merck (NYSE: MRK), Bristol-Myers Squibb (NYSE: BMY), and Pfizer (NYSE: PFE). Or to knock America Online (NYSE: AOL) off its perch as an online provider. A Rule Maker must, in fact, rule. The narrower the industry, the more dominant the company must be.

The above criteria are not optional. They require the deepest analysis, the most power from the skeptical mind. But identify companies that possess these characteristics and you've got the makings of a strong watch list. At some point, though, you're going to want to add in some financial analysis, since we do want to be able to place a value on the damn things. So we should attach some financial tests. The more of these a company passes, the better, but each one is optional.

3. A Rule Maker has been dominant for more than a decade.
This eliminates many different kinds of companies, most notably newer ones. We do not want to assume that companies that have recently ascended to power will stay there forever, because a market changing that rapidly does not generally settle down all at once. We want a company to show that it possesses good economics through a full market cycle. That means having access to 10 years' worth of financial data.

4. Cash King Margin in excess of 10%.
We believe that the free cash flow of a company is a much better determinant of economic strength than earnings. A company that can create 10% or more free cash flow from its revenues is producing a powerful weapon: money that it can either reinvest or return to shareholders. Some businesses, such as many types of retailing, will not allow such margins.

5. Efficient Working Capital Management, measured by a Foolish Flow Ratio below 1.25.
This item is nearly universal. There are very few businesses where the need to pay out money faster than it comes in is a positive attribute. The components of the Flow Ratio are current assets - cash, divided by current liabilities - short-term debt. Temporary spikes are OK, long-term bad capital management is not.

6. Sales above $4 billion per year, and growing revenues at 10% plus rates.
The first part of this will eliminate all but a few select companies, the second even more so. Cross them over and almost no company will be able to meet the test. Still, we want big companies, and we would like them to be in industries that have promising futures, evidenced by above-average growth today. Neither, however, should be taken as hard limits, and be wary of any company that consistently says it's going to grow at 15%+ rates. Be even more wary of a company that is growing at slower rates than its competition.

7. Best-of-class management.
We are not going to know everything about a company, and sometimes managements perceived by the public as great turn out to be anything but (example: Enron). Still, you want to try to own companies run by managers who are honest and who show above-average skill at increasing the value of people's investments in good times and in bad.

8. Return On Invested Capital above 11%.
ROIC measures the amount of money a company creates using its capital base. A company that produces anything below 11% is not providing enough return to compensate investors for this added risk they are taking in buying individual equities rather than simply buying an index fund comprised of the S&P 500.

9. Cash no less than 1.5 times debt.
This one is important. Only under extraordinary circumstances would an investor want to buy a company that is being financed by enormous amounts of debt. Some debt is good; bunches of debt introduce an enormous risk to investors.

Following these, we add our valuation component.

10. A reasonable purchase (or holding) price.
We'd like to be able to buy a company that approaches 60% of our calculation of its intrinsic value and sell it as it approaches 100%. Some companies might grow and NEVER make it to 100% -- the prospects for future business might be improving along with the stock price. In order to make such determinations, an investor requires a firm understanding of a company's underlying business and future prospects.

Well, that about does it. We can take these new criteria and tape them up on the wall or some other convenient place, like, for example, our neighbor's back. Use these criteria as a basis for evaluation and work your noodle in terms of valuation, and you can be on the road to identifying the truly superior companies and determining what value to assign them. We'll be here to help, to provide feedback, and, if need be, to mock. I've gotten some great ideas from people for Rule Maker companies to study. Be sure to keep them coming!

Cisco Reports
One final note: After the bell yesterday, Cisco announced that it had tripled its earnings over the same period last year, to $0.10 per share. Cisco's revenue numbers were flat, though its earnings from equipment sales were down slightly. Obviously, this is a company that still faces a brutal environment for its products, since we are still mired in a telecommunications debt overhang. However, there were a few things to really like about Cisco's earnings report. It was thorough and included gobs more information than its past earnings releases, including a very clear description of the alterations between GAAP and pro forma earnings. It also made tremendous strides in improving its cash conversion cycles, with tremendous decreases in receivables and inventories. Given the grim environment, there was a lot to like in Cisco's report.

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

Bill Mann's still trying to use the word "yclept" in an article. At time of publishing, he had beneficial interest in Cisco and Pfizer. The Motley Fool is investors writing for investors.