"It takes a long time to bring excellence to maturity."
-- Publius Syrus
So, OK, you've decided that Rule Maker investing might make sense. You like the idea of trading infrequently -- buying a stock in the hopes of never selling. You're tired of making stock brokers a little rich, and making market makers (the people who profit from the bid-and-ask price "spreads") a lot richer, and you're thinking there might be a lot of long-term money in all this. But, of course, an investment approach that steers you into holding a stock possibly for decades should make you awfully picky about which stocks to buy! Pick the wrong one, or few, and you might get very little return for a very long time.
Ahh, now it's time to look at some of the general guidelines we use to select Rule Maker candidates.
The Rule Maker criteria rest on the premise that understanding a company's business -- both its location and its direction -- is essential to successful investing. The 10 guidelines below aim to help you synthesize the essential elements of a company's business model. We consider the first two items to be "must haves" -- companies lacking these would not be defined as Rule Makers. The remaining eight are more subjective: Certain companies do not have businesses that lend themselves to big margins, for example. In these cases, we want the company to pass each of these tests but do not require them to. Be prepared, though. For each criterion that the company does not meet, you should as a matter of course be able to describe why it still qualifies. These criteria are not meant to form the basis of a mechanical methodology -- the Rule Maker should be a thinking man's strategy, one where the companies are vetted backwards and forwards, and only then are they considered for potential investment.
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.
So, without further ado, here are the Rule Maker criteria:
- Sustainable competitive advantage
- The company must be dominant in its given industry
- A Rule Maker has been dominant for more than a decade
- Cash King Margin in excess of 10%
- Foolish Flow Ratio below 1.25
- Sales above $4 billion per year and growing revenues at 10% plus rates
- Great management
- Return On Invested Capital above 11%
- Cash no less than 1.5 times debt
- A reasonable purchase (or holding) price
The key, then, is to identify a great Rule Making company. The top two are "must-have" characteristics, followed by eight criteria:
1. The company must have at least one sustainable competitive advantage. The more, the better.
Companies with sustainable advantages are 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.
A sustainable competitive advantage is the fertile soil for long-term wealth creation. As Warren Buffett often quips, find a company surrounded by a wide moat filled with crocodiles and you've taken the first step towards identifying a company worth owning for many, many years. Finding companies with at least one sustainable competitive advantage is the first step toward locating the Rule Makers you'll want to hold for years, maybe decades.
In looking at competition, be sure to take a wide view. The competitive landscape is far more than a company's head-to-head rivals. Competition also potentially includes any powerful buyers and suppliers, the threat of new entrants, and the threat of substitute products. Is it any wonder that Intel (Nasdaq: INTC) Chairman Andy Grove says that "only the paranoid survive" in the business world?
But what exactly is a sustainable competitive advantage (hereafter, SCA)? Here's a definition: SCA is not only about doing it better (though that's certainly part of it), but it is also about doing it differently. There are probably as many varieties of SCAs as there are great businesses. What they all have in common, however, is differentiation -- something that sets apart a company's product or service from the rest of the pack. More specifically, a product or service is differentiated when it is: 1) unique, 2) widely valued, and 3) rewarded for its uniqueness with a premium price.
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.
Note that, in many industries, the company need not be dominant overall. For example, there is not one single pharmaceutical company that controls 50% or more of the total market, nor need there be. In restaurants it's the same: McDonald's (NYSE: MCD) has plenty of good competition, some of it from other companies that could be designated Rule Makers as well, such as Wendy's (NYSE: WEN). What one must control against is the potential for new or existing competition to come up and knock it off its perch.
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.
Why 10? It's an arbitrary number, actually. But in any 10-year period, you are generally guaranteed to have one or two bad years included, so you can see how the company operates in all types of economic environments. When the Rule Maker bought Nokia (NYSE: NOK) in early 2000, we had found the certain king of the mobile phone world. What we had not seen was how Nokia would perform when times got tough. The answer turned out to be: pretty well, but not well enough to meet the assumptions built for the company when times were great. We bought the right company, but our lack of patience got us into it at the wrong price. Nokia had only led the field for three years, and, at the time, no one knew what was coming next. We never will, and as such we need to seek safety in the price we pay.
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.
The Cash King Margin is similar to the net margin, except that instead of measuring profits with net income from the income statement, we use free cash flow from the cash flow statement. The advantage of measuring profits with free cash flow is that cash flow isn't as easily manipulated as net income. The calculation here is free cash flow divided by sales. We're looking for Rule Makers that generate lots of the green stuff, and thus we want to see a Cash King Margin of at least 10%. (For an in-depth explanation of free cash flow, this article serves as a good reference.)
Turning to Intel's cash flow statement for 2000, we see that the silicon king generated $12.8 billion in "Net Cash Provided by Operating Activities." We can also see that the company invested $6.7 billion in "Additions to Property, Plant, and Equipment." Calculating free cash flow is a simple matter of taking operating cash flow ($12.8B) minus capital expenditures ($6.7B), which leaves us with $6.1 billion in cash that Intel has free rein to distribute to shareholders either as a dividend or via a share buyback -- or it could just sock it in the bank.
We're now ready to calculate the Cash King Margin:
Intel Fiscal Year 2000 Sales Free Cash Flow Cash King Margin $33.7B $6.1B 18.1%
In other words, for every dollar of sales, Intel generated 18.1 cents in free cash flow.
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.
In the day-to-day management of a company's operation, money is going to rush through the front door from sales, and it's going to fly out the window and the backdoor from expenses. As noted earlier in these steps, businesses survive on cash. That's their oxygen. Without dollars coming in, they can't pay for employees, for equipment, for insurance, for holiday parties, for new technology, for anything. So, how a business manages the dollars that flow through their daily operations is of critical importance.
We want our companies to bring money in quickly, but to pay it out slowly. More cash coming in today, less cash going out today. If that makes sense, then let's go to the balance sheet and dig up some relevant entries, specifically current assets and current liabilities. Current assets represent assets that are expected to turn into cash in the coming year, while current liabilities represent all costs that will have to be paid down in the coming year.
This is where we might get confusing. We're going to try to convince you that non-cash current assets aren't assets at all. They're liabilities! And some liabilities are, for all practical purposes, assets! OK, stay with us, we can explain.
When you take the cash out of current assets, you're left with two primary categories: inventory and accounts receivable. The former is product in various stages of development that hasn't yet been sold. Some of it is raw material; some of it is finished product waiting to be sold. But let us convince you that all of it is a liability. Why? Because there's a cost to storing inventory on shelves in an enormous warehouse outside of town. Wouldn't you be much happier to see that inventory in a store today, in the form of a giant stuffed Donald Duck doll, in the hands of a parent out birthday shopping? So would we. Certainly, every company on the planet has to carry inventory. We just like those that can quickly assemble a product and race it out to the door into the marketplace. Because, after all, inventory is just potential cash sitting on shelves. We'd rather have the cash, thanks.
The remaining current asset category is accounts receivable, which reflects payments that your company hasn't collected yet. Let's say that you've invested in a camera maker that has $43 million in accounts receivable. That entry reflects $43 million of cash from operations that your company is owed by its customers. Maybe $10 million of it came from camera sales into Europe -- from which payments take 8-10 weeks. That cash isn't yet in your company's coffers. It isn't going to work for the business. Its delayed arrival, Fool, is a liability to the business. Well-positioned companies are able to require upfront payments from customers and also have mastered the art of keeping inventory low while driving sales higher.
That's the current assets line. And, as we've said, when cash and marketable securities are removed from the grouping, we like to see that number low and falling.
"Low -- huh? Low relative to what?"
Aha, yes. By "low" we mean low relative to current liabilities. Now that you know that current assets represent all things that will be turned into cash in the year ahead, you know as well that current liabilities represent all costs that will have to be paid down over the next year. Contrary to your personal finances, many companies would like to hold off their short-term payments for as long as possible. If they can earn more by holding their cash than they can by doling it out to their suppliers, they should want to hold onto it. The key to that is in their writing of contracts and in the stable, prominent, desirable position they've gained in their industry. For example, small businesses working with General Electric (NYSE: GE) will often gladly accept payments three months after billing. Why? Because working with General Electric brings them steady income, strengthens their reputation, and helps them stay in business!
So, what we've just proposed is as contrary as it comes. We're telling you, Fool, that when it comes to large, profitable companies, you should think of current assets as actually being current liabilities and vice versa. Those accounts receivable and those inventories are a bad thing. Those payments your company can hold off for a few more weeks are a good thing. Except for short-term debt, which carries the burden of interest, all other current liabilities represent a free form of financing. Free is good. We like free.
But, you ask, "How can we possibly measure all that?" Well, with a little something we call the Foolish Flow Ratio. The Foolish Flow Ratio enables you to cut through accounting shenanigans and artfully constructed income statements to get a clear snapshot of how a company is managing its cash.
The simple calculation here is:
(Current Assets - Cash*) Flow Ratio = -------------------------------- (Current Liabilities - ST Debt**)
* Cash = cash & equivalents, marketable securities, and short-term investments
** Short-term Debt = notes payable and current portion of long-term debt
Guidelines for the numbers? We go in search of Flow Ratios that run lower than 1.25, ideally below 1.0. If they get below 1.0, it means that the business is able to delay more payments than they're carrying in costs of inventory and unpaid bills. In this group below 1.0, you'll find companies like Microsoft (Nasdaq: MSFT), AOL Time Warner (NYSE: AOL), Intel, and others. Companies in such strong position that they have leverage over their partners -- both those that supply them with raw materials or services and those that help them distribute stuff to the end consumer.
Ready for an example?
Intel Fiscal Year 2000 Cash & Cash Equivalents = $13.8B Current Assets = 21.2B Short-term Debt = 0.4B Current Liabilities = 8.7B (Current Assets - Cash & Equiv.) Flow Ratio = --------------------------------------- (Current Liabilities - Short-term Debt) = (21.2 - 13.8) / (8.7 - 0.4) = 0.89
The Flow Ratio is just one of many measures of quality, but we think it makes an excellent starting point. Again, we want companies that have a Flow Ratio less than 1.25, and ideally less than 1.0. The Flowie is your friend. By running it, you'll be measuring how tightly the company manages cash as it flows through their business. Are they being lazy in collecting their bills? Are they being sloppy in managing their inventory? Are they in such a weak financial position that their partners demand cash payments from them upfront? If so, look out... this probably isn't a darling horse nor a long-term winner.
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.
That leads us to ask such questions as:
- Will the company be more or less relevant in the future as it is today?
- Does the company compete in an industry that will support growth?
- Does the company have lots of options to grow?
Sales growth is the most fundamental indication of an expanding business. While net profit growth is also important, it can be the result of cost-cutting measures rather than pure business growth. Cost-cutting is all fine and well, but we want to isolate a company's ability to sell more and more of its stuff year after year. And that's exactly what sales growth tells us. We're looking for companies that are growing sales (a.k.a. revenue) by at least 10% per year. This metric is easy to calculate. Using a company's income statement, simply divide the current year's sales by the previous year's sales and subtract one.
Here's an example:
Intel Fiscal Year 2000 2000 Sales 1999 Sales Growth $33.7B $29.4B 14.6%
7. Best-of-class management.
We won't 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.
As Philip Fisher wrote, "The success of a stock purchase does not depend on what is generally known about a company at the time purchase is made. Rather, it depends upon what gets to be known about it after the stock has been bought." He wrote those words more than 40 years ago in his investment classic, Common Stocks & Uncommon Profits.
In Fisher, we find the roots of Rule Maker investing. His approach was to buy the truly exceptional growth company that could be held forever (ideally). He summed up the process of finding these types of companies in his famous "15 Points." These characteristics, in his words, were "to distinguish the relatively few companies with outstanding investment possibilities from the much greater number whose future would vary all the way from the moderately successful to the complete failure."
Using the seven Fisher Points related to management quality, here are some characteristics of great management (with their associated Fisher Point #):
- Unquestionable integrity (Point 15)
- Commitment to new product development (Point 2)
- Outstanding labor and personnel relations (Point 7)
- Outstanding executive relations (Point 8)
- Managerial depth (Point 9)
- Long-range outlook on profits (Point 12)
- Open communication with investors (Point 14)
8. Return On Invested Capital above 11%.
Return on Invested Capital (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 the added risk of 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.
The best Rule Makers sport little or no debt and plenty of cash. If we want to invest in a company that's going to thrive for 10-20 years or more, we don't want short-term profits at the expense of long-term survival and success. No, no... we prefer to find companies that grow their business out of profits from operations and, thus, don't have substantial interest payments to make to banks in the years ahead. Therefore, we require that a company's cash be at least 1.5x greater than their total debt (including both long-term and short-term debt).
Things can go wrong. Things will go wrong. We want companies with the cash to buy themselves out of trouble when it comes knocking on the door. Under the umbrella of cash, we also include such "near cash" line items as cash equivalents, short-term investments, and trading assets. All of these balance sheet entries qualify as funds that are available for immediate use if necessary.
Now, pulling numbers from the balance sheet, here's an example:
Intel Fiscal Year 2000 Cash LT Debt + ST Debt Cash-to-Debt $13.8B $0.7B + 0.4B 12.5x
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.
That leads us to ask such questions as:
- Will the company be more or less relevant in the future as it is today?
- Does the company compete in an industry that will support growth?
- Does the company have lots of options to grow?
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.
In the short term, the investing community can hammer any individual stock. Expect the stock price of even the company you most believe in to get cut in half at some point. Oftentimes, the sell-off will be unwarranted; Mr. Market is just playing games with your short-term emotions. Keep your wits about you. If the stock has a rapid run up, or begins to drop in price, pull out the criteria and run through them again. Do you see any problems or issues in the financials that you had missed before? While the market may simply be telling you "I'm manic," it may also signal that there is something very, very wrong.
We suggest that you largely ignore the short-term wanderings of stock prices and focus on the much harder and yet more rewarding task of trying to accurately project a company's future based on its present financial standing, its managerial strengths, and the scope of its opportunities in the years ahead.
In your search, Fool, you must ask yourself: Are this company's products likely to fulfill needs in the future even better than they did in the past and as they do today? Does management have the vision and operational skill to continue its outstanding performance? And how much opportunity for growth around this planet (and, hey, maybe other worlds someday) is there for this company? These are extremely difficult questions to answer. But to the best of your ability, you'll want to answer 'em. You may get a few wrong. But, remember, one great company compounding market-beating growth for you over the next four decades can pay down your losses many times over.
Step 7: Assessing Valuation ï¿½
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