The Rule Maker strategy is built upon the idea that individuals should have at least a portion of their portfolio dedicated to rock-solid companies that they plan not to sell for 5-10 years or longer. This buy-and-hold model limits the commission-, tax- and opportunity-costs of investing.
The quintessential Rule Making company is one who manufactures products and provides services bought every day or every week by tens of millions of people the world over. This repeated sale of the same profitable item, over and over, results in the methodical accumulation of a mother lode of cash on a Rule Maker's balance sheet.
But a Rule Maker is more than just an industry leader. Certain industries don't yet (and may never) offer the sort of company that would attract a good Fool's investment money. For instance, as an investor, the leading maker of sewing machines is likely far less attractive than America's third-best pharmaceutical business. Some industries will create zero Rule Makers, while others may house a half-dozen. Finding Rule Makers is more about finding the appropriate business model for long-term investment than it is about picking the leaders in each category.
There are 10 characteristics that we look for in a worthy Rule Maker investment candidate:
1. At least one sustainable competitive advantage -- and the more, the better.
A company with a sustainable competitive advantage has differentiated itself in such a way that it's sheltered from competition. Brands, trade names, patents, de facto standards, consumer monopolies, and superior distribution systems are just a few examples of sustainable competitive advantage.
2. Great management of unquestionable integrity and with a track record of excellence.
When making an investment, no matter how much research you do on a particular company, it's just plain impossible to know everything. Therefore, the best way to minimize the risk and maximize the opportunity of what you don't know is to buy a company with best-of-class management.
3. Expanding possibilities that will allow the company to have a future that's sweeter than the present.
We want to invest in businesses that can be bigger and stronger five or ten years from now than they are today. 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?
4. Annual sales growth of at least 10%.
Sales growth is the most fundamental indication of an expanding business. A company with growing sales has either rising customer demand or pricing power -- or perhaps both. We're looking for companies that are growing sales (a.k.a. revenue) by at least 10% per year, which is a decent clip for large-cap Rule Makers.
5. Gross margins greater than 50%.
Gross margins are a reflection of how expensive it is to manufacture a product relative to the price at which it can be sold. Ideally, a Rule Maker has a product that costs very little to manufacture, but that can be sold dearly. Thus, we would like to see gross margins ringing in above the very lofty perch of 50%.
6. Net profit margin of at least 10%.
The net margin tells us how much profit a company is making after every cost has been subtracted from sales revenues. The calculation is net income (after all expenses that include taxes, the marketing and administrative expenses, etc.) divided by sales. Thus, we're looking for companies that earn at least a dime of profit on each dollar of sales.
7. Cash King Margin greater than 10%.
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%.
8. Cash no less than 1.5 times total debt.
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).
9. Efficient working capital management, as measured by a Foolish Flow Ratio no greater than 1.25.
One of the most important attributes of a Rule Maker is efficient use of cash. We want our companies to bring money in quickly, but to pay it out slowly. We can measure how well a company does this with our Foolish Flow Ratio. This is the ratio of current assets less cash, divided by current liabilities less short-term debt. We go in search of Flow Ratios that run lower than 1.25.
10. A reasonable purchase price that allows for the clear possibility of 2x/5y.
This last one is an investment criterion. With Rule Makers, our goal is to buy at a price that allows us to have a good shot at doubling our money (2x) over the course of five years (5y) -- that's a 14.9% annual return. The 2x/5y pursuit is not so much a matter of stock valuation, but rather of business e-valuation. In order to assess the likelihood of a company's market cap doubling in the next five years, you need a solid understanding of the underlying business and its future prospects.