When I began investing, I was starting from a knowledge base of zero.
One of the first books I read was The Motley Fool's Rule Breakers, Rule Makers. In it, Motley Fool co-founder Tom Gardner laid out specific criteria for crowning a company a Rule Maker: a mature, consumer-facing business that's king of its market space, and an investment that can confidently and profitably be held onto for years with only quarterly check-ins.
His step-by-step process for analyzing a business was an easily understandable way for a beginner like me to quickly get up to speed, but its back-to-basics approach will benefit even advanced investors. Today we're going to run video game publisher Activision Blizzard (NASDAQ: ATVI) through Tom's merciless gauntlet and see exactly what makes it a classic Rule-Maker.
1. The mass-market, repeat purchase of low-priced goods
Do you know what World of Warcraft is? Call of Duty? If so, then you know Activision Blizzard, the publisher of these extraordinarily popular video games. Activision Blizzard makes titles for Nintendo's Wii, Microsoft's Xbox, and Sony's (NYSE:SNE) PlayStation and is the world's No. 1 video-game publisher.
The games aren't exactly cheap, but at $59 for the latest version of Call of Duty for Xbox, they're not terribly expensive, either. As such, when updates are released, fans rush out and scoop them up. So Activision Blizzard clearly makes mass-market items at reasonable enough prices to keep consumers coming back for more. Well done on our first Rule-Maker benchmark, Activision.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%.
- At 63%, Activision easily aces this Rule-Maker metric.
- Rival game publisher Electronic Arts (NASDAQ:EA) does very well, too, with a trailing-12-month gross margin of 62%.
- Sony manages only a 20% gross margin, but Sony does a lot more than just publish software; it's much tougher to have a high gross margin when you're manufacturing hardware. Even Apple (NASDAQ:AAPL) hits only 44% on this metric, and it runs one of the leanest, meanest hardware manufacturing operations in the business. As such, we'll cut Sony some slack here.
3. Net-profit margin
Net-profit margin dictates how many pennies a company gets to keep from every dollar of sales. Tom Gardner likes to see net-profit margins of 10% for his Rule Makers.
- Activision's net-profit margin TTM is a positively whopping 19.89%.
- Electronic Arts' net-profit margin TTM is a positively unwhopping 0.37%. That's worse than some supermarket chains, which can have some of the slimmest profit margins of any industry.
- Sony is apparently losing money on all it's sales right now, with a net-profit margin TTM of -6.97%.
4. Sales growth
Year-over-year sales, or revenue, growth counts even for big companies, where it will naturally slow with age, because it's an indicator of business momentum. Top-tier rule makers grow their sales by 10% every year.
- Activision grew its year-over-year quarterly sales by a Rule-Making 11.5%.
- Electronic Arts YOY quarterly sales actually contracted by 0.6%.
- Sony grew its YOY quarterly sales by 1.9%, which is better than no growth at all or negative growth.
5. Cash-to-debt ratio
Rule Makers should be cash heavy and debt light, ideally having at least 1.5 times more cash than debt:
- $3.4 billion in cash and zero debt gives Activision the best cash-to-debt position possible.
- $1.3 billion in cash and $549 million in debt gives Electronic Arts the enviable C/D of 2.37.
- $5.4 billion in cash and $16.2 billion in debt gives EMC the unenviable C/D of 0.33.
Money is so cheap right now. As such, too many companies are in debt up to their corner offices. Kudos to two of our companies for keeping their balance sheets in top Rule-Making trim.
6. The Foolish Flow Ratio
The Foolish Flow Ratio measures how well a company manages its inventory and cash. A company should be keeping its inventory and accounts receivables low and its accounts payables high: strong indicators of market-space dominance.
To calculate the Foolish Flow Ratio, take current assets minus cash, cash equivalents, and short-term investments, then divide by current liabilities. The acceptable upper limit for the Foolish flow ratio is 1.25, but the lower the number the better:
- Activision comes in very solid on this metric, with an F/F of 0.77.
- Electronic Arts also does even better, with an F/F of 0.50.
- And Sony comes in with the best F/F of all: 0.48.
7. Your familiarity and interest
What's in a name? Quite a bit. Your familiarity and interest with a company help you understand exactly what it does and how it makes money, thereby lowering your overall investing risk.
Activision Blizzard isn't the big name here so much as the names of the titles the company publishes, but it's still a well-enough known name in and of itself. And the company's business model is dead easy: making and publishing video games. The company scores solid, then, on this final Rule-Maker benchmark.
Activision Blizzard: above and beyond the call of duty
Activision doesn't miss a beat on any of our Rule-Maker metrics. As such, there's no question the video game publishing superstar is also a classic Rule Maker. But always remember to check in on your Rule-Maker investments once a quarter by running them through this simple checklist. In Rule Breakers, Rule Makers, Tom Gardner goes into even greater depth and detail about what exactly makes a Rule Maker a Rule Maker. So I suggest you pick up a copy for yourself and get the whole story from the man who wrote the book on it.
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The Motley Fool owns shares of Apple, Amazon.com, Activision Blizzard, and Microsoft, is short Sony, and has options on Sony. Motley Fool newsletter services recommend Apple, Amazon.com, Activision Blizzard, Electronic Arts, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.