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 Chipotle Mexican Grill (NYSE:CMG) through Tom's merciless gauntlet and see exactly what makes it a classic Rule Maker and, as such, possibly the perfect long-term stock.
1. The mass-market, repeat purchase of low-priced goods
This is an easy benchmark for the boutique burrito maker to hit. Chipotle makes burritos -- relatively cheap food, filling, and easy to make. The ones Chipotle makes are particularly good, made with the highest-quality ingredients. And good enough to keep people coming back over and over again.
Now, a Chipotle burrito isn't as cheap as a can of soda from Coca-Cola (NYSE:KO) -- the company that practically defines the mass-market/repeat purchase/low-priced goods Rule Maker category -- but it's cheap enough in a relative sense to keep the company's cash registers ringing and ringing and ringing.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%.
- Chipotle comes in at a gross margin trailing 12 months of 38%. (More on why that's good in a moment.)
- Yum! Brands (NYSE:YUM), operator of that other burrito joint, has a gross margin TTM of 27%.
- Finally, McDonald's (NYSE:MCD) comes in at a gross margin TTM of 39%.
Not all industries are born equal. As such, not all benchmarks can be applied equally, gross margin being one in this case. 60% is a reasonable ask for the fast-food/casual dining sector, the average gross margin being only 32%. This means Chipotle's 38%, as well as McDonald's 39%, are both exceptional.
3. Net profit margin
Net profit margin dictates how many pennies a company gets to keep from every dollar of sales. Tom likes to see net profit margins of 10% for his Rule Makers.
- Chipotle's net profit margin TTM is a spot-on 10.4%.
- Yum!'s net profit margin TTM is even better at 11.9% TTM.
- McDonald's serves up the Big Mac of net profit margins here: 21.7% TTM. The size of company -- and the economies of scale that come with that size -- is what helps make that high net profit margin possible.
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.
- Chipotle grew its year-over-year sales by a big 18.4%.
- Yum! grew its YOY sales by a solid 9%.
- McDonald's had a tough quarter, however, with YOY sales down by 0.2%.
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:
- $574 million in cash and $3.6 million in debt gives Chipotle the rarely seen, brilliant 159:1 ratio.
- Put that in your burrito and wrap it, McDonald's, which -- with $2.2 billion in cash and $13.3 billion in debt on the books -- serves up the not-too-tasty 0.17 ratio.
- Finally, $942 million in cash and $3 billion in debt gives Yum! the ever-so-slightly better 0.31 ratio.
Money is extraordinarily cheap right now. As such, too many companies are in debt up to their corner offices. Kudos at least to Chipotle for keeping its balance sheet in proper Rule Maker trim here.
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:
- Chipotle does very well on this metric, with a 0.52 ratio.
- Yum! does very well, too, with a 0.50 ratio.
- McDonald's is no slacker on this metric either, with a 0.49 ratio.
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.
If you're reading this article, chances are you know and love what Chipotle does: It makes some of the finest burritos on the planet. And the great thing about investing in a company like this is that you know exactly how it makes money; there's no mystery line of business buried down in the books that's going to jump out and bite you. As such, Chipotle easily maxes out, this, our final Rule Maker metric.
Great burritos, great investment
Other than the realities of gross margin for this industry, there's nothing to apologize here for Chipotle. Quite the opposite, in fact. Chipotle easily hits or sails past all of our Rule Maker benchmarks, making it not only a classic Rule Maker, but a perfect long-term investment.
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 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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Fool contributor John Grgurich owns no shares of any of the companies mentioned in this column. Follow John's dispatches from the bleeding edge of capitalism on Twitter @TMFGrgurich. The Motley Fool owns shares of Chipotle Mexican Grill and McDonald's. Motley Fool newsletter services have recommended buying shares of Chipotle Mexican Grill, Coca-Cola, and McDonald's. Motley Fool newsletter services have recommended creating a bull call spread position in McDonald's. The Motley Fool has a strangely gripping disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.