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 lululemon athletica (NASDAQ:LULU) 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
Mass market? Check. Lululemon has retail stores across the globe. Repeat purchase? Sure. All clothing eventually wears out, and at some point you'll even have to replace your very-well-made lululemon yoga gear (especially if you're an ardent and particularly hard-working yoga practitioner). Low priced? Not so much. Lululemon makes great workout clothing, but it ain't cheap.
But that's OK. Two out of three on this, our first Rule Maker benchmark, is good enough to score solid marks for lululemon.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%.
- Lululemon comes in strong here, with a gross margin trailing 12 months of 56%.
- Versus only 43% for super-powered rival Nike (NYSE:NKE).
- More similarly sized Under Armour (NYSE:UAA) hits a 48% gross margin.
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.
- Lululemon's net profit margin TTM is a better-than-Rule-Making 18.5%.
- Nike is solid on this metric, with a net profit margin of 8.7%.
- Under Armour could stand to be getting more pennies from its dollars of sales, with a net profit margin of only 6.4%.
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.
- Lululemon grew its year-over-year sales by a staggering 33.1%.
- Nike comes in at a very healthy 9.7% on this metric.
- Under Armour had a great quarter, too, with YOY sales growth of 23.6%.
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:
- Lululemon has $444 million in cash and zero debt. It doesn't get much better than that.
- $3.3 billion in cash and $364 million in debt gives Nike an excellent 9:1 ratio.
- $157 million in cash and $72 million in debt gives Under Armour a similarly excellent 2:2 ratio.
Money is extraordinarily cheap right now. As such, too many companies are in debt up to their corner offices. Kudos to all three of our companies for keeping their balance sheets in proper Rule Maker 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:
- Lululemon, frankly, could be doing better here, with 2:1 ratio.
- Nike needs some help on this metric, too, with its identical 2:1 ratio.
- Under Armour joins lululemon and Nike, with its own poor 2:7 ratio.
7. Your familiarity and interest
What's in a name? Quite a bit. Your familiarity with and interest in a company can 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 already know and love what lululemon does: It makes some of the planet's finest yoga and general workout gear. The great thing about investing in a company like this is that you know exactly how it makes money; there's most likely no mystery line of business buried down in the books that's going to jump out and bite you. As such, lululemon easily maxes out this, our final Rule-Maker metric.
Great yoga gear, great investment
Aside from a considerable deficiency in the Foolish Flow Ratio, which, to be fair, all three of our companies seem to suffer from, lululemon did fabulously on all 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 companies mentioned in this column. Follow John's dispatches from the bleeding edge of capitalism on Twitter @TMFGrgurich. The Motley Fool owns shares of Under Armour. Motley Fool newsletter services have recommended buying shares of Under Armour, Nike, and lululemon athletica. Motley Fool newsletter services have recommended creating a diagonal call position in Nike. 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.