When I began investing, I was starting from a knowledge base of zero. Nada. Absolute scratch.
One of the first books I read was The Motley Fool's Rule Breakers, Rule Makers. In it, Motley Fool co-founder and CEO Tom Gardner laid out specific criteria for crowning a company a "rule maker," i.e., a large, mature, consumer-facing company that's king of its market space, and an investment that can be confidently and profitably 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 methodology will benefit even advanced investors.
Today we're going to run networking giant Cisco Systems (Nasdaq: CSCO) through Tom Gardner's merciless gauntlet and see exactly what it takes to make the rule-maker grade. In the course of our analysis, we'll use quarterly earnings numbers for the period ending July 30 of this year.
1. The mass-market, repeated purchase of low-priced goods
After more than 25 years, Cisco is still the leading manufacturer of networking products for local- and wide-area networks and computing systems.
And for a company that operates only business to business, it has significant name recognition among the general public, much more so than peers Alcatel Lucent (NYSE: ALU) and Riverbed Technology (Nasdaq: RVBD). Cisco makes the grade here.
2. Gross margin
The gross margin for a rule maker should be 60% or more, indicating market-dominating pricing power and manufacturing efficiencies. Cisco's is a solid 60%. In comparison, peer Hewlett-Packard's (NYSE: HPQ) gross margin is a mere 23%.
3. Net profit margin
As Tom Gardner so aptly puts it in the book, "The reward of high gross margin is surpassed only by the treasures of high net profit margin." Net profit margin, as a reminder, tells us how much profit a company makes from every dollar of sales. Cisco's is 11%, nicely topping our rule-maker minimum of 10%.
4. Sales growth
A year-over-year growth in sales counts even for big companies, where it will naturally slow with age, because it's an indicator of business momentum.
Cisco's sales growth is 3.3%. In Tom Gardner's book, that earns Cisco a middling rule-maker score, i.e., it's not bad, but it could be better. Top-tier rule makers grow their sales by 10% every year. In comparison, peer Juniper Networks' (NYSE: JNPR) sales growth is a very healthy 14.5%.
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. A look at the balance sheet shows us Cisco has $44.6 billion in cash and cash equivalents and $16.2 billion in debt, giving the company 2.75 times more cash than debt. Nicely done, Cisco.
6. The Foolish flow ratio
The Foolish flow ratio measures how well a company manages its inventory and cash. Specifically, a company should be keeping its inventory and accounts receivable low, and paying suppliers on its own terms -- both strong indicators of market-space dominance.
To calculate the Foolish flow ratio, take current assets minus cash and divide by current liabilities. Cisco comes in at 0.76. The best companies have Foolish flow ratios of 1.0 or less. So far so good.
7. Your familiarity and interest
What's in a name, you ask? A lot. Your familiarity and interest in a company help you understand exactly what the business does and how it makes money, thereby lowering your overall risk.
Cisco isn't exactly Coca-Cola in these terms, but the company is well enough known and has an understandable enough business model to get it a satisfactory rule-maker rating from me in this category.
Cisco, you may ascend the throne
Solid pricing power. A fine top line and a great bottom line. And one item we need to watch: the Foolish flow ratio. Nevertheless, Cisco is a true rule maker in its market space. As a reminder, the metrics used here should be applied to all of your rule-maker investments each quarter, at earnings time.
In The Motley Fool's 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, literally, wrote the book on it.
Cisco isn't the only stock you can profitably and confidently hold onto for the long term. My fellow Fools have picked out -- and bought shares of -- five more companies they think will maintain their edge and outperform over the long term. You can get a free copy of their special report by clicking here.
