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 energy industry equipment maker National Oilwell Varco (NYSE:NOV) 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
This space is normally reserved for companies that 99% of people have previously heard of. National Oilwell Varco is not one of those companies, but it has such a beautifully simple -- and globally in-demand -- business model that I just couldn't pass it up.
Varco is the world's largest equipment manufacturer for the energy industry: selling and servicing just about every product under the sun for oil and natural gas drilling. Varco makes everything from the iconic deepwater drilling rigs found in all parts of the world, to the spare parts that keep all the industry's equipment -- big and small -- running smoothly.
While Varco is not a mass-marketer of products in the consumer goods sense, it certainly serves a mass market. And while Varco is a mix of high-priced and low-priced goods, there's certainly a lot of repeat purchase in the energy industry: whether for new equipment or for replacement parts. As such, while Varco doesn't ace our first Rule Maker benchmark, it performs solidly.
2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%.
- Varco's gross margin is 28% (hardly in striking distance of our benchmark, but more on that in a moment).
- Rival Halliburton (NYSE:HAL) has a trailing-12-month gross margin of only 17%.
- Weatherford International (NYSE: WFT) manages 26%.
For some industries, a 60% gross margin just isn't a possibility, no mater how much any of us want it to be. The average gross margin for this sector is 31%. Given that, we'll say that Varco is solid on this Rule Maker benchmark.
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.
- Varco's trailing-12-month net-profit margin is a benchmark-beating 12.88%.
- Halliburton's trailing-12-month net-profit margin is very strong, too, at 10.16%.
- Weatherford's net-profit margin? Not so strong: 2.53%.
4. Sales growth
Year-over-year sales, or revenue, growth counts even for big companies, where it will naturally slows with age, because it's an indicator of business momentum. Top-tier Rule Makers grow their sales by 10% every year.
- Varco grew its revenue by a stunning 42.2%.
- Halliburton was a solid 8.6%.
- And Weatherford did very well on this metric, to say the least, with year-over-year revenue growth of 26%.
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:
- $1.7 billion in cash and $1.5 billion in debt gives Varco a cash to debt ratio of 1.13.
- $2 billion in cash and $4.8 billion in debt gives Halliburton a cash to debt ratio of 0.42.
- And $339 million in cash and $7.9 billion in debt gives Weatherford a cash to debt ratio of 0.04.
Money is so cheap right now. As such, too many companies are in debt up to their corner offices. Kudos to Varco for at least remaining within striking distance of a good cash to debt ratio.
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:
- Varco comes in high on this metric, with a Foolish Flow Ratio of 1.71.
- Halliburton comes in even higher: Foolish Flow Ratio of 2.33.
- Weatherford does the best of all our Rule Maker contestants here, with an Foolish Flow Ratio of 1.6, but all of our companies could really stand to tighten up their ships in this respect.
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.
Again, you may have never heard of Varco before, but a clear understanding of how the company makes money (which you now have) should go a long way toward giving you a solid level of comfort investing in Varco, and therefore give Varco solid marks on this final Rule Maker metric.
Varco: a classic Rule Maker
Varco's cash to debt ratio and Foolish Flow Ratio both could be better, and the company should work to shore these ratios up. But the company is more than solid otherwise: It dominates an expanding industry, has great profit margins and revenue growth, and has a dead-simple business model. And remember, Rule Makers don't have to hit every metric out of the park; they just need to be great performing companies over the long run. That's what counts, and that's what makes Varco a 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.