1. Dominant brand
2. Repeat-purchase business
3. Convenience
4. Expanding possibilities
5. Your familiarity and interest
6. Sales growth of at least 10%
7. Gross margins of at least 50%
8. Net profit margins of 7% or greater
9. Cash no less than 1.5x total debt
10. Efficient Use of Cash (Flow Ratio below 1.25)

1. Dominant Brand

True Rule Makers are looking to establish a direct connection with billions of consumer minds, day in and day out. And they'd like to consistently draw a clear distinction between their product and the generic, competing brand. For example, when you ask for a hanky during allergy season, there's a good chance you'll call for a Kleenex. And when you head out to buy a pair of jeans next month, you might tell a friend, "I'm going to buy some Levi's."

When a product achieves that instant recognition, that consumer habit, it is Foolishly said to have "mindshare." It has burrowed a small home into your cerebellum. And when this happens en masse -- when you, your neighbors, your colleagues, and your enemies all say, "Haaa-choooo! Ugh. Eeew! Do you have a Kleenex, Joe?" -- you have an increasingly defensible business. Having one product with mindshare, or better yet several, is the first sign of a true Rule Maker business.

2. Repeat-Purchase Business

We love these businesses because every time a sale is made, the customer is reminded once again of the value of the company's product. The more often this free advertising occurs, the better. A product that is used often but purchased infrequently, such as software or an automobile, benefits from frequent (and hopefully positive) customer contact. However, future income is more predictable when the product or service is actually repurchased often.

Not surprisingly, the more people who know and appreciate the product, the better chance the company's stock will reward shareholders -- because in business, it's much harder to reverse the purchasing behavior of millions (or billions) of consumers than it is to reverse the purchasing behavior of a few large, wealthy buyers. If, for instance, one of the five corporate buyers of your $10 million video technology take their business elsewhere… you just lost 20% of your business! Ouch. Much better is a mass-market base that doesn't shift and that doesn't have an ability to shake the foundation of your business in an instant.

This stability is best accomplished by driving product popularity, consistent branding, the repeat purchasing of low-priced stuff, and a focus on reaching more and more buyers across the planet.

Please note that this should not be interpreted to mean that software or technology companies can't be Rule Makers. On the contrary, Microsoft and Intel, for example, are Rule Makers, in our opinion. Their high gross and profit margins make it easy to overlook any disadvantage that comes from the relatively infrequent purchase of their products, especially since most buyers of their products use them almost daily. One can imagine, also, that in a networked world, we might be buying services from these providers every week or month online.

3. Convenience

To establish Rule Maker authority, a business must position its products as the most accessible and convenient in its industry. History shows that in virtually every consumer sector, there are few ways to underrate the value of being the leader in convenience for customers. Whether it's buying midlevel shelf space in a supermarket, placing the gas station fifty yards closer to the exit ramp, delivering books right to the doorstep, selling coffee on the corner, or preloading software on a computer, convenience for the customer is crucial to a company's long-term success.

To be sure, rating a company's convenience is a highly subjective endeavor and relies on your ability to make a judgment call comparing a company to its lead competitors. Try to determine if a given company provides the most accessible products or services in its industry. The gold star only goes to companies with best-of-class convenience.

The software industry provides an example of a company that excels in convenience. Its name begins with M and ends with T. Microsoft certainly provides the most conveniently placed software for individuals and corporations. Flip on any computer, a Dell or Gateway, a Compaq or Apple, and preloaded Microsoft icons will peek out at you. Redmond, Washington's software giant committed early on to trying to provide the most accessible and most visible applications for desktop computing.

4. Expanding Possibilities

In the public markets, even more important than the past is the future. We're looking for companies with a direction that's even sweeter than its present location. Sure, historical performance leads us to some great companies, but it doesn't correlate perfectly with future results. Instead, we need to think seriously about a company's future prospects. Is the world going to be buying Beanie Babies in 2010? Does Coca-Cola's brand name have staying power? Are video rental stores going out of business?

Now, the most common mistake an investor can make (financial reporters are particularly prone to this) is to be pessimistic about everything. Gloom-and-doomers can find potential calamity in the cards for any business. You can imagine them taking the following positions:

1. With Coca-Cola, caffeine will be their eventual undoing.
2. General Electric -- they lost Seinfeld at NBC; those guys are toast.
3. Microsoft? When the Justice Department breaks up that monopoly, it'll fall apart.
4. The Gap... they're in a fad business. They can't possibly have staying power.

We're not saying that making these determinations is easy, nor that you shouldn't be skeptical. You'll want to probe your own habits, your own thoughts, read through the company's statements, and ask questions on the message boards to figure if the business you're studying has staying power. And because this one isn't quantifiable, you'll want to return to it again and again. When in doubt, try asking yourself the following questions:

• Do my friends know about and use the company's products?
• Is worldwide expansion believable for their stuff?

Strange musings, yes, but you don't typically have to think for more than ten minutes.

5. Your Familiarity and Interest

On the face of it, the last of our qualitative criteria for finding Rule Makers seems absurd. How does your interest and familiarity with a corporation improve its chances of excelling? It doesn't. This requirement, rather than being applied to public companies, is applied to you, the investor. Absent an understanding of what your businesses really do, you open yourself up to subpar returns. The likelihood that you'll understand whether the bumps and bruises along the way are minor nicks or life-threatening injuries for your company is very high if you can understand and follow its progress.

Thus, this criterion of the Rule Maker is that you find it easy to follow the operational direction of the business. It proposes that you'll dramatically improve your chances of scoring above-average investment returns if you weed out the unfamiliar and concentrate on companies whose products, marketing approach, management, and reputation with customers you'll enjoy following. Whether it's dedicated to the business of NASCAR racing, to selling sandwiches, or manufacturing personal computers, a company will more likely serve you well if you know it well.

6. Sales Growth of at Least 10% Year-Over-Year

Ahh, the numbers... something to hold onto... something to tap into your calculator or spreadsheet! Or perhaps numbers make you shudder…don't worry, though, these are easy.

Sales growth is the most fundamental indication of an expanding business. While net profit growth is important too, it can be the result of cost-cutting measures rather than pure business growth. Cost-cutting is all fine and well, but we want to isolate a company's ability to sell more and more of its stuff year after year. And that's exactly what sales growth tells us. We're looking for companies that are growing sales (a.k.a. revenue) by at least 10% per year. This metric is easy to calculate. Using a company's income statement, simply divide the current year's sales by the previous year's sales and subtract one.

Here's an example:

Schering-Plough (NYSE: SGP) Fiscal Year 1998

1998 Sales  1997 Sales  Growth
$8.08 bil   $6.78 bil   19.2%

Again, we like to see sales growth (current sales divided by year-ago sales minus one) of at least 10%.

7. Gross Margins of at Least 50%

Strong sales growth is dandy, but only if each dollar of sales is profitable. We will not be making a long-term investment in the Rule Maker portfolio in any companies that aren't profitable. Riskier investments in smaller, unprofitable companies can make sense. But since we'll be focusing on mature, consumer-brand behemoths, we want to see substantial profits already in place. So continuing with the income statement, let's look at gross margins.

Gross margins are defined as the gross profits (sales minus cost of goods sold) for a period divided by the revenues for the same period. (If you just got dizzy, we apologize. This is easy. Re-read that.) Here we would like to see gross margins ringing in above the very lofty perch of 50%. In other words, we'd like the company's cost of making the product or providing the service to be no more than half of what that product or service can be sold for.

Here's an example:

Schering-Plough Fiscal Year 1998

           Cost of      Gross      Gross
Sales      Goods Sold   Profits    Margin
$8.08 bil  $1.60 bil    $6.48 bil  80.2%

Again, to calculate gross margins, divide gross profits by sales. We're looking for that number to be above 50%.

8. Net Profit Margins of at Least 7%

It's nice to know that a company can sell its products for double the cost of producing them, but that'd be of little positive consequence if the promotion and overhead expenses associated with that product ended up wiping out the profits. We want the company to still earn good money, even if they pay out $1 million for that advertisement on the Super Bowl. And we don't want the government's 35% tax bite to whittle the bottom line into nothingness.

Therefore, our next objective is that net profit margins be at least 7%. The calculation is net income (after all expenses that include taxes, the marketing and administrative expenses, etc.) divided by sales. So, simply divide the bottom-line earnings by the top-line sales to figure the net profit margin.

Using the income statement, here's an example:

Schering-Plough Fiscal Year 1998

Sales       Net Income    Net Margins
$8.08 bil   $1.76 bil     21.8%

Again, we're looking for net margins (net income divided by sales) to sit above 7%.

9. Cash No Less Than 1.5x Total Debt

We said it of your personal finances, and we'll say it of Rule Maker companies. We'd prefer the financial statements to show little or no debt. Who wants to own a business that announces phenomenal earnings today only because they borrowed heavily from their tomorrow? If we want to invest in a company that's going to thrive for 10-20 years or more, we don't want short-term profits at the expense of long-term survival and success. No, no... we'd prefer to find companies that grow their business out of profits from operations and, thus, don't have substantial interest payments to make to banks in the years ahead.

Because most companies will, and must, borrow money at some point, we don't want to cross off our list all businesses with some debt on their balance sheet. Therefore, we require that a company's cash be at least 1.5x greater than their total debt (including both long-term and short-term debt). A moderate amount of debt doesn't particularly worry us, but if and when bad things do occur, when something goes bump in the night, it's essential that the company have ample and immediate cash resources to deal with the problem. We want them to get their business back on track quickly, earning moola for shareholders. And make no mistake about it, over the course of a decade or two, or three, bad things will happen to every company, even the greatest ones imaginable. Do you remember New Coke? How about Microsoft's MSN Online, Version 1? And what about McDonald's infamous McDLT? Or, who remembers their McLean sandwich?

Things can go wrong. Things will go wrong. We want companies with the cash to buy themselves out of trouble when it comes knocking on the door.

Now pulling numbers from the balance sheet, here's an example:

Schering-Plough Fiscal Year 1998

Cash         LT Debt + ST Debt   Multiple
$1,259 mil   $562 mil            2.24x

Again, we want businesses that have cash that amounts to 150% (or 1.5x) of their total debt.

10. Efficient Use of Cash (Flow Ratio below 1.25)

Okay, and now for one more important metric -- the use of that cash. In the day-to-day management of a company's operation, money is going to rush through the front door from sales, and it's going to fly out the window and the backdoor from expenses. As noted earlier in these steps, businesses survive on cash. That's their oxygen. Without dollars coming in, they can't pay for employees, for equipment, for insurance, for holiday parties, for new technology, for anything. So, how a business manages the dollars that flow through their daily operations is of critical importance.

We want our companies to bring money in quickly, but to pay it out slowly. More cash coming in today, less cash going out today. If that makes sense, then let's go to the balance sheet and dig up some relevant entries, specifically current assets and current liabilities. Current assets represent assets that are expected to turn into cash in the coming year, while current liabilities represent all costs that will have to be paid down in the coming year.

This is where we might get confusing. We're going to try to convince you that non-cash current assets aren't assets at all. They're liabilities! And some liabilities are, for all practical purposes, assets! OK, stay with us, we can explain.

When you take the cash out of current assets, you're left with two primary categories: inventory and accounts receivable. The former is product in various stages of development that hasn't been sold yet. Some of it is raw material; some of it is finished product waiting to be sold. But let us convince you that all of it is a liability. Why? Because there's a cost to storing inventory on shelves in an enormous warehouse outside of town. Wouldn't you be much happier to see that inventory in a store today, in the form of a giant stuffed Donald Duck doll, in the hands of a parent out birthday shopping? So would we. Certainly, every company on the planet has to carry inventory. We just like those that can quickly assemble product and race it out to the door into the marketplace. Because, after all, inventory is just potential cash sitting on shelves. We'd rather have the cash, thanks.

The remaining current asset category is accounts receivable, which reflect payments that your company hasn't collected yet. Let's say that you've invested in a camera maker that has $43 million in accounts receivable. That entry reflects $43 million of cash from operations that your company is owed by its customers. Maybe $10 million of it came from camera sales into Europe -- from which payments take 8-10 weeks. That cash isn't yet in your company's coffers. It isn't going to work for the business. Its delayed arrival, Fool, is a liability to the business. Well-positioned companies are able to require upfront payments from customers and also have mastered the art of keeping inventory low while driving sales higher.

That's the current assets line. And as we've said, when cash and marketable securities are removed from the grouping, we like to see that number low and falling.

"Low -- huh? Low relative to what?"

Aha, yes. By "low" we mean low relative to current liabilities. Now that you know that current assets represent all things that will be turned into cash in the year ahead, you know as well that current liabilities represent all costs that will have to be paid down over the next year. Contrary to your personal finances, many companies would like to hold off their short-term payments for as long as possible. If they can earn more by holding their cash than they can by doling it out to their suppliers, they should want to hold onto it. The key to that is in their writing of contracts and in the stable, prominent, desirable position they've gained in their industry. For example, small businesses working with General Electric will often gladly accept payments three months after billing. Why? Because working with General Electric brings them steady income, strengthens their reputation, and helps them stay in business!

So what we've just proposed is as contrary as it comes. We're telling you, Fool, that when it comes to large, profitable companies, you should think of current assets as actually being current liabilities, and vice versa. Those accounts receivable and those inventories are a bad thing. Those payments your company can hold off for a few more weeks are a good thing. Except for short-term debt, which carries the burden of interest, all other current liabilities represent a free form of financing. Free is good. We like free.

But, you ask, "How can we possibly measure all that?" Well, with a little something we call the Flow Ratio. The Flow Ratio enables you to cut through accounting shenanigans and artfully constructed income statements to get a clear snapshot of how a company is managing its cash.

The simple calculation here is:

     (Current Assets - Cash*)
---------------------------------                 
(Current Liabilities - ST Debt**)

Guidelines for the numbers? We go in search of Flow Ratios that run lower than 1.25, ideally below 1.0. If they get below 1.0, it means that the business is able to delay more payments than they're carrying in costs of inventory and unpaid bills. In this group below 1.0, you'll find companies like Microsoft, America Online, Intel, and others. Companies in such strong position that they have leverage over their partners -- both those that supply them with raw materials or services and those that help them distribute stuff to the end consumer.

Ready for an example?

Schering-Plough Fiscal Year 1998

Cash & Cash Equivalents= $1,259 mil
Current Assets =  3,958
Short-term Debt=    558
Current Liabilities=  3,032

              (Current Assets -
               Cash & Equiv.) 
Flow Ratio  = ----------------------
              (Current Liabilities -
               Short-term Debt) 

= (3,958 - 1,259) / (3,032 - 558) 

= 1.09

The Flow Ratio is just one of many measures of quality, but we think it makes an excellent starting point. Again, we want companies that have a Flow Ratio less than 1.25, and ideally less than 1.0.

The Flowie is your friend. By running it, you'll be measuring how tightly the company manages cash as it flows through their business. Are they being lazy in collecting their bills? Are they being sloppy in managing their inventory? Are they in such a weak financial position that their partners demand cash payments from them upfront? If so, look out... this probably isn't a darling horse nor a long-term winner.

Super-size the company!

Finally, it will probably come as no surprise that Rule Makers tend to be enormous in size. This is not so much a criterion as it is a mere statement of fact. We tend not to look for Rule Maker companies with anything less than $1 billion in annual sales. And we look for companies with a total value, or a market capitalization (share price multiplied by the number of shares outstanding) of at least $5 billion. Most Rule Makers have sales figures and market caps substantially larger than $1 billion and $5 billion, respectively. But those are good baseline numbers.

Conclusion

In the short term, the investing community can hammer any individual stock. Expect the stock price of even the company you most believe in to get cut in half at some point. Oftentimes, the sell-off will be unwarranted; Mr. Market is just playing games with your short-term emotions.

For this reason, we suggest that you largely ignore the short-term wanderings of stock prices and focus on the much harder and yet more rewarding task of trying to accurately project a company's future based on its present financial standing, its managerial strengths, and the scope of its opportunities in the years ahead. Some of these businesses will prove gigantic winners over the next century, just as Hershey's, Johnson & Johnson, and Coca-Cola have rung up bewilderingly great returns for their shareholders over the past eight decades. Others will just match the overall market's average returns. Still others will disappoint. On par, though, if you select great companies and hold them for a very long time, your portfolio should beat the market's average.

In your search, Fool, you must ask yourself: Are this company's products likely to fulfill needs in the future even better than they did in the past and they do today? Does management have the vision and operational skill to continue its outstanding performance? And how much opportunity for growth around this planet (and, hey, maybe other worlds someday) is there for this company? These are extremely difficult questions to answer. But to the best of your ability, you'll want to answer 'em. You may get a few wrong... but remember, one great company compounding market-beating growth for you over the next four decades will pay down your losses 100 times over -- and much more.

Let's just list the ten criteria for those still taking notes (very diligent of you, Fool):

1. Dominant brand
2. Repeat-purchase business
3. Convenience
4. Expanding possibilities
5. Your familiarity and interest
6. Sales growth of at least 10%
7. Gross margins of at least 50%
8. Net profit margins of 7% or greater
9. Cash no less than 1.5x total debt
10. Efficient Use of Cash (Flow Ratio below 1.25)

Not all of our companies will meet all ten criteria, but we now have a base to work from. Just to make things easy, we even have a free spreadsheet that'll help you evaluate companies using these ten criteria. If you're new to the Rule Maker way of investing, this is the spreadsheet for you:

Excel 95 and 97 users, click here.

One last thing, as we stated earlier, these ten measures aren't the only means for evaluating potential Rule Makers. In David and Tom Gardner's book Rule Breakers, Rule Makers, Tom expands on the above criteria with a more comprehensive method of measuring a company's Rule-Making authority. If you've read the book or are a veteran of Rule Maker investing, we have another spreadsheet (also free!). This one will help you tally up a company's Rule Maker score based on the criteria in the book:

• Excel 97 users, click here: Excel 97, 68k
• Excel 95 users, click here: Excel 95, 41k

So, onward to Step 7... with its explanation of our thoughts on valuation and business quality.

Step 7: QuaVa - Quality vs. Valuation »

Email this page to a friend    Format for Printing

 See Also