Rule Maker Portfolio
Mini-Makers, Part 1 of 2

By Zeke Ashton (TMF Centaur)

ZURICH, SWITZERLAND (Sept. 15, 1999) -- Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> is the single most dominant commercial entity the world has ever seen. Softy is the ultimate Cash King, the Big Kahuna of Rule Makers. Indeed, investors continue to search far and wide for a company of comparable quality in the quest to discover the next Microsoft. Alas, there isn't a software company to be found that can lay their financial reports next to Microsoft's awe-inspiring income statement, bulletproof balance sheet, and consistently exceptional earnings growth and survive the comparison without looking ridiculous.

Until now. That's right, I've found a company that can get into the ring with Mr. Softy, stare that big monster right in the eye, and take the best punch Microsoft can deliver. I bet that got your attention. Before I reveal the name of our challenger, let's do a tale of the tape. 

                Microsoft  Company X

Market cap       $441,164   $162,448
Enterprise value $427,237   $149,048
Price/earnings       60.9       18.6
Forward P/E          55.4       16.5
EV/E                 59.0       17.1
OK, folks, let's get ready to rumble! For round one, we'll compare the most recent income statements:

                   Microsoft    Company X

Revenue                4,331       13,271
Revenue growth         14.7%        28.4%
Cost of revenue          350        3,818
Gross margin           91.9%        71.2%
Net income             1,917        2,255
Net margin             44.2%        17.0%
Net income growth      43.3%        38.9%
Diluted EPS growth     40.0%        35.3%
(Microsoft's quarter shown here is the quarter ended March 31, 1999. The quarter for Company X is ended June 30, 1999. Revenue growth, net income growth, and diluted earnings per share (EPS) growth are all comparisons versus the same quarter from the previous year.)

Microsoft wins round one thanks to those amazing gross and net margins and superior earnings growth. But Company X is surprisingly close, and is still looking strong as we head into round two, the balance sheet:
                   Microsoft    Company X

Cash & securities     21,761       13,400
Long term debt             0            0
Cash/debt            No debt      No debt
Flow Ratio              0.29         0.39
Wow. A very close comparison! Look at those Flows! Round two is nearly a dead heat.

Round three compares return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC): 
                   Microsoft    Company X

ROA                    23.2%        22.6%
ROE                    31.5%        40.1%
ROIC                   27.4%        35.8%
Dividend yield          0.0          0.9
(The ROIC calculated for Microsoft is the last nine months' return on average invested capital. The ROIC calculated for Company X is the last six months' return on average invested capital. Both figures are annualized. The ROA and ROE are the last 12 months' figures for both companies.)

How 'bout that? Company X hangs in there and steals a round from the champion by the barest of margins.

For our fourth and final round, we'll compare various growth measures and the historical stock price returns over the last year, the last three years, and the last five years: 
                   Microsoft    Company X

1 Year EPS growth      69.1%        46.0%
5 Year Sales growth    33.8%        18.7%
5 Year EPS growth      43.0%        46.9%
Return - 12 months     80.2%        60.1%
Return - 3 years      464.5%       244.1%
Return - 5 years     1089.7%       919.9%
On the strength of those amazing returns, Microsoft walks away with the championship belt, but can you imagine a better-matched pair of companies? Should I reveal the identity of our formidable challenger, Company X?

Not just yet. I have a small confession to make at this point. You see, for each of the above financial comparisons, the value expressed for Microsoft is in billions and the value for Company X is in millions. This is certainly not a trivial difference, but my point is this: There are companies of very high quality out there, companies that approach even the highest standards of the greatest Rule Maker companies on the planet. They just aren't as big. They're Mini-Rule Makers. And the Rule Maker criteria can be just as effectively applied to these companies as to the behemoths to which we normally apply the Rule Maker tenets.

Here in the Rule Maker portfolio, we're generally interested in buying shares in the biggest, most dominating companies we can find. But size isn't the most important factor. Rather, the most important factor is the quality of the business. The Rule Maker checklist creates an imposing filter, one that eliminates all but a dozen or so of the biggest and best companies in the world. But what about those few extraordinary companies, such as Company X, that meet and exceed every one of the Rule Maker quality measurements but just aren't big enough to qualify as Rule Makers?

There's no framework that accommodates these smaller-sized, high-quality companies in Fooldom. The Foolish 8, introduced in The Motley Fool Investment Guide, is the closest thing a Fool can find to a Rule Maker approach to small-cap companies. (The Rule Breaker strategy is also designed for investing in smaller companies, but the Breaker philosophy is a horse of a different color entirely, requiring more of a venture capitalist, swing-for-the-fences mentality as opposed to the high-percentage Rule Maker framework.) I'd like to introduce a first pass at a Rule Maker approach to smaller companies, based upon the solid foundation of Rule Maker criteria combined with elements of the Foolish 8.

I admit I'm pushing the envelope a bit here. I should emphasize that there's absolutely no reason to ever stray from the tried and true Rule Maker approach, and it is unlikely that we'll be adding a Mini-Maker to the Rule Maker portfolio anytime soon. For the vast majority of investors, particularly those who enjoy the low maintenance requirements of the Rule Maker philosophy, a portfolio of six to ten carefully chosen Rule Makers is entirely Foolish. But for those investors with an appetite for a little more risk, a desire to cast a slightly wider net, or maybe just a bit of curiosity, I will present my prototype Mini-Maker checklist specifically targeted towards helping investors identify companies of ordinary size and extraordinary quality in tomorrow's report.

Oh, and what about Company X? I've decided to wait and divulge the name of this little gem of a company in Part 2. (Gotta give you some incentive to come back, now, don't I?) In the meantime, let's hear some of your ideas for who this company might be on the Rule Maker Strategy board. First person to guess correctly wins a Fool ballcap.

Until next time, y'all stay Foolish