The Rule Maker strategy is built upon the idea that individuals should have at least a portion of their portfolio dedicated to rock-solid companies that they plan not to sell for 5-10 years or longer. This buy-and-hold model limits the commission-, tax- and opportunity-costs of investing.
The quintessential Rule Making company is one who manufactures products and provides services bought every day or every week by tens of millions of people the world over. This repeated sale of the same profitable item, over and over, results in the methodical accumulation of a mother lode of cash on a Rule Maker's balance sheet.
But a Rule Maker is more than just an industry leader. Certain industries don't yet (and may never) offer the sort of company that would attract a Fool's investment money. For instance, as an investor, the leading maker of sewing machines is likely far less attractive than America's third-best pharmaceutical business. Some industries will create zero Rule Makers, while others may house a half-dozen. Finding Rule Makers is more about finding the appropriate business model for long-term investment than it is about picking the leaders in each category.
There are 10 characteristics that we look for in a worthy Rule Maker investment candidate. These steps are explained in much greater depth in the 11 Rule Maker Steps:
1. The company must have at least one sustainable competitive advantage. The more, the better.
Companies with sustainable advantages are sheltered from competition. They have powerful brands, a deep-seated corporate culture, low-cost processes, de facto monopolies or standards, patents, or unduplicable distribution systems.
2. The company must be dominant in its given industry.
Think of how difficult it would be for another soft drink company to muscle in on Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %> and PepsiCo<% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %>. Or how much money it would take for a company to duplicate the distribution network of one of the pharmaceutical oligarchs like Merck <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MRK)") else Response.Write("(NYSE: MRK)") end if %>, Bristol-Myers Squibb <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BMY)") else Response.Write("(NYSE: BMY)") end if %>, and Pfizer<% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PFE)") else Response.Write("(NYSE: PFE)") end if %>. Or to knock America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %> off its perch as an online provider. A Rule Maker must, in fact, rule. The narrower the industry, the more dominant the company must be.
3. A Rule Maker has been dominant for more than a decade.
This eliminates many different kinds of companies, most notably newer ones. We do not want to assume that companies that have recently ascended to power will stay there forever, because a market changing that rapidly does not generally settle down all at once. We want a company to show that it possesses good economics through a full market cycle. That means having access to 10 years' worth of financial data.
4. Cash King Margin in excess of 10%.
The Cash King Margin is similar to the net margin, except that instead of measuring profits with net income from the income statement, we use free cash flow from the cash flow statement. The advantage of measuring profits with free cash flow is that cash flow isn't as easily manipulated as net income. The calculation here is free cash flow divided by sales. We're looking for Rule Makers that generate lots of the green stuff, and thus we want to see a Cash King Margin of at least 10%.
5. Efficient Working Capital Management, measured by a Foolish Flow Ratio below 1.25.
This item is nearly universal. There are very few businesses where the need to pay out money faster than it comes in is a positive attribute. 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.
6. Sales above $4 billion per year and growing revenues at 10% plus rates.
We want big companies, and we would like them to be in industries that have promising futures, evidenced by above-average growth today. Be wary of a company that is growing at slower rates than its competition. Sales growth is the most fundamental indication of an expanding business.
7. Best-of-class management.
We won't know everything about a company, and sometimes managements perceived by the public as great turn out to be anything but (example: Enron). Still, you want to try to own companies run by managers who are honest and who show above-average skill at increasing the value of people's investments in good times and in bad.
8. Return On Invested Capital above 11%.
Return on Invested Capital (ROIC) measures the amount of money a company creates using its capital base. A company that produces anything below 11% is not providing enough return to compensate investors for the added risk of buying individual equities rather than simply buying an index fund comprised of the S&P 500.
9. Cash no less than 1.5 times debt.
This one is important. Only under extraordinary circumstances would an investor want to buy a company that is being financed by enormous amounts of debt. Some debt is good; bunches of debt introduce an enormous risk to investors.
10. A reasonable purchase (or holding) price.
We'd like to be able to buy a company that approaches 60% of our calculation of its intrinsic value and sell it as it approaches 100%. Some companies might grow and NEVER make it to 100% -- the prospects for future business might be improving along with the stock price.
Ready to learn more about Rule Maker investing? Great! The Motley Fool has produced a series called "The 11 Steps to Rule Maker Investing," plus we have some other great tools for you here!
The 11 Rule Maker Steps: These steps form the foundation of Rule Maker investing. They review how to locate superior large-cap growth stocks, how to evaluate their financial standing, and how to include them in a portfolio.
Rule Maker Discussion: We offer a discussion board where you can share insights with your fellow Fools and get your questions answered (a free trial is required to access the Fool Discussion Boards). Discussion on the Rule Maker Strategy board centers on Rule Maker investment concepts and companies that are Making Rules and taking names. Here you can ask any kind of question you wish.
Rule Maker Spreadsheets: These free spreadsheets will help you evaluate a company's Rule Maker potential.
The Rule Maker Portfolio: For a period of five years, The Motley Fool ran a real-money portfolio using the Rule Maker strategy, which we discontinued in March of 2003. You can read about all of the successes and failures of our application of the Rule Maker -- where we went right, where we went... a little less than right. It's all right here.
-- Archives: We started the Rule Maker portfolio in January 1998 and have more than five years of articles saved in the archives.
-- Portfolio Holdings and Returns: Here's where to find out which companies we held in our real-money portfolio and how they performed.
-- Trade History: Check our historical trades. The real-money Rule Maker Portfolio began with $20,000 on February 2, 1998, and at the cessation of operations had invested $45,000. All of our trades are kept here.
