The 13 Steps to Investing Foolishly
Step 10: Understand Rule Maker Investing
"The Rule Maker solution buys stalwart businesses and relies only on simple numerics, common-sense logic, and your patience. It's an investment model that is as convenient as a mutual fund, but which offers above-average performance and lower expense." -- The Motley Fool's Rule Breakers, Rule Makers
The Rule Maker investing philosophy begins with the same premise that all Foolish investment philosophies do:
You are the best manager for your money and the Wall Street Wise telling you that you don't have the time or the skills to manage your money to market-beating returns are dead wrong.
If you go about making your selections properly, in short order you can acquire a portfolio of 8-15 giant companies that are out there Making the Rules in our economy. Once having bought these Rule Makers, you can pull a virtual Rip Van Winkle,
shutting your investing eyes for a quick ten-year snooze, and then wake up to outstanding returns.
When compared with industry peers, the Rule Maker candidate should clearly be at the head of the class.
The criteria for identifying Rule Makers begin with looking for the No. 1 brand name in an industry. And not just the No. 1 brand here in America -- we're talking King of the World brands. What companies come to mind when you think of soda, razor blades, diamond rings, and microprocessors? We suspect that most people will name Coke, Gillette, Tiffany, and Intel.
Repeat mass-market purchases also characterize Rule Maker companies. People who aren't NBA stars don't buy many automobiles in a year, so General Motors is out. (Unless of course the NBA expands to include 6000 or 7000 teams. And even then, we're not sure General Motors is the brand that'll find multiple purchases each year.) Think instead of things you routinely use, either because you like to or you have to: soda, casual clothing, blood-pressure pills, shampoo. Think Coca-Cola, Gap, Merck, and Procter & Gamble.
When crunching financial numbers looking for possible Rule Makers, you need to check a few measures. Start with strong historical performance from the company. If you're making a ten-year commitment to buy and hold just a few companies, you'd like to make sure that they are the kind of companies that have richly rewarded their owners in the past. Check out the ten-year record of your companies to make sure they're worthy of your attention. Click here for some Fool ten-year price graphs of Coca-Cola, Gap, and Pfizer.
The Numbers
Rule Makers sport gross margins (gross profits divided by revenues) above 50%, net margins (net income divided by revenues) topping 7%, and sales growing faster than 10% per year. Some companies that pass muster on these counts include drugmaker Schering-Plough (gross margins of roughly 80%), Internet infrastructure builder Cisco Systems (net margins around 16%), and the Gap (sales growth topping 16%). The preceding terms are covered in more detail by clicking here.
Cash Is King
These are companies that have been around for a while and have been making loads o' cash throughout that time. Therefore, by now they should have a nice big vault of it, with which they can expand their own operations in the future, not having to borrow money from anybody else. You can find how fat a company's coffers are by reading the balance sheet. Looking for a low flow ratio is a special metric of Rule Maker investing. The "flowie" reveals whether a company is managing cash flow effectively by demanding payment from its customers quickly (an indication of strength), and paying its obligations slowly.
Even more important than how a company fares on the above measures is the direction it's heading. Since a stock's price will always be tied to how the market views a company's future prospects,
you want the present to be better than the past, with indications that such a trend will be growing even stronger. Look for rising margins, a company that is buying back its own shares, and cash continuing to pile up. Think about the $19 billion or so that Microsoft currently has in its bank account. When compared with industry peers, the Rule Maker candidate should clearly be at the head of the class.
Rule Maker investments are meant to be long-term ones -- for the most part, you should be able to leave your money invested for a decade or longer.
Rule Maker investments are meant to be long-term ones. The idea is that once you identify and invest in these powerful companies, you should, for the most part, be able to leave your money invested for a decade or longer. This means you won't be making many buy and sell decisions and won't be forking over capital gains taxes to Uncle Sam.
With deep-discount brokers offering trades for as low as $7 to $10, a Fool could buy ten Rule Maker stocks for a total fee of $100, starting with an initial investment between $5,000 and $10,000. This would meet the Foolish aim of keeping commission costs below 2% ($100/$5000 = 2%).
There's a lot more involved in identifying and investing in Rule Makers (hey, there's half a book devoted to it), but these are some of the core principles. This tip-of-the-iceberg treatment ought to give you an idea of whether this might be a strategy to which you want to devote a little more time. (Here's a tiny little prod though, the Rule Maker Portfolio is beating the market since its inception).
You can learn more about the specifics of the approach as Fools around the globe discuss the Rule Maker strategy 24 hours a day on the Rule Maker Strategy message board. To read about companies you think might be Rule Makers, go to the Rule Maker Companies message board, and try asking your first questions on the Rule Maker Beginners message board.
The Rule Maker strategy is a relatively conservative one since it invests only in proven winners. If you're a more advanced investor, are looking for a little bit more of a thrill in your investing, and you're ready to take on a bit more risk with the possibility of a bit more reward, Step 11 of Foolish Investing looks at the companies that are Breaking the Rules...
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