Modified Rule Maker Stock Study Criteria

1. Excellent Business Model:

Does the business have a monopoly-type or toll-bridge-type business with an instantly recognizable product or service? Is the product or service so superior over its competitors that it commands buyer loyalty? Does the company make products that wear out fast or are used up quickly? If the products are not purchased frequently are they used by the public on a daily basis? Are their products so popular that price competition is shifted from the company to its merchants? Can the company raise its prices to stay ahead of inflation without incurring a decline in demand? Does the business have a repetitive consumer service that people are constantly in need of, where non-union workers with little or no skills can perform the services? Is the company in an industry with large barriers of entry? Is it in the business of making products that do not require that it spend heavily on sophisticated plants and on-going capital improvements? Do my friends know about or use the company’s products?

2. Expanding Possibilities:

Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years? Is worldwide expansion believable for their products?

3. Familiarity and Interest:

Is the company in a business or industry that interests me? Do I understand the business model? Is it clear to me how they are conducting business?...how they are making money? Would I find it easy and enjoyable to follow the operational direction of the business, including the products, marketing approach, management and reputation with customers? Chances of investment success are greatly increased if I’m interested in following the company’s success and failures.

4. Consistent Demand for Products and Services:

Sales growth is the most fundamental indication of an expanding business. If I’m going to invest, I want to make sure that the company is providing products and services people want.

First, I want a company with at least 5 years of financial history to ensure that it is established, and that management has encountered varying conditions in which to prove its mettle.

Second, I want the company to have sales growth of at least 15%, with a record of consistent growth over the long-term.

a) To determine current sales growth: Divide the most recent year’s sales by the previous year’s sales, and subtract 1.00. Did sales grow at least 15%?

b) Look at the 10-year and 5-year growth rates. The 10-year rate of return is listed on the bottom of the SSG visual analysis. Alt G will give the 5-year rate. Are sales accelerating over the near-term?

c) Is it likely that the company will be able to increase sales by at least 10% year-over-year for the next several years?

5. Profitable Business Model:

A profitable business is evidenced by a gross margin of at least 50%. Strong sales are great, but only if each dollar of sales is profitable. I’d like to see a company’s cost of making its product, or providing its service, to be no more than half of what that product or service can be sold for.

Gross Margin is defined at "Sales minus Cost of Goods Sold divided by Sales." These numbers can be found on the Income Statement. Marketguide.com also figures the gross margin under "Comparison." Are gross margins currently 50%?

6. Profitable Bottom Line:

A profitable business is also evidenced by a net margin of at least 7%. A company’s ability to sell its products and services for double the cost of producing them is of little consequence if the promotion, overhead expenses and taxes wipe out the net earnings.

Net margin is defined as "Net Income divided by Sales." These figures can be found on the Income Statement, Value Line, and Marketguide.

7. Consistent and Strong Earnings:

A profitable bottom line should result in earnings growth of at least 15%, with a record of consistent growth over the long-term.

To determine current EPS growth: Divide the most recent year’s EPS by the previous year’s EPS, and subtract 1.00. Did EPS grow at least 15%?

a) Look at the 10-year and 5-year growth rates. The 10-year rate of return is listed on the bottom of the SSG visual analysis. Alt G will give the 5-year rate. Are EPS accelerating over the near-term?

b) Is it likely that the company will be able to increase EPS by at least 15% year-over-year for the next several years?

8. Strong Financial Position:

Excellent business models generate a lot of cash that allow them to grow their businesses out of the profits from operations. They have little or no debt and, thus, are not obligated to pay substantial interest payments. Low debt and a large cash position allow a company to buy their way out of trouble when it comes knocking on their door. Therefore I want to invest in a company whose cash is double the amount of total debt (or 2:1).

Cash-to-debt is defined as "Cash and Cash Equivalents" divided by "Long Term Debt plus Short Term Debt." These figures can be found on the balance sheet. They can also be calculated on the Value Line. Find "Cash Assets" in the Current Position Box, and divide it by the "Total Debt" in the Capital Structure Box.

9. Excellent Management of Cash Flow:

In the day-to-day operations of a company, money is going to rush in the front door from sales, and rush out the back door from expenses. How a company manages the dollars that flow through their daily operations is of critical importance.

Cash management deals with current assets and current liabilities.

Current assets consist of cash and cash equivalents, inventory that has yet to be sold, and accounts receivable. While inventory and accounts receivable are considered assets, they are actually liabilities because the company cannot benefit from them until they are converted into cash.

Current liabilities consist of all expenses that must be paid within one year. Except for short-term debt, which carries the burden of interest, all other current liabilities represent a free form of financing. The goal is to bring money in quickly, and pay it out slowly. In the interim, that cash can be used more effectively by investing it in short-term securities and interest-bearing accounts.

The Flow Ratio cuts through the accounting shenanigans to get a clear snapshot of how a company is managing its cash. The calculation is:

"Current Assets minus Cash" divided by "Current Liabilities minus Short Term Debt."

I am looking for a Flow Ratio that runs lower than 1.25, preferably less than 1.00. If the ratio gets below 1.00, it means the business is able to delay more payments than it’s carrying in the costs of inventory and unpaid bills. A company that is this financially strong has leverage over its suppliers.

The components of the Flow Ratio can be found on the balance sheet. They are also available on Value Line in the Current Position Box. To use Value Line:

Current Assets - Cash Assets = your asset number
Current Liabilities - Debt Due = your liability number
The asset number divided by the liability number = Flow Ratio

If the number exceeds 1.25, 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 suppliers demand cash payments from them upfront? If so, beware!

10. Careful Management of Inventory:

Excellent businesses keep a tight reign on product flows. This is evidenced by inventory that is not growing faster than sales. I don’t want to buy into a business that has gotten sloppy with product delivery. The inventory figure can be found on the balance sheet. It is also located in the Current Position Box on the Value Line. To determine the growth of inventory, divide the current year’s inventory figure by last year’s inventory figure, and subtract 1.00. Compare it to the % of sales growth for the same time period. It should be growing slower.

11. Accurate Representation of Growth:

Just as with inventory, accounts receivable should not be outpacing sales. I don’t want to be an owner in a company that inflates performance by reporting uncollected bills as sales. The accounts receivable figure can be found on the balance sheet. It’s also located in the Current Position Box on the Value Line. I can calculate and compare this figure, just as I would inventory.

12. Minimal or No Payment of Dividends:

A great company has the capacity to take retained earnings and reinvest them in business ventures that will give them an additional high return. An investment held over time can be greatly enhanced by this compounding of growth. When a company pays a dividend, the money is taken out of the investment, and the investor is taxed at short term, ordinary income tax rates. When the money is retained, it continues to compound. When the investment is later sold, the investor is taxed at the lower, long-term capital gains tax. Therefore, I want companies that pay 10% or less of their annual earnings to the shareholders.

13. Ability to Turn R&D Expenses into Earnings :

For most businesses, research and development spending is required for continued growth. The simple test is to compare a company’s number of patents against its competitors. For something more accurate, the "One Dollar Premise" should be used. The figures can be found in the company’s financials.

To determine the company’s 5-year growth of earnings from R&D:
Add all R&D figures for the last 5 years.
Add all net earnings for the last 5 years.
Divide the total net earnings by the total R&D expenses.
The result should be in excess of $1.00.

This figure can be used to compare companies from different industries.

14. Purchasing at a Price that Makes Good Business Sense:

Choosing to purchase stock in a company that meets or exceeds the above criteria will give me a better chance of producing a strong return. However, the price I pay will determine the rate of return I receive. Now is the time to revisit the SSG, and use the knowledge gained from these answers to refine my judgements and determine whether I will purchase the stock now, or place it on my watch list.

"LInk!  Don't Steal"

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