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Comparing RM and GG criteria

by xerohype

As a team leader in the currently running RM Seminar I have noticed a number of similarities and contrasts between the RM and GG investing methods. My premise with this post is that the RM method can be used in a complementary fashion to help gauge the strength of mature Gorillas (Gorillas that have reached Main Street, but still have years of great returns left). The RM method applies to all kinds of businesses, but combined with the GG method it can provide a razor sharp way to evaluate the strength of established technology companies.

Let's first review the basic criteria for both methods:

Rule Maker 11 Steps

The 11 criteria that Rule Maker companies must possess are:

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. Flow Ratio below 1.25
11. Cash King Margin of at Least 10%

RM investing was invented by Tom Gardner, Chief Fool here at TMF. It is a LTBH strategy. The goal is to pick those companies that are making the rules by dominating their market sectors and that have achieved long-standing greatness.


GG criteria (from GG FAQ):

1. Discontinuous innovation
2. Proprietary open architecture
3. High barriers to entry
4. High switching costs
5. Strong value chain formation
6. Tornado market exists or foreseeable

Ten rules of GG (from the book by Geoffrey A. Moore, Paul Johnson and Tom Kippola):

1. If the category is application software, begin buying in the bowling alley.

2. If the category is enabling hardware or software, begin buying after the tornado has formed.

3. Buy a basket comprising of all the gorilla candidates-usually at least two, sometimes three, and normally no more than four companies.

4. Hold gorilla stocks for the long term. Sell only on proven substitution threat.

5. Hold application software chimp stocks as long as they exhibit potential for further market expansion. Do not hold enabling-technology chimps.

6. Hold kings and princes lightly, selling individual stocks on a marketplace stumble and the category upon deceleration of hypergrowth.

7. Once it becomes clear to you that a company will never become a gorilla, sell its stock.

8. Money taken out of non-gorilla stocks should immediately be reinvested in the remaining gorilla candidates.

9. In a gorilla collision, hold your gorilla candidates until there has been a definitive outcome.

10. Most news has nothing to do with the gorilla game. Learn to ignore it.


Let's go in order by using the RM criteria as our guide.

First let's look at the RM criteria of dominant brand, repeat-purchase businesses, convenience and your familiarity and interest. A Gorilla doesn't necessary have to have these attributes, but mature Gorillas that have reached Main Street will usually sport a powerful brand with examples such as Microsoft and Intel (both dominating the PC space) and Oracle with a powerful business brand in the database software market. Once Gorillas reach Main Street their products will be recognizable in most cases by the average Joe on the street. Just look at Cisco, even though it provides internet infrastructure equipment, it Is building its brand through advertising. Gorillas represent a convenient place for customers to turn to (nobody ever got fired by buying IBM can be substituted now with Cisco). Strong value chain formation reinforces the convenience factor. The value chain will support the Gorilla and help expand its dominance in the marketplace.

Godzilla game stocks are very strong in the branding and convenience attributes. Just look at Yahoo!, Ebay, Amazon and Priceline, all of which have excellent brands.

The more established our Gorillas become the more they become recognized as brands and as leaders. The branding and repeat-purchase criteria go hand in hand with high switching costs. Rule Makers like to build moats around them, but Gorillas have ready-made moats (high barriers to entry) with their open proprietary architectures and high switching costs helping them.

Expanding possibilities are essential to Rule Makers since businesses that do not grow tend to stagnate and lose ground to upstarts. Discontinuous innovation (DI) is always a threat and Gorillas must be willing to expand their markets into new areas to fend off this threat.

Sales growth of at least 10% are a requirement for Rule Makers. Even mature Gorillas should be able to meet this burden since they have gone through a tornado or have one that is forseeable. During a tornado the year over year growth in revenues will be in excess of 100%. Some strong Gorillas move from tornado to tornado such as CSCO moving from routers to IP telephony and optical networking. Mature Gorillas are coming out of the steep side of the S curve, but they still should have many good years of growth left in them.

Young Gorillas going through the early parts of a tornado can be evaluated in conjunction with the RB method:

The rest of the quantitative criteria for Rule Makers can be used to gauge the financial strength of mature Rule Makers:
Gross margins of at least 50%
Net profit margins of 7% or greater
Cash no less than 1.5x total debt
Flow Ratio below 1.25
Cash King Margin of at Least 10%

A drop below Rule Maker levels may indicate that an upstart company with DI may be taking over the alpha ape position. A healthy Gorilla should be able to easily best all of these metrics, especially in regards to cash. When you own the open proprietary architecture money should be flowing in faster than you can count it.

These articles should help explain the Flowie and the Cash King Margin

Examining the Flow Ratio

Answers to Flow Ratio ?s

The Value of Cash Flow

Cash Flow Efficiency

Calculating Cash Flow Ratios

Now how about the differences. The GG method advises to hold lightly Kings once they are out of the tornado, while the RM method will hold Kings long term as long as they meet the RM criteria. The GG method will advise consolidation of holdings into the Gorilla while the RM method looks for companies with staying power whether they are Gorillas or not. Also the RM method applies to all businesses, not just tech, while GG is only applied for tech stocks. The RM method doesn't bother with baskets, it just chooses the strongest and the best in terms of financial performance. Both methods don't use price or valuation as a criteria for inclusion.

Here's a good article that details reasons to sell RM stocks:

When to Sell a Rule Maker

Overall, I believe that the GG method is suited to picking stocks that will become Rule Makers. Once those stocks reach Main Street with their product cycle, the RM method can be used to measure their financial strength. The RM criteria can provide an early warning system for when Gorillas have reached the end of their life because a nimbler upstart has taken them over with a DI.

While I caution that the methods shouldn't be melded together in a piecemeal fashion, they can be used separately to measure the mettle of strong companies. As a LTBH investor I really like having both methods in my arsenal.

Some sources and resources:


SI GG FAQ (as of 5/28/2000):

The Gorilla Game: Picking Winners in High Technology written by Geoffrey A. Moore, Paul Johnson and Tom Kippola.

RM Portfolio FAQ:

Rule Breakers, Rule Makers written by David and Tom Gardner

I hope this helps. As always feel free to point out any errors or omissions in my flimsy use of what passes for logic.


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