THE BILL CARA FIDUCIARY PROTOCOL
Gate One: Quality
The first of four sequential gates governing every portfolio decision.
Every name considered for a Bill Cara portfolio must pass through four gates, in order. Gate One asks whether the company is a high-quality business. Gate Two asks whether the timing is right, measured by the INSTAT composite. Gate Three asks for confirmation from RSI and MACD. Gate Four is a manual Point and Figure chart review. A company that fails any gate does not advance. This paper sets out Gate One in full, so that subscribers can see exactly what the quality standard is and hold us to it.
WHAT GATE ONE MEASURES
Gate One scores a business on four legs. Each leg is built from audited financial statements, the income statement and the balance sheet, so that the inputs are factual and reproducible rather than a matter of opinion. The four legs are then combined into a single composite score on a scale of 0 to 100. The composite, not any one leg, is what determines whether a company passes.
Leg 1. Profitability
The profitability leg asks a simple question: does this business earn a strong and consistent return on the capital it employs. The standard set includes return on equity, return on assets, and return on invested capital, together with the full margin stack (gross margin, operating margin, net margin, and free cash flow margin). All of these come straight from the income statement and balance sheet. Of the four legs, this is the one that speaks most directly to business quality, because a company that earns high and durable returns is, by definition, doing something the competition cannot easily copy.
Leg 2. Financial Strength
The financial strength leg asks whether the company can withstand a difficult market without distress. The standard set includes debt to equity, net debt to EBITDA, interest coverage, the current and quick ratios, and free cash flow measured against total debt. All are driven by the balance sheet and income statement. These ratios are deliberately conservative, because survival comes before growth in any market regime, and especially in an Age of Austerity.
One important caution applies here. These ratios are meaningful for industrial, consumer, healthcare, and technology companies, but they are not meaningful for banks and insurers. A deposit funded balance sheet has no comparable debt to EBITDA, and the leverage of a regulated financial institution is a feature of its business model rather than a sign of risk. For that reason, financial companies are scored on a separate, sector specific set of measures described later in this paper.
Leg 3. Valuation
The valuation leg asks whether the current market price is reasonable in relation to what the business actually produces. The standard set includes earnings yield, sales to market capitalization, enterprise value multiples, and cash flow multiples. Valuation leans on price, and it is measured against peers rather than in the abstract, so that a company is judged cheap or dear relative to comparable businesses in its own sector.
Valuation carries less weight at Gate One than the other three legs, by design. The watchlist is a quality screen first. Price discipline is enforced more sharply further down the funnel, at Gate Two (the INSTAT floor), Gate Three (RSI and MACD), and Gate Four (the Point and Figure review). A company can therefore pass Gate One while looking expensive, on the understanding that we will not buy it until the timing gates say the price is right. The note on enterprise value above applies again here: enterprise value is close to meaningless for a deposit funded balance sheet, so the financials set substitutes a price to book measure in its place.
Leg 4. Growth
The growth leg asks whether the business is actually expanding. The standard set is trailing growth in revenue, earnings, and free cash flow, measured over one, three, and five years. The Cara growth leg is trailing only. It does not give credit for forward growth based on management guidance or analyst projections.
This is a deliberate choice, and it sets the Cara standard apart from the convention. Most quality scores blend in forecast growth, which flatters the names where the market is paying for a future that has not yet arrived, early-stage biotechnology being the clearest example. By scoring only what the company has already delivered, the Cara growth leg is more conservative and, we would argue, more honest in an Age of Austerity, when promises about the future deserve less benefit of the doubt than they received in the prior cycle. The cost of this discipline is that a genuinely fast growing company may score lower here until its results catch up with its prospects. We accept that cost in exchange for resting the standard on fact rather than forecast.
THE COMPOSITE SCORE
The four legs are combined into a single composite score on a 0 to 100 scale. It is worth stating plainly that there are four legs, not five. The composite is the blend of the four, and not a fifth leg of its own. A company passes Gate One when its composite score reaches 80 or higher.
The legs are not weighted equally. The weighting emphasizes the durable core of business quality, profitability and financial strength, with growth and valuation acting as supporting legs. This reflects the simple conviction that a business which earns high returns and can survive a downturn is of higher quality than one that is merely growing fast or trading cheaply. The precise weights are calibrated against the reference universe described below.
The calibration anchor
A score of 80 must mean the same thing everywhere. To guarantee that, the composite is calibrated against a fixed, broad reference universe of established global companies, and not against the narrow membership of whichever portfolio is being built. This matters most for the specialized portfolios. A portfolio drawn from a single sub-industry, a single theme, or a single country contains companies that are early, fragile, or simply lower in quality than the global leaders. If quality were scored only relative to that narrow group, something would always rank highest within it, and a weak universe would manufacture high scores that do not reflect real quality. Anchoring the score to a fixed reference universe prevents this. A score of 80 reflects absolute quality, so it carries the same meaning in a deep, diversified watchlist as it does in a narrow, specialized one.
FINANCIALS AND INSURERS
As noted under Leg 2 and Leg 3, the standard ratios for financial strength and valuation do not describe a bank or an insurer honestly. A deposit funded balance sheet has no comparable debt to EBITDA, and enterprise value is close to meaningless for it. Financial companies are therefore scored on a sector specific set: capital adequacy and balance sheet quality in place of the standard leverage and coverage ratios, and book value-based measures (such as price to book and return on equity against book) in place of enterprise value multiples. The four legs and the 80 threshold remain the same. Only the measures inside the financial strength and valuation legs change, so that a bank is judged by the standards that actually apply to a bank.
HOW THE STANDARD IS APPLIED
Gate One is an absolute standard. The threshold of 80 is fixed, and it is the same for every portfolio. Where the manager elects, on his own fiduciary judgment, to retain a company that does not meet the standard, that decision is disclosed plainly and the company is identified as held on discretion. It is never presented as a Gate One pass. Transparency is the point of publishing this protocol, and a relaxed standard wearing the Gate One label would defeat that point entirely.
For the specialized portfolios, some will contain few names, or none, that clear Gate One on an absolute basis. That is an honest outcome, not a failure. Where the quality standard cannot be met, we say so, and the accompanying playbook explains what we are offering instead, and why a low-cost index fund for the theme may in some cases serve the subscriber better than a constructed portfolio. The full treatment of these cases belongs to a companion paper on portfolio tiers. Gate One itself does not bend to fill a portfolio.
Bill Cara, billcara.com
This document describes the methodology of Gate One of the Four Gate Funnel. It is for subscriber information and does not constitute personalized investment advice.