Consider Rule Breakers and Small Caps

Warning: Rule Breakers are for the most bold and daring of investors. Those who are brand new to all this investing stuff should understand the risks involved. So should those who aren't brand new.

Rule Breaker stocks should make up only a part of any portfolio -- and investors should be prepared to lose the money they invest in these companies. However, high risk can bring high reward.

Here are the six main characteristics of Rule Breaker companies:

1. The company should be a top dog and a first-mover in an important, emerging field. Being top dog in the left-handed scissors industry isn't enough. The left-handed scissors industry is pretty mature -- and it ain't going anywhere in the near or distant future. As an example, in the emergence of electronic commerce Amazon.com (Nasdaq: AMZN) is the top dog and first-mover.

2. The company needs to demonstrate sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors. Examples include Wal-Mart (NYSE: WMT) (with net income gains of 25% during much of the 1980s), Amgen (Nasdaq: AMGN) (with patent protection of its drug formulas), and Microsoft (Nasdaq: MSFT) (with visionary leadership that benefited from Apple Computer's (Nasdaq: AAPL) regrettable decision not to license its technology).

3. The market should have rewarded a Rule Breaker's promise with strong price appreciation, measured by a relative strength rating of 90 or above. (Relative strength ratings appear in Investor's Business Daily.)

4. Look for good management and strong backing. The steel company (yes, steel!) Nucor (NYSE: NUE), led by Ken Iverson, became a world-class powerhouse by revolutionizing steel production processes. Also consider the "backing," or supporters of a company. eBay (Nasdaq: EBAY) was backed by executives from Starbucks (Nasdaq: SBUX) and Sun Microsystems (Nasdaq: SUNW).

5. Rule Breakers should have a strong consumer brand. Again, consider Starbucks. Its name recognition is much stronger than competitors such as... um... like.... (Get the point?)

6. It's a good sign when the financial media calls an up-and-coming company overvalued.

To learn more about Rule Breakers, read The Motley Fool's Rule Breakers, Rule Makers. We recommend making Rule Breakers just a part of your overall investment strategy. A completely nutritious Foolish mix might include a bunch of Rule Maker stocks, with a few Rule Breakers thrown in to spice things up.

The beauty of small-cap investing

You should consider including a number of small-cap growth companies in your portfolio, Rule Breakers or otherwise. Small-caps give the individual investor a chance to beat the Wise to the punch.

The size and structure of most mutual funds and a pesky SEC regulation make it hard for funds to establish meaningful positions in small-caps. In order to buy a position large enough to make a difference to their fund's performance, they would have to buy 10% or 20% of a small-cap company (which their own guidelines frequently restrict them from doing).

Before they can do that, though, they have to file with the SEC. By that time, they've already tipped their hand to the market and inflated the previously attractive price by buying 5% of the company. Individual investors who have the ability to spot promising companies can get in before the institutions do. When institutions do get in, they'll do so in a big way, buying many shares and pushing up the share price.

Another reason to buy small-cap companies is that they can grow quickly. Small companies are in a much better position than their larger brethren to expand their businesses. Rapidly multiplying earnings often translate into higher share prices.

The downside of small-caps

Small-caps are for experienced investors. Novices should steer clear. You wouldn't go up in a lunar orbiter without prior training, nor should you try small-cap investing until you've cut your teeth on some large- and mid-cap issues.

You should also stay away from small-caps (all stocks, really) if you're ponying up your mortgage payment (or any other much-needed funds) to make the purchase. The money you invest in small-caps should be money you can afford to lose.

Time -- or the lack thereof -- is another dissuading factor. Finding good small-caps is a lot of work before and after you've made your purchase. If you don't have the time, energy, or inclination to keep up with the news on your portfolio, you're better off in an index fund. We're serious about this. We'd even rather you just pay fees to some expensive mutual fund out there than go into small-cap investing with a lackadaisical attitude. (Wow, did we just say that? Whew! Down, boy.)

Finally, if you have a natural aversion to risk, stay away from volatile small-cap growth stocks. If the mere thought of a 5% drop in one day gives you an ulcer, you're better off saving your stomach. Index funds will give you respectable returns without the acid-blockers.

Useful Resources

You'll also run across some tasty small-caps in our well-regarded newsletters, such as Tom Gardner's Motley Fool Hidden Gems, which focuses on smaller companies. Our other newsletters include The Motley Fool Stock Advisor and Motley Fool Income Investor. Check out our other offerings, too! We back them up with money-back guarantees.

Now that you've got small-caps under your belt, proceed to Step 12, where even more advanced investing issues are confronted.