Finding the Next Home Run Stock

Founding Fool David Gardner has made a career by bucking conventional wisdom with his Rule Breaker philosophy of stock selection; he finds companies that, though viewed as overvalued, have game-changing advantages over their peers.

Luckily for us, he has laid out six signs of the perfect Rule Breaker stock.

  1.  A top dog and first mover in an important, emerging industry.
  2.  Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors.
  3.  Strong past price appreciation.
  4.  Good management and smart backing.
  5.  Strong consumer appeal.
  6.  A documented history of being viewed as overvalued.

I've actually written articles using this very strategy three times before,  and it has led me to big gainers, like 3D Systems and lululemon athletica, which are up 195% and 106%, respectively, since I wrote about them.

And even if we take some of the underperformers into account, buying all of the stocks that came through this screener from the time I wrote about them would have produced a portfolio that has returned 38%, besting the S&P 500 -- including dividends -- by 10 percentage points.

Read below to see how you can find the next home run stock, and at the end, I'll offer up access to a special free report on The Motley Fool's top stock for 2013.

Talk about a needle in a haystack
While most of the six traits traits are qualitative in nature, two of them could be considered quantitative. This can help us mere mortals get started by setting up a screen to narrow down our field.

We can find strong past price appreciation by screening for stocks that are up at least 100% over the past year. To zero in on stocks that are viewed as overvalued -- David's second quantitative trait -- I looked for one or two-star stocks as rated by CAPS, as well as for companies with a P/E over 35.

When I ran the screen last week, I got five companies that weren't already Rule Breakers.

Company

Market Cap

P/E 

52-Week Price Change

What it's involved in...

Pharmacyclics (NASDAQ: PCYC  )

$6.6 billion

80

265%

Biopharmaceuticals

Medidata Solutions (NASDAQ: MDSO  )

$1.4 billion

76

116%

Software for clinical medical studies

PulteGroup (NYSE: PHM  )

$7.8 billion

37

138%

Building/Financing homes

Spectranetics (NASDAQ: SPNC  )

$648 million

311

139%

Makes single-use instruments for heart operations

Ryland Group (NYSE: RYL  )

$1.7 billion

45

118%

Building/Financing homes

Source: Yahoo! Finance.

Now, we can use the rest of Dave's qualitative traits to narrow down our field.

1. Top dog and first mover in an important, emerging industry
Of these five companies, two were easy to throw out from the get-go. Both PulteGroup and Ryland Group are riding the waves of optimism in the home building sector after it absolutely crashed during the Great Recession. Though shareholders have been treated to a nice ride over the past year, neither of these companies are in any way part of an emerging (new) industry.

2. Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors
All three of these companies pass on this test. Pharmacyclics, by virtue of its status as a biopharmaceutical company, holds patents on a number of its treatments. The same can be said for Spectranetics, which holds more than 60 patents.

When it comes to Medidata Solutions, I'm going to let it pass on to the next round as it has shown significant business momentum lately. The company basically streamlines medical research and clinical trials by putting previously tedious paperwork on the cloud. Though earnings shrunk over the past year, it was due to investments in meeting global demand. Revenues, in this case a better indicator, grew by 20% during the third quarter of 2012  -- especially impressive with slowing business from European customers.

3. Good management and smart backing
This is a more difficult characteristic to judge quickly. For brevity's sake (before you make a final decision, you'll want to dig deeper), I looked at whether the founders still play a role in the company they started. Pharmacyclics and Spectranetics, unfortunately, don't make the cut here, as neither of their founders are still with their respective companies.

Medidata, on the other hand, has one co-founder, Tarek Sherif, serving as chairman and CEO of the company, while Glen De Vries, another co-founder, serves as president of the company. 

4. Strong consumer appeal
I'm going to have to give Medidata another thumbs-up here. Though I'm no doctor, I know that the process of putting a potential medicine through the application and testing phases of clinical trials can be grueling. By streamlining the process through the cloud, this company provides an invaluable service.

So should you buy it?
Truth be told, this is the first time I've come into contact with Medidata, but the story is compelling enough for me to make a bullish CAPScall on my All-Star CAPS profile on the company, and begin digging deeper.

If you're interested in Medidata, I suggest you join me in investigating the company. But if you're looking for other ideas, The Motley Fool's chief investment officer has selected his No. 1 stock for the next year. Find out which stock it is in the brand-new free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.


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