The Rules of Rule Breaking

In this interview, Fool contributor Tim Beyers discovers how Rule Breaker investor David Gardner finds tomorrow's great growth stocks early in their disruptive stage. That's the point in their development where the products they create are poised to reshape our lives. It's also the point where a few dynamic, forward-looking investors make decisions upon which fortunes are built. Follow along as we learn what classifies a stock as a Rule Breaker and what the next great growth stock might look like.

Tim: Can you define a Rule Breaker for us, David?

David: Sure, though it has many definitions. There are really four aspects to Rule Breakers. There are Rule Breaking companies, Rule Breaking stocks, Rule Breaking investors, and Rule Breaking managers.

Tim: Let's stick with companies for now.

David: OK, but I want to talk about Rule Breaking managers, too. That's because every Rule Breaking company I've ever invested in had a Rule Breaking manager. Take Michael Dell, for example. Where would Dell (Nasdaq: DELL  ) be if he hadn't decided that it was OK to assemble computers in a garage after you ordered them and then ship them to you in a box? That defied every rule of computing at the time. Back then -- in the late '70s and early '80s -- Apple (Nasdaq: AAPL  ) and Compaq had barely gotten done convincing a relatively small subsection of the populace that it was actually OK to have a computer as a personal tool. Dell was way ahead of his time. He was, and still is, a Rule Breaker. That's why I still like the stock.

Tim: So you invest in companies that are ahead of their time?

David: That's generally the aim. Let's take a look at the phrase "Rule Breaker." What does it mean? "Rule" reminds us that common conventions exist in our business world: Don't compete with eBay (Nasdaq: EBAY  ) ; Wal-Mart (NYSE: WMT  ) is king when it comes to making a buck from charging rock-bottom prices; Coca-Cola (NYSE: KO  ) and PepsiCo (NYSE: PEP  ) have a lock on soft drinks; et cetera. When these business realities persist long enough, they become generally accepted principles -- "Rules." Occasionally, a great entrepreneur -- someone aged 25-34, in the vast majority of cases, as Forbes recently printed -- will then come in and create a start-up that takes aim at such Rules, defying such maxims. I call those people and, more importantly, the companies and stocks they create Rule Breakers. Another way of putting it: Goliath needs to exist to create David. And Compaq, Apple, and IBM (NYSE: IBM  ) had to exist to create Dell.

Tim: OK, so how do you find the next Dell? It seems as though you're asking investors to become futurists.

David: Well, in a way, I am. Rule Breaker investing is both art and science. I often spend time researching and pondering industries that could be radically changed by the introduction of a new idea or technology. For example, I remember years ago posting to our Amazon (Nasdaq: AMZN  ) discussion board that there might one day be a downloadable movie database available online, and that Amazon was well positioned to do it. Most of our community members at the time told me I was crazy, but that's exactly what I think Amazon is working toward today. And of course, we now have Netflix (Nasdaq: NFLX  ) and TiVo (Nasdaq: TIVO  ) trying to compete here, too.

Tim: So is that why you like Netflix's stock?

David: Yes and no. Yes, because of the potential for a Rule-Breaking innovation that could benefit millions of people, and no, because the stock could be considered overvalued. There's no getting around the science of fundamental analysis in stock picking, and that includes Rule Breaker investing.

Tim: So you screen for valuation first?

David: No, there is a science to Rule Breaker investing, but it's not like the classic valuation work you'd find for value stocks. That's because Rule Breakers don't naturally lend themselves to classic valuation work. Instead, you have to imagine a future market, place a price tag on it, and figure the odds you're backing a winner that will claim the majority share of your predicted profits. That's where the art and science of Rule Breaking converges.

Take Taser (Nasdaq: TASR  ) , which I selected as a pick for Rule Breakers and which is currently down from our selection price because of some very bad press. Its enterprise value to free cash flow is 64. This isn't totally unjustified because of the company's growth. But it's not cheap, either. It's also not what matters. Taser is selling what could become the standard sidearm for global law enforcement. That's a potential market that reaches into the billions.

Tim: So valuation doesn't matter?

David: Valuation always matters, but what kind of valuation? Most traditional valuation work looks backwards at the company's trailing earnings or present-day book value. When it comes to Rule Breakers, you need to be in the business of assessing what could be, far more than what is. You're speculating, but in as informed a way as possible.

Tim: And how do you do that?

David: Well, let's take Netflix and TiVo, for example. What would happen if they created a downloadable movie database available to a broadband-connected digital video recorder? What's the likelihood of that happening?

Netflix would, of course, have to secure digital rights to rent movies, but it already has rights to rent thousands of DVDs. Negotiating for digital rights shouldn't be that much harder. It's just a licensing fee. Plus, security software exists today to keep DVDs encrypted. Why can't that same software be applied to a downloaded file?

Broadband exists today, and TiVo already has the means to connect to the Internet. It isn't much of a stretch to assume that future TiVos will someday include Netflix downloading software to access DVD-quality movies on, say, the Netflix channel. Sure, the downloads would take some time. But is that any different from when you set your TiVo to record a two-hour special you watch later? No, and even an overnight download, by the way, is faster than a 2-day mailing. ...

Now I'm just thinking out loud here, and am not suggesting any of these predictions are going to come to pass. Instead, my intent is to demonstrate the kinds of assumptions that must be made when assessing potential Rule Breakers. Remember: The aim is to find them and invest in them before the herds arrive. And that requires a little conjecture.

Since TiVo is the delivery device, let's use their subscriber base to figure out what might happen in terms of sales. TiVo said at the end of its October quarter that it had 2.6 million subscribers. It projects 3 million by the end of the fiscal year. Assuming no growth in that number, and that half of TiVo subscribers sign up for the Netflix channel at $20 a month for unlimited downloads, that's $30 million in revenue per month, or $360 million in sales per year. Combined, TiVo and Netflix had $599 million in revenue over the trailing 12 months. So that's a $600 million combined business that could become a $1 billion enterprise with one disruptive innovation. I invest when I see Rule Breaking opportunities like that.

Tim: So you're saying that you value opportunities, not stocks.

David: The Rule Breakers team doesn't ignore valuation -- for instance, I will look at today's multiples off of tomorrow's expected cash flow, and we teach this same principle in the newsletter service. But we really do focus most of our effort on finding and analyzing the potential power of open-ended situations that could generate billion-dollar opportunities. eBay is a perfect example of that. And, by the way, eBay has never, ever, ever looked cheap.

Tim: So are cheap stocks overrated?

David: No, great companies that trade at a discount to their real worth are always attractive, and they almost always lead to market-beating returns. But my mega-winners were never cheap stocks. AOL (NYSE: TWX  ) , Amazon, and Marvel (NYSE: MVL  ) had all doubled the year before I bought them. I think there's an important lesson in that. So many investors see stocks going up, up, up and figure they've missed the opportunity. But winners tend to keep on winning.

Think about it: What if that same stock that had skyrocketed the year before was instead your college roommate who graduated with honors? What if he landed a premium job and earned big raises for two straight years? Would you suddenly expect him to stop being successful? Of course not. But each day, millions of investors in eBay, Amazon, and other well-run businesses conclude that the good times can't possibly continue -- they're over and done with, "now that the stock has doubled" -- and sell. Or they just never invest in the first place. That's poor investment thinking and will hurt your long-term returns.

Tim: But it takes guts to defy conventional thinking that way. How can you know you've found a Rule Breaker?

David: There's no straight litmus test, but there are good indicators. For example, I have always felt nervous when buying a stock the Street hates. That's a natural reaction, because you're defying the conventional wisdom. But that's the very essence of Rule Breaking.

I remember when we first recommended Taser for Rule Breakers. The stock had gone way up -- more than 30% -- before we included it in the buy report. After such a run, it's tempting to lose faith. But I believed in the business then and still do. So we recommended to our subscribers that they dollar-cost average into the stock at a pace that made them comfortable. That's what I did with AOL in 1994, after it had already quadrupled. Doing so helped defuse my nervousness, and the stock went on to be perhaps the best investment of my career. Up more than 100 times in value... coming after that quadruple.

Tim: There's a lot of risk to your approach. How should the conservative investor who wants to try Rule Breaking protect his returns?

David: Well, it's important for investors to recognize that they're going to be wrong. A lot. But for the true Rule Breaker investor, that's OK. The Rule Breaker investor takes numerous big swings with a minority portion of his portfolio -- anywhere from 5% to 30%, depending on time horizon and risk tolerance.

Picking Rule-Breaking stocks is swinging for the fences -- there's no way around that essential truth. You'll get your share of strikeouts, but your home runs will win games and may send your team -- that is, your portfolio -- into the playoffs or the Hall of Fame. Remember: Mickey Mantle was one of the most prolific strikeout hitters of all time, but his home runs well outweighed those strikeouts, and today he is the stuff of legend -- and a Hall of Famer.

Tim: If you could impart just one piece of advice to help our readers start their own searches for Rule Breakers, what would it be?

David: Learn as much as you can about any company's management, and look for greatness. Remember when we talked about Michael Dell? He was a compelling manager with a compelling vision, a deep understanding of his market, and the guts to buck the conventional wisdom. That made him a Rule Breaker, and that's what made his company a Rule Breaker. Same thing with Jeff Bezos at Amazon, and the list goes on.

One of the reasons I'm confident about Netflix despite its recent downturn is because I think CEO Reed Hastings is a smart, visionary, good guy. If I were forced to buy 25 stocks and simply walk away for 10 years, I would spend my due diligence searching for people like him and investing in them. I think management talent is a more powerful indicator of success than the popularity of any product in any given year.

Tim: Even the iPod?

David: Yep, even the iPod, though Steve Jobs is another obvious Rule Breaker of a manager in his own right.

Tim: Finally, what would you tell the reader who is curious about the Motley Fool Rule Breakers service?

David: Our strategy is simple. We focus on finding billion-dollar opportunities created by new technologies or business models. In that way, we're offering a service that's a little like venture capital investing, with the same expectation for market-crushing returns right alongside our share of flameouts. The next ultimate growth stock is out there. I'm confident that with our expert team and a growing community of smart Fools, we'll find it. If that's your interest, too, then take a free trial and join the effort.

To join a lively discussion of related topics, visit our boards.

Motley Fool contributorTim Beyerssometimes breaks the rules when it comes to household chores. Till his wife sets him straight, that is. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. To see what stocks are in his portfolio, check out his Fool profile, which ishere. The Motley Fool isinvestors writing for investorsand has adisclosure policy.


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