A few weeks back, Fool co-founder David Gardner discussed the six signs of a Rule Breaking company. Over the next few weeks, our analysts will be examining each of these signs in greater depth. After the series has run its course, you should be able to identify Rule Breakers for yourself. Today, we'll look at sign No. 3: Strong past price appreciation.
I'm a father of three, which means I have the following phrases programmed on autopilot:
"Can you hand me the remote, honey?"
"Mmmmmm, jelly doughnuts."
"Stop hurting your sister!"
And, of course, the classic: "Get down! You'll hurt yourself!"
A case of investing acrophobia
As a parent, I worry when my young kids are climbing where they shouldn't. I'm afraid they'll fall and hurt themselves. As an investor, I get nervous when one or more of the stocks I own reaches a new high in its per-share price.
You know that feeling, don't you? Of course you do. That's why the popular maxim of investing success says to "buy low and sell high." Is there a higher high than a new 52-week high? (Say that three times fast, won't you?) No, there isn't. That's why most among us ask only two questions when our stocks perch themselves in the nosebleed section of the market:
- Should I hold?
- Should I sell?
Notice that we almost never wonder if we should buy more. That, Fool, is a mistake.
The Rule Breaker in you would
When David Gardner outlined his six signs of a Rule Breaker a couple of weeks ago, No. 3 was strong past price appreciation. When looking for great stocks, you should seek the ones that have reached for the heavens over the prior 12 months or two years.
Don't just take my word for it. Take a look at this chart for Starbucks (Nasdaq: SBUX ) and you'll see what I mean. Heady gains were to be had investing in the latte king, even if you'd bought at the height of the dot-com bust. And need I mention the G-word? Oh, come on. Don't pretend you don't know.
It's all relative
I'm talking about Google (Nasdaq: GOOG ) , of course. IPO price: $85. The price as I write today: $296.69. Total gain in less than a year: 249%. Certainly some folks would argue that now is a great time to sell Google. But there were plenty who were screaming sell at $200. That worked out well, eh?
But let's not get distracted. The plain fact is that there is some degree of momentum that governs investing. Stocks tend to continue to appreciate, even after they've appreciated a lot. That's why William J. O'Neill, founder of Investor's Business Daily, created a metric called "relative strength." It measures a stock's price appreciation compared to all others in the market. (In other words: a stock rated 99 has outperformed all but 1% of the stocks available over the trailing 12 months.) Google is an obvious 99 in a market loaded with 40s, 50s, and 60s.
What goes up ... usually keeps going up
David also picked three obvious 99s to profile in his 1999 book Rule Breakers, Rule Makers: Cisco (Nasdaq: CSCO ) , Yahoo! (Nasdaq: YHOO ) , and McAfee (NYSE: MFE ) . All three, like Google, had provided terrific gains over recent history. But each was also doomed to darker days that punished investors who bought at the top. That's the danger of relying on past gains alone to predict future price appreciation.
That's not to say past gains don't matter. I'm just going to do as David did and put them in perspective. Let's refer back to the book one more time, shall we? Therein, David conjured the ghost of the famous physicist Sir Isaac Newton to make a key point about investing. (Newton was the dude who deduced the idea of gravity after being conked on the noggin by a falling apple.) You see, Newton was the first to understand that an object would continue in one direction until some force was applied against it. For example, a car won't stop unless its brakes are applied. Similarly, a stock on the rise won't stop climbing until there's a reason for it to do so.
C'mon up, the view's good
Reasons appeared for Cisco, Yahoo!, and McAfee, and periods of distinct underperformance followed. Investors who weren't paying attention to the state of the underlying businesses and the stock price relative to real growth prospects were badly burned.
But when you mix substantial price appreciation with great management and a competitive advantage, great results can follow. Consider chip maker NVIDIA (Nasdaq: NVDA ) , which is part of our Rule Breaker Universe watch list. Its microprocessors have become must-haves for developing video game systems, fueling massive gains in the stock over the past year. But that run-up was fueled by equally massive improvements in sales and earnings. And management remains heavily engaged with an 8% stake in the company.
Eight little Fools went to the market
Then there's the Foolish 8, an older screen for small-cap winners that was given a fair amount of attention in The Motley Fool Investment Guide. Extraordinary past price appreciation was one of the key criteria of the model, which -- while never intended as a purely mechanical stock-picking approach -- would have returned more than 400% since 1998, according to the American Association of Individual Investors (AAII). The S&P 500 returned a little better than 20% over the same period.
It's difficult to jump onto a moving train -- it just feels like you're going to get hurt. And, well, yeah, you would -- if we were talking about a real train. But we're talking stocks here, Fool. History has proven that fast-growing companies whose potential hasn't been fully appreciated can be extraordinarily lucrative.
That's what we're attempting to do at Motley Fool Rule Breakers. We're using David's six attributes to find the next ultimate growth stock before it becomes ... the next ultimate growth stock. We're talking about the eBay that was nothing but a Pez dispenser depot; the Marvel Enterprises (NYSE: MVL ) that was merely a comic book wholesaler; and the Starbucks that was just a coffee shop. Right now, you can join the hunt for the next crop of stocks like these for nothing. Just take a 30-day risk-free trial to Rule Breakers. You'll get all of our recommendations and access to a community of determined Fools who, like you, want nothing less than the highest possible returns. Click here to learn more.
Buy low and sell high? No thanks. I'd prefer to buy high and hang on for growth. That, after all, is the Rule Breaker way.
For related Foolishness:
- Rick Munarriz reveals sign No. 1 in Be First, Be Great.
- Charly Travers examines sign No. 2 in Thwarting the Big Bad Wolf.
Fool contributor Tim Beyers has sat in the nosebleed section at the ballpark waaaay too many times. But that won't stop him from going again. Tim didn't own stock in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile, which is here. The Motley Fool has an ironclad disclosure policy.