The Highest Possible Returns. Period.

In 1992, I was 26 and already spending my fair share of time online. For several years, I'd been a satisfied customer of America Online. Although I liked the service, I decided not to buy shares of the company at the initial public offering that year. I thought I'd wait awhile. (Idiot.)

I kicked myself for two years while the stock quadrupled. In the spring of '94, I followed my instincts and became an AOL shareholder -- in spite of an article in a major financial publication that declared AOL grossly overvalued and predicted that the stock would decline by 35%.

The following year, the stock dropped 25% or more three times. And then in 1996, shares absorbed a drop of 65%! Despite these setbacks, the company went on to wreak havoc on both the business and journalistic establishments en route to putting up some of the best returns available during a decade of great investment returns.

Even with all the temporary downturns, and even though the stock is today down from its all-time high, my initial investment has still increased about 19 times overall -- $10,000 in stock at that time would now be worth $190,658, which amounts to an annualized return of more than 23%.

We'd all love to find the next AOL or Amazon.com (NYSE: AMZN  ) or whatever. That goes without saying.

But how can ordinary investors like you and me -- a couple of regular Fools -- find the next great company? It's not impossible. If you can train your eyes to spot innovative companies breaking the rules in their industries, you increase your odds dramatically.

You can't score if you don't shoot
The Wise of Wall Street would chalk up AOL's 23% annualized gains to luck. "No one can really identify the great companies of the next generation," they'd say. Growth stocks are too risky; it's best to avoid that style of investing altogether and let a Street "expert" manage your investments.

I disagree. Investing in great companies early in their high-growth stages and then holding them for the long term will provide the highest possible returns. Period.

We call those companies Rule Breakers. Our investment service of the same name seeks out the great growth stocks of tomorrow -- the potential AOLs -- before the Street catches on.

Think big, but keep an eye on the basics
Boiled down, I look for six signs of a potential Rule Breaker:

  • Sign No. 1: Top dog and first mover in an important, emerging industry.

    Top dogs are active, fast-moving market leaders. In 1994, AOL was a top dog. Some years earlier, Microsoft was a top dog before making its impressive run. First movers seize a temporary edge over the competition and then exploit that advantage. These companies come from emerging industries -- for example, from biotechnology today or e-commerce a few years back -- because it's unlikely that the railroad or meat-packing industries have much room left to run.

    Rule Breakers are not hidden; they are right before our eyes, and they bring a disruptive technology, clever and effective marketing, or a brand-new business model to this little backwater planet of ours. They rattle our capitalistic foundations.

  • Sign No. 2: Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors.

    Can the company protect the advantage it obtained from its first-mover status? Apple, for example, absolutely dominated Microsoft and Sony (NYSE: SNE  ) in portable music players and now is trying to do the same thing with smartphones to Nokia (NYSE: NOK  ) , Motorola (NYSE: MOT  ) , Palm (Nasdaq: PALM  ) , and Research In Motion.

  • Sign No. 3: Strong past price appreciation.

    Sometimes, the best investments appear overvalued. I bought AOL after it quadrupled. Was Tiger Woods unknown before he joined the professional tour and started winning majors? Was No. 23 unheralded when he joined the Chicago Bulls after his junior year at North Carolina?

  • Sign No. 4: Good management and smart backing.

    This is the most important attribute of all -- and it might be the most difficult to get right. Few would disagree that visionary leaders are behind the greatest companies of our generation: Nike has Phil Knight, Microsoft had Bill Gates, and Google has Eric Schmidt, Sergey Brin, and Larry Page. Investors should also be prepared to learn about the venture-backers of a young company. If the very best venture capital firms are behind a company, maybe you should be, too.

  • Sign No. 5: Strong consumer appeal.

    Rule Breaking companies provide products or services that improve the quality of people's lives. Microsoft, for example, made home computer use a reality.

  • Sign No. 6: You must find documented proof that it is overvalued according to the financial media.

    This is the easiest one of all to identify. Every day, the Wall Street pooh-bahs declare that this or that stock is overvalued. Google shares begin trading publicly, and the naysayers predict another tech "meltdown." Even today, with the vast majority of stocks having taken huge hits, there are some companies with improving fundamentals that Wall Street is afraid to touch because they appear more expensive than others.

    If a company's growing earnings lead to an increasing valuation, someone somewhere will surely argue that the company is overvalued. The reason this is valuable is that it keeps people out of a stock. Later on, as the company proves out its position as a profitable, even dominant, leader, then the skeptics finally buy -- which is what can give you serious appreciation as an early investor in Rule Breaker stocks!

Before they were blue chips
So there you have it. Those are the characteristics I look for in tomorrow's landscape-changing companies.

It's essential to our strategy to identify great companies early in their growth cycles. Then we hold for the long term. Indeed, many of the best examples of Rule Breakers are today's blue-chip companies. You may recognize a few:

Company

Date*

Initial Investment

Current Value**

Return

Compound Annual Growth Rate

Best Buy (NYSE: BBY  )

1989

$1,000

$54,620

5,362%

22%

McAfee (NYSE: MFE  )

1994

$1,000

$14,618

1,362%

21%

Microsoft

1994

$1,000

$75,629

7,463%

15%

* Two years after the company went public.
** All prices adjusted for splits and dividends.

Each of these companies had the six signs of a Rule Breaker at one point in its growth cycle -- and each posted fantastic returns as a result. There are other not-as-famous companies out there -- hundreds of them -- that once were poised for the limelight but now are forgotten. In most cases, the flameouts and the fakers significantly lacked one or more of the signs we pointed to above.

There is no trade-off
With detailed information on more than 9,000 publicly traded companies, the stock market can't help being fairly efficient. But the market doesn't have all the information, does it? Many people insist on following the rules laid down by Wall Street or by the latest "this is the way to invest" fad investment book, regardless of how banal or unsuccessful these prescribed rules behave in practice.

There's our opportunity. My team of analysts at our Motley Fool Rule Breakers investment service searches obsessively for these opportunities. Each month, we give you two new Rule Breaking ideas that we believe are worth holding onto over the long run and will have superior returns to the market.

If you'd like to read our analysis of all our potential Rule Breakers in greater depth, join us for a free 30-day trial today. You can cancel your trial at any time -- you have my word. Click here to learn more.

And one last thing. As big-time Rule Breaker Steve Jobs told Stanford graduates: "Stay hungry. Stay Foolish."

This article was originally published on June 23, 2005. It has been updated.

Fool co-founder David Gardner owns shares of Amazon.com, Microsoft, Apple, and AOL's parent company, Time Warner. Microsoft, Nokia, and Best Buy are Motley Fool Inside Value recommendations. Apple, Best Buy, and Amazon.com are Stock Advisor selections. Google is a Rule Breakers pick. The Fool owns shares of Best Buy and has a disclosure policy.


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  • Report this Comment On January 24, 2009, at 4:48 PM, bg6455 wrote:

    Motley Fool sounds more and more like the "Wall Street pooh-bahs" that they deride. Less time shrilly shilling TMF's lineup of reports and more time providing useful information, please.

  • Report this Comment On January 26, 2009, at 10:33 AM, SanjeeSingla wrote:

    Unfortunately there are errors in your CAGR numbers. MSFT's annualized returns are above 30%, assuming your current share values are correct. Your claim of 15% CAGR would net you less cumulative value than either of the other companies given MSFT is joint youngest.

    I agree with bg6455 that the tone of your article ends with an anticlimactic plug for a product - I would rather have seen some balance to the unequivocal tone of the rest of the piece. I have some issue with your use of the phrase 'documented proof' in Sign No. 6 - the concept of proof in equity research is dangerous to an investor's mindset and irrelevant to ensuring a strong investment.

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