Finding the Next Rule Breaker

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.

Talk about a needle in a haystack
While most of these 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 winnow out clear non-Rule Breakers -- so we can find the next great Rule Breaker.

We can find strong past price appreciation -- one of David's traits -- 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-star stocks as rated by CAPS, as well as for companies with a P/E over 40. One-star stocks are clearly out of favor in our Foolish community, and many a prudent investor would resist paying for a stock that trades at 40 times its earnings.

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

Company

Market Cap

P/E

52-Week Price Change

What It's Involved in ...

Houston American Energy $562 million 174 194% energy
Sandy Spring Bancorp $454 million 61 119% banking
Travelzoo (Nasdaq: TZOO  ) $676 million 46 237% Internet travel
lululemon athletica (Nasdaq: LULU  ) $5.07 billion 54 127% apparel
Zumiez (Nasdaq: ZUMZ  ) $832 million 46 111% apparel
Dice Holdings $919 million 57 119% Internet job listings
Entropic Communications (Nasdaq: ENTR  ) $1.01 billion 52 294% microchips
Krispy Kreme Doughnuts (NYSE: KKD  ) $479 million 51 137% food
Jazz Pharmaceuticals (Nasdaq: JAZZ  ) $775 million 52 150% pharmaceutical

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
I immediately eliminated four of the above companies. Houston American Energy (oil) and Travelzoo (Internet-based travel) are by no means the top dogs in their respective fields. Similarly, Krispy Kreme Doughnuts -- although extremely tasty -- and Sandy Spring Bancorp are not part of important, emerging industries.

2. Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors
None of the remaining companies on our list missed the mark here. Entropic and Dice have business momentum due to macroeconomic trends at their back. lululemon and Zumiez have visionary leadership teams on board; and Jazz, with its hand in pharmaceuticals, sustains its advantage through patents.

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. Of the companies that remain on my list, all but Dice Holdings still have their founders on board as executives or on their boards of directors.

4. Strong consumer appeal
Jazz Pharmaceuticals, maker of narcolepsy drug Xylem and OCD drug Luvox, is bringing in the cash ... for now. But it can't rest on its laurels. It will have to remain consistently innovative, because patents always expire, allowing cheaper generic brands to gain the upper hand. That was enough for me to take it off the final list.

That leaves three stocks that deserve a closer look
Taking the remaining companies in reverse alphabetical order, Zumiez was founded in 1978 and is a one-stop shop for snowboarders, surfers, skateboarders, and BMXers (think X-Games). The retailer has an avid following among its fan base, and that base is growing. In its most recent quarter, the company reported comparable-store sales increased 14.4%. Zumiez currently has about 400 stores, and some believe that the growth story might be coming to an end. But I think that would be a mistake; at the beginning of 2010, Zumiez had yet to enter 15 states and plans on expanding to Canada soon.

lululemon athletica has been on a tear. A few weeks back, I predicted that lulu would become to female athletes what Under Armour (NYSE: UA  ) is to male athletes. With a relatively small number of stores, plans to expand abroad, and strong same-store sales growth of 29%, lulu looks poised to pop.

And finally, Entropic. I believe that the home of the future will be filled with appliances -- TVs, DVRs, computers, stereo and video game systems -- that are able to communicate with each other. The key to making this happen lies with Entropic's microchips. Although its P/E sits north of 50, its potential future growth is high enough to justify that valuation, in my view.

Going forward
The numbers I chose to use in my screen are by no means absolute. I used them as a starting point to turn up ideas for my search. I encourage you to jump on our screener and input slightly different numbers, dig into some of the companies, and share your finds below. The Motley Fool was founded to educate, so I encourage you to use the comments section to contribute to our communal pool of knowledge.

For more on Rule Breakers:

Fool contributor Brian Stoffel owns shares of lululemon. Zumiez is a Motley Fool Big Short short-sale selection. lululemon and Under Armour are Motley Fool Rule Breakers recommendations. The Fool owns shares of Under Armour, which is also a Motley Fool Hidden Gems selection. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 04, 2011, at 10:58 AM, TMFBreakerForce wrote:

    Actually, LULU is a Rule Breaker Recommendation. :)

  • Report this Comment On January 04, 2011, at 12:02 PM, brewersfan81 wrote:

    TMFBreakerForce,

    Believe it or not, I started the article long before it was rec'd. The holidays put this on the backburner for quite a while, so I guess I spotted one!

    Brian Stoffel

  • Report this Comment On January 04, 2011, at 12:31 PM, Mliaom wrote:

    Yes, I can vouch for that. He discovered it before it was a RB pick.

    It was great write up, I still haven't stopped kicking my self for not acting on it. It jumped almost 25% after the blow out earnings right after his report.

  • Report this Comment On January 04, 2011, at 6:19 PM, DDHv wrote:

    AXPW.OB is likely to be a rule breaker in a year or two. Wouldn't hurt to keep an eye on it.

  • Report this Comment On January 06, 2011, at 7:58 AM, pondee619 wrote:

    "Actually, LULU is a Rule Breaker Recommendation. :)"

    "so I guess I spotted one!

    Brian Stoffel"

    That's the type of attention to detail that those of us who read the fool seriously (hoping beyond hope for relaible information) look for. Don't check the facts in your "atricle", Brian, just publish it.

  • Report this Comment On January 06, 2011, at 11:54 AM, brewersfan81 wrote:

    pondee,

    As a freelance writer, I don't have automatic membership to all of the Fool's services. Although I am a regular at Stock Advisor, I do not have a membership to Rule Breakers. The rec was news to me, but in no way would change the information in the article.

    Brian Stoffel

  • Report this Comment On January 06, 2011, at 4:48 PM, Mliaom wrote:

    pondee,

    read the disclossure, its right there.

    mliaom.

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