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.
- A top dog and first mover in an important, emerging industry.
- Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors.
- Strong past price appreciation.
- Good management and smart backing.
- Strong consumer appeal.
- 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.
52-Week Price Change
What It's Involved in ...
|Houston American Energy
|Sandy Spring Bancorp
|Travelzoo (Nasdaq: TZOO )
|lululemon athletica (Nasdaq: LULU )
|Zumiez (Nasdaq: ZUMZ )
||Internet job listings
|Entropic Communications (Nasdaq: ENTR )
|Krispy Kreme Doughnuts (NYSE: KKD )
|Jazz Pharmaceuticals (Nasdaq: JAZZ )
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.
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.
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