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. David finds companies that the market considers overvalued, but which enjoy game-changing advantages over their peers.

Luckily for us, he's 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.

We can find strong past price appreciation by screening for stocks that are up at least 100% over the past year. To zero in on stocks considered overvalued, I looked for one-star stocks as rated by CAPS, as well as for companies with a P/E greater than 40. One-star stocks are clearly out of favor in our Foolish community, and many prudent investors would resist paying for a stock that trades at 40 times its earnings.

When I ran the screen, I got five companies that weren't already Rule Breakers, and which had a market cap of more than $200 million:

Company

Market Cap

P/E

52-Week % Change

What It Does

3D Systems (Nasdaq: TDSC  ) $1.01 billion

52

195%

3-D printing and prototype design
Allied Nevada Gold (AMEX: ANV  ) $2.68 billion

74

100%

Gold mining
Ariba (Nasdaq: ARBA  ) $2.76 billion

49

130%

Commerce solutions
Commercial Vehicle Group (Nasdaq: CVGI  ) $409 million

59

137%

Vehicle parts
Travelzoo (Nasdaq: TZOO  ) $736 million

56

236%

Travel solutions

Source: Motley Fool CAPS.

Now we can use the rest of David's qualitative criteria to narrow down our field:

1. Top dog and first mover in an important, emerging industry
I immediately eliminated three of the above companies. Allied Nevada Gold, which -- what else -- mines for gold in Nevada, is hardly a first mover. Travelzoo is dwarfed by top dog priceline.com (Nasdaq: PCLN  ) in the online travel industry. And although it looks like a promising under-the-radar stock, Commercial Vehicle Group, which provides parts and solutions to the worldwide commercial vehicle market, is not part of an emerging industry.

2. Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors
Neither of the remaining companies on our list missed the mark here. Even though it faces competition from monsters like Oracle (Nasdaq: ORCL  ) , Ariba has serious momentum at its back. Some 94 Fortune 100 companies currently use Ariba software.

3D Systems, on the other hand, has visionary leadership guiding it. The word "stereolithography" (which refers to how 3D Systems can create an actual object from a 3-D computer model) was itself coined by founder and Chief Technology Officer Chuck Hull. He literally created this niche of the industry!

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. None of Ariba's original co-founders serves as a director or major executive. 3D Systems, as mentioned above, still has founder Chuck Hull on as Chief Technology Officer.

4. Strong consumer appeal
It took me a second to really wrap my head around this, but consider what 3D Systems offers. Its aforementioned stereolithography (SLA) process allows engineers -- and just about anyone else -- to create a three-dimensional product on demand, with the blueprint provided by 3D's proprietary software.

That leaves just one stock 
Currently, 3D Systems offers products in the transportation, consumer, recreation, health-care, and education industries. Furthermore, the company has partnered with York Technical College, located near 3D's headquarters in South Carolina, to train customers and employees how to best use their products.

Though 3D's shares trade for a premium today, the company has shown strong earnings increases over the past year. In 2009, it earned $0.05 per share. In 2010, that number increased more than 1,500% to $0.83 per share. Analysts predict that 3D will earn $1.39 per share this year, representing a further 67% increase from 2010. In addition, the company has a clean balance sheet.

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 that pop up, and share your finds below in the comments section.

Add 3D Systems to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Fool contributor Brian Stoffel owns none of the companies mentioned here. priceline.com is a Motley Fool Stock Advisor choice. The Fool owns shares of Oracle. 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 Motley Fool has a disclosure policy.


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