Rule Breaker Portfolio

<THE RULE BREAKER PORTFOLIO>

Back to the Basics
Tonight, let us return to our roots

By David Gardner (David G@fool.com)

Alexandria, VA (July 21, 1999) -- The Rule Breaker Portfolio came back strong Wednesday, rising 2.39% over lesser gains in the Nasdaq (up 1.08%) and the S&P 500 (up 0.16%).

America Online (NYSE: AOL) announced earnings after market close, and I'm watching the headlines scroll as I write. "Average usage is 52 minutes a day, versus 44 minutes a day." "Advertising, commerce, and other revenues up 87%, operating margins up to 16% from 9% in last year's 4th quarter." Etc. Earnings per share came in at 13 cents. You can talk about it more on our AOL message board, where the conversation is fast and furious.

Amazon.com (Nasdaq: AMZN) also announced its June quarter results, though not providing me quite enough time to make sense of them. Revenues were $314 million, and the losses were, as usual, substantial. We'll be looking at Amazon in more detail in Fool News soon and probably this space, as well.

But hey, how do you think these stocks are going to open tomorrow, based on the above information?

You mean, you're actually able to answer that question?! We at Fool HQ wouldn't presume to. Most earnings reports have already been pretty effectively priced into their respective companies' stocks -- often, the next day's movement is the very opposite of what one might expect. A strong company announces a bang-up quarter and BOOM, the next day it drops. Or the reverse happens. This is why Fools invest for the long term. The long term is dependable. The short term is mostly random, and trading on randomness is both expensive, time-consuming, and less effective (as numerous studies have demonstrated).

Time and again in life, it's helpful to return to our roots. Go back to the hometown. Write an old college prof. Hang out with your first gym teacher. With so many new people visiting the Fool this summer, I want to take time out to restate our six Rule Breaker attributes. (These are summarized briefly in one of this portfolio's management principles, #4, which can be read here.)

Before we go on, remember that for a stock to be a "Rule Breaker," it must meet all six of our selection criteria. If a company does not clearly meet each one, we discard it and look elsewhere. Does that mean if a company doesn't qualify as a Rule Breaker, that it won't be a great investment? Heck, no. Our investment philosophy is just one among many potentially successful ways to make money on the market. You're here presumably because you're interested in this one. Great. I'm assuming you know many others. (Like the index fund, for starters.)

The Top Dog -- WOOF!

The first attribute of a Rule Breaker is that it is the top dog and first-mover in an important, emerging industry. Just about every one of those words is loaded. When I say "top dog" I mean the clearly recognized leader. When I say "first-mover," I mean the company that got started doing what it is doing (in the way it is doing it) before anyone else. The industry? It's got to be important. One of my worst investments ever, detailed in The Motley Fool Investment Guide, was Styles on Video. Styles on Video put a digital camera in salons that took a picture of a woman's face, and then digitally superimposed 20 different hairstyles on her head, printing out a full-color picture of each -- this, prior to having her hair cut, or her "look" redone. It was extremely lifelike, very funny, quite amazing. But if Styles on Video's business had disappeared off the face of the earth, no one would've cared that much. It was not important.

Gee, it just occurred to me: Styles on Video did pretty much disappear off the face of the earth. Point made.

OK now, we're not talking just important, but also emerging. Here's a quick example: Railroads are no longer emerging, in case you thought they were. Nope. A century too late. Not emerging. You get the point.

Put all those criteria together and you have the first -- and probably most important -- attribute of the Rule Breaker. It must be the top dog and first-mover in an important, emerging industry.

A Sustainable Advantage

Up second is "sustainable advantage." We are not interested in a company unless we believe it can sustain its status as top dog. Why bother investing in vulnerability? No, no. When we invest our own darn money in something, we insist that this thing have a sustainable advantage of 2-3 years -- 2-3 years as a continued top dog. At least. Forever is better.

How does a company get a sustainable advantage? We focus on four different ways -- which are not mutually exclusive. In some rare situations, they can all exist.

The first is business momentum. Just sheer, flat-out sales and earnings growth multiplying at uncatchable rates. Amazon.com's revenue growth as an e-commerce giant provides a fine example. Take a look at these sales numbers:

1996: $16 million
1997: $148 million
1998: $610 million

In the first quarter of '99, the company tallied $293 million in sales, appearing to put the company on track for its first year of billion-dollar sales. (As you saw above, the second quarter results are in, at over $300 million.) Even though Amazon has yet to turn a profit, that is absolutely astounding growth for a startup. The debate rages on as to when and how Amazon will turn a profit; as we own the stock, we obviously think it will, and the market's valuation accorded to the company points to the same opinion. But regardless, that is not the point here. We're talking about sustainable advantage via business momentum. Amazon.com is one of the premiere examples of business momentum in international business today.

The second sustainable advantage is patent protection. Amgen (Nasdaq: AMGN), our biotechnology Rule Breaker, perfectly illustrates this. When Amgen develops a new biopharmaceutical, it obtains a patent on that product that lasts for nearly 20 years from the date of application.

A third and fourth form of sustainable advantage involve two things that are independent, but often correlative. The third is visionary management. If we become convinced, through reading about and studying a manager or management team, that they are possessed of a true vision that is unique and beyond the ability of their competitors to envision -- or imitate -- we have our sustainable advantage. I've always felt that Bill Gates is this way. Same is true of Apple's Steve Jobs. And there are other visionary managers out there. The fourth sustainable advantage comes in the form of inept competitors. Often, a company is competing with old business models owned by fat cats who simply cannot reinvent themselves quickly or effectively enough. I view Merrill Lynch, when we talk about online trading, as a classic example of an inept competitor.

I mentioned that the third and fourth are often kissing cousins because so very often, visionary management creates inept competition.

Excellent Past Performance

The third attribute is the only one that involves a number. In that way, unlike the others, it's not a judgement call. It's straightforward and simple, like a screen. We're looking for stocks with a relative strength of 90 or higher.

What's that mean? Relative strength, as our long-time readers know, is a numerical grade given to the performance of the stock. It is the percentile of performance under which the stock falls over the past 12 months. Thus, stocks that are 90 or higher have outperformed 90% or more of all other stocks over the past 12 months.

Where do you find this number? Investor's Business Daily, the newspaper, is our primary source. Some other online sites have it (I think MSN is one), though we will shortly (and finally) have it right here in Fooldom for you.

Why do we care about this number? Simple. We're looking for great companies, and the market recognizes and rewards truly great companies. If we really have a top dog with a sustainable advantage, it darn well better have excellent past price appreciation! Otherwise, we'd wonder why not. Otherwise, the market must have real questions about one or another aspect of the company. The market and its opinion is, here, our guide.

Tomorrow I'll finish our look at the Rule Breaker attributes by looking at the last two criteria.

See you tomorrow night. Fool on!

-- David Gardner, July 21, 1999

07/21/99 Close
Stock  Change    Bid 
------------------ 
AMGN  +1 11/16   74.69
AMZN  +5 5/16   125.44
AOL   +2 3/16   115.88
ATHM  +1 15/16   47.00
CAT   +  7/16    60.63
CHV   +  15/16   94.25
DD    +1 3/8     72.19
DJT   -  3/16     5.19
EBAY  +2 3/8    115.31
GT    -2 7/8     54.75
IOM   -  1/16     4.38
SBUX  +  3/8     25.25
TDFX  -  15/16   14.31


                  Day     Month  Year   History   Annualized 
      R-BREAKER  +2.39%  -0.73%  27.71% 1181.79%   67.27%
        S&P:     +0.16%   0.47%  12.79%  215.15%   26.05%
        NASDAQ:  +1.08%   2.82%  25.95%  283.48%   31.14%


    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91    115.88   12649.63%
   9/9/97  1320 Amazon.com     6.58    125.44    1806.56%
  5/17/95  1960 Iomega Cor     1.28      4.38     241.69%
 12/16/98   580 Amgen         42.88     74.69      74.20%
  12/4/98   900 Excite@Hom    28.04     47.00      67.62%
  4/30/97 -1170*Trump*         8.47      5.19      38.75%
  2/23/99   300 Caterpilla    46.96     60.63      29.09%
  2/20/98   260 DuPont        58.84     72.19      22.68%
  2/23/99   180 Chevron       79.17     94.25      19.05%
  2/26/99   300 eBay         100.53    115.31      14.71%
  2/23/99   290 Goodyear T    48.72     54.75      12.39%
   7/2/98   470 Starbucks     27.95     25.25      -9.67%
   1/8/98   425 3Dfx          25.67     14.31     -44.24%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 254925.00  $252925.53
   9/9/97  1320 Amazon.com  8684.60 165577.50  $156892.90
 12/16/98   580 Amgen      24867.50  43318.75   $18451.25
  12/4/98   900 Excite@Hom 25236.13  42300.00   $17063.87
  5/17/95  1960 Iomega Cor  2509.60   8575.00    $6065.40
  2/26/99   300 eBay       30158.00  34593.75    $4435.75
  2/23/99   300 Caterpilla 14089.25  18187.50    $4098.25
  4/30/97 -1170*Trump*     -9908.50  -6069.38    $3839.13
  2/20/98   260 DuPont     15299.43  18768.75    $3469.32
  2/23/99   180 Chevron    14250.50  16965.00    $2714.50
  2/23/99   290 Goodyear T 14127.38  15877.50    $1750.13
   7/2/98   470 Starbucks  13138.63  11867.50   -$1271.13
   1/8/98   425 3Dfx       10908.63   6082.81   -$4825.81

                              CASH   $9924.87
                             TOTAL $640894.56
 
Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.

</THE RULE BREAKER PORTFOLIO>

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