Rule Breaker Portfolio

Our Next Buy
And how we made our decision

We're finally adding a new stock to the portfolio, after 10 months of holding a significant cash balance. We should have bought Spiders in the interim, which we will do in the future. We made our buy decision after long discussions about future prospects, in search of a company that could appreciate 900% in five years. As always, we selected a very risky, richly valued stock.

By The Breaker Team
September 21, 2000

Good evening, fellow Fools. The time has finally come for us to allocate the cash that has been sitting in our account since February. It's not often that we make a buy, so this is a red-letter day for our little portfolio. Keep in mind, though, that this is just one portfolio, one group's idea of a good collection of investments. We don't determine whether a stock is or is not a "Rule Breaker," we just choose our stocks based on the criteria and principles we've outlined. This is not an anointing ceremony. It's a simple stock purchase for a single portfolio run by a group of very opinionated people.

Before we get to that, though, we'd like to make a couple of points about the portfolio specifically and portfolio management in general.

Stay fully invested
We erred in not reinvesting our cash sooner. That is not to say that we should have bought the first stock that caught our fancy as soon as we had some money. We feel no regret about taking our sweet time deciding on a purchase, especially given the risky nature of Rule Breakers. We do regret, however, not staying fully invested. If your portfolio, like ours, consists of money that you won't need for at least five years (preferably longer), then your best bet is to have it fully invested in the market at all times.

If you choose to invest in a focused group of stocks, but you haven't yet decided on your next purchase, don't rush the process. Take your time and do as much research as you can. In the meantime, do yourself a favor and put that extra money into the general market, either through an index fund or exchange-traded index shares -- such as Spiders (AMEX: SPY) (S&P Index Depositary Receipts) or Cubes (Nasdaq: QQQ) (Nasdaq-100 Index Tracking Shares).

That's what we should have done. We will in the future. It's just one more reason why you shouldn't mimic us. We make mistakes. Plenty of 'em. Learn what you can from us and make your own decisions.

The decision-making process
OK, now that all that's out of the way, let's cut to the chase. We had whittled our world of potential Rule Breakers to nine candidates: Akamai (Nasdaq: AKAM), USInternetworking (Nasdaq: USIX), Millennium Pharmaceuticals (Nasdaq: MLNM), Ariba (Nasdaq: ARBA), Lernout & Hauspie (Nasdaq: LHSP), Phone.com (Nasdaq: PHCM), Human Genome Sciences (Nasdaq: HGSI), Webvan (Nasdaq: WBVN), and InfoSpace (Nasdaq: INSP).

To decide upon our finalists, we held two meetings, which dragged on for hour after excruciating hour. (Getting us four to stay on topic and make decisions is like the proverbial herding of cats.) We started by winnowing out the chaff, the companies that we knew wouldn't make the grade -- USInternetworking, Lernout & Hauspie, and Webvan. The latter two had been discounted in the Break Down. USIX is more like a Breaker, but the ASP industry as a whole has been punished mercilessly on Wall Street lately. This causes us to question whether we're missing a fatal flaw in the still-emerging business model.

At this point, faced with six excellent candidates, we considered the potential returns of each. Since Rule Breaker investing is a high-risk, high-potential-return strategy, we introduced a new benchmark that we may use more in the future: 10x/5y. We want to buy into companies that we think have the potential, assuming things go their way, to appreciate in value tenfold in five years. So we took a guess at the best-case market cap potential of each stock. That helped us develop the expectations we have for our investment.

It also helped us eliminate Millennium, since its potential for appreciation did not seem as great as that of Human Genome Sciences, the other biotech candidate. Although Millennium's revenue stream is much more predictable and secure, HGS has the greater potential to be a true Rule Breaker, by virtue of its novel approach to developing drugs. David asked us which of our finalists, if not selected, would leave us feeling like we had missed a revolution, if the dream panned out. By this measure, we preferred HGS to Millennium. We're looking for revolutions in this portfolio.

After a long discussion on the future of the wireless Internet, we decided to hold off on Phone.com and InfoSpace. The industry is so underdeveloped that we didn't feel confident predicting who, if anyone, will profit from it. Once its future becomes clearer to us, we may revisit these companies.

Then there were three: Akamai, HGS, and Ariba. We decided to run them through the six Rule Breaker criteria and score them on a scale of one to three for each criterion. Though we differed in the particulars of our scoring, we each separately came to the same conclusion: Our next Rule Breaker should be Human Genome Sciences.

And so it will be. In accordance with our trading policy, we'll buy about $45,000 worth of Human Genome Sciences sometime in the next five trading days.

Important points about Human Genome Sciences
We described our reasons for buying HGS more completely in our Break Down, but we wanted to make a few important points here.

1. HGS is our most risky investment to date. It has virtually no revenue. The revenue it hopes to generate in the future depends on the approval of its drugs, the protection of its patents, the acceptance of its technology, and other uncertain factors. Even in the best-case scenario, HGS won't see revenue from its first drug for three to five years. It may make money from its data in the meantime, but that is not its business. Thus, significant revenue is years away, and actual profit some years beyond that, since HGS will spend heavily on research during that time.
   
   
2. We are taking a long-term outlook on its prospects. Because of its lack of revenue or profitability and its extremely rich $9 billion market cap, HGS could easily perform horribly in the short- to intermediate-term. The next three years could be total busts for the share price. As long as it maintains what we see as its competitive advantage in the proteomics industry, we intend to hold through any such bad times.
   
   
3. We are paying for the pipeline. The main reason that we like HGS is that it has one of the most promising pipelines in the industry. It has a massive lead in patent filings -- having filed for nearly 10,000 patents, mostly proteomic-related. That's more than any other company that we know of. With its drug pipeline and the possibilities for future royalties from its data, HGS is well-positioned should proteomic drug discovery meet its suggested potential. Proteomics itself offers higher-quality products than traditional pharmaceutical research, since the targeted application of naturally occurring, signal-carrying proteins and their antibodies could enable them to hurdle clinical trials at a higher success rate.
   
   Nothing here is assured, however. Pipelines can rupture. If HGS's early drugs get rejected, revenue and profits will sink even further down on the horizon, and could disappear entirely.

For more information about our decision to buy HGS, see our Break Down. If you want to embark on the search for other biotech stocks with great potential but don't feel that you have an understanding of the industry, enroll in our Biotechnology Seminar, which starts October 16. If you'd like to express your opinion about this purchase and hear what other Fools have to say, stop and sit a while on the Rule Breaker Companies and Human Genome Sciences discussion boards.

By the way, if you'd like to have the convenience of receiving an email alert when any of our Foolish portfolios make a trade, we offer Motley Fool Trade Alerts for $25. (These email alerts arrive in your inbox about the same time the information is made available here in our forum.)

Now, let's welcome HGS into our portfolio with a round of applause! May you stay a long time and prove to be the best investment we've ever made.

Related Links:

Biotechnology Investing Online Seminar

Break Down: Human Genome Sciences, part 1

Break Down: Human Genome Sciences, part 2

More Biotech Rule Breakers?, Rule Breaker, 9/13/00

Human Genome Sciences FAQ, by ElricSeven

Human Genome Sciences website

Stocks Fools Love: HGSI, 02/08/00, by Jeff Fischer