The Criteria

Four criteria for a Rule Breaker are quite subjective, but they are also fundamental aspects of great companies. Who wouldn't want to own the top dog and first mover in an important, emerging industry? What's the argument against having sustainable advantage over your competitors through patents or other de facto barriers? Does anyone want something other than good management and smart backing? Is there a downside to having as good a consumer brand as possible?

The other two criteria are factual and objective, but, despite their easy application, are also the most maligned. Who cares about a relative strength above 90? It only has to do with momentum over the last 12 months, after all. And what difference does it make if most of the financial media has called it overvalued? The prattling of pen-pushers isn't going to make your company's business any better or worse.

The Rationale

When I first read Rule Breakers, Rule Makers, I thought that there was a lot of insight in the Breaker portion. It presented some of the most important elements of a great business in a clear, accessible way. I was puzzled, however, by these weird relative strength and bearish financial media points, which have no bearing on the business whatsoever. I promptly dismissed those criteria as irrelevant.

As they've stewed in my head for a while, however, I've come to think that they had some usefulness as good indicators of future performance. Had, I say, because they were conceived in a different market environment than we currently face (or at least have faced recently).

Here's how my thinking goes: we look for up-and-coming companies in emerging industries. Those companies almost always will not appear successful when measured by standard metrics, such as gross or profit margin, return on invested capital, and the o'erglorified P/E ratio. To the casual observer, who isn't taking more than a glance at the stock, a company with big losses looks way overvalued at $500 million. It's a simple, knee-jerk reaction.

To the more practiced eyes of those who really follow the industry, however, the company's potential is much more important than its past financials. The people I'm talking about here are not we individual investors with our small accounts (though we factor into the equation), but the folks with the real money -- the buy-side analysts at investment banks and mutual funds.

With more than $7 trillion in assets, the mutual fund industry exerts considerably more influence on the market than Joe Modem. Don't you believe it when we're told that "online traders" are responsible for things like Qualcomm's (Nasdaq: QCOM) run-up last year. By the end of it, over 80% of the float was owned by institutions. A quick look at the current number (about 40%) shows that they also have factored large in Qualcomm's run-down.

But buy-siders are sharp folks, well-trained not only in financial analysis but, much more importantly, business analysis. Many may suffer from institutional thinking or be too willing to trade in and out for a quick gain (foibles we all struggle with), but plenty of them know a hawk from a handsaw. They'll spy a diamond in the rough.

So, not so long ago, when the financial media had not yet cottoned on to the phenomenon of a Rule Breaker, investors had. They had studied their market history and had seen the extraordinary growth of Wal-Mart (NYSE: WMT) and Home Depot (NYSE: HD) and Microsoft (Nasdaq: MSFT), companies that had long appeared overvalued but had repeatedly proved equal to or better than their expectations. They could see the same look in the eyes of Cisco (Nasdaq: CSCO) and AOL (NYSE: AOL) and Yahoo! (Nasdaq: YHOO), which led to high relative strengths for these companies, even though the media decried the madness.

Hence Rule Breaker criteria #3 and 6. In tandem, they pointed out those companies that the so-called "smart money" was chasing, even though so-called "common sense" told casual observers and conservative investors that they were overvalued. The criteria were not perfect gauges on their own, to be sure, but they provided a good initial screen for finding companies that fit the four subjective criteria.

The Present Reality

Then an interesting thing happened. As more people started paying attention to the market, observing the stocks that their mutual fund held and even (gasp!) investing for themselves, everyone began looking for the mythical "next Microsoft." The more attention that got paid to the small, quickly appreciating stocks, the more the media began to think that their customers didn't want to hear pessimistic valuations, but rather optimistic forecasts. The more the media talked up the companies, the more mutual funds wanted to buy them, so that they could look cutting edge, sending the stock even higher. So the positive-feedback loop continued.

You probably know this story. The skyrocketing valuations led to more initial public offerings (IPOs) and more option-based compensation, which meant lots of low- or no-revenue companies with small floats being chased by lots of cash. Rather than sifting through the start-ups for businesses that fit the four other Rule Breaker criteria, people just started buying anything that sounded good at a glance.

That's done a few things: it's made it a lot harder to find Rule Breakers amid the fray (which in part accounts for our tardiness in finding our next stock); it's increased valuations right from the IPO, thereby reducing returns that ordinary folks can get; and, sadly, it's thrown our two objective criteria into disarray.

If it weren't for Barron's (bless them), it'd be almost impossible to find a bearish voice in the media these days. That is changing, of course, as the market falls and more of these bets don't pay off. It has nevertheless rendered our "bearish media" criterion virtually useless of late. If you read the Celera (NYSE: CRA) buy report, you see that it is completely ignored. And rightly so.

The Future

Let's hope that the bear market deepens, so that we can start paying $500 million again for high-potential companies like Millennium Pharmaceuticals (Nasdaq: MLNM) and Human Genome Sciences (Nasdaq: HGSI), rather than the $7-8 billion we're being asked to pay. At that time, too, maybe our relative strength and bearish media criteria will return to their former glory.

Until then, the temptation to work around these two points is strong. They remain very good signs for a stock, but they are harder and harder to find. Is it a valid practice to ignore points that have served us well in the past, or would we be flirting with disaster? Please let us know what you think about the subject on the Rule Breaker Strategies board!

-- Brian Lund, known to the pigeons of Alexandria as TMF Tardior

Your Turn:

Poll: Do you think that Relative Strength and Bearish Media are still viable Rule-Breaker investing criteria?
  1. Yes, both are still great indicators of future success.
  2. Relative Strength still helps, but the Bearish Media is too hard to find.
  3. I look for Bearish Media, but bypass Relative Strength.
  4. No, neither is helpful anymore.
  5. I've always worked around both.