Foreword: O, for a Muse of Fire
Introduction: Breaking, and Then Making, Rules
Part 1: Rule Breakers
1. Rule Breakers Introduction: Evolution
2. First to a New World
3. Anatomy of Melancholy
4. Sir Isaac and the Land of Mo
5. Aubrey at the Helm
6. The Artistry of Campbell's Soup Cans
7. Percentages, NOT Points!
8. Rule Breakers Summary
Part II: Tweeners
9. The Death Rattle or the Crown?
Part III: Rule Makers
10. Rule Makers Introduction: Authority
11. The Names We Call Our Own
12. A Measure of Excellence
13. Ascending the Throne
14. The Monopoly Board
15. The Last Word on Rule Makers (For Now)
16. Drink Me
Afterword: We Few, We Happy Few
Appendix: Ranking Rule Makers
A Note From The Gardners
This book closes out a trilogy of investment works that begins with You Have More Than You Think and then progresses to The Motley Fool Investment Guide. So if you're new to investing, you should put this book down and start with You Have More Than You Think, then read The Motley Fool Investment Guide. And only after that, pick up this book again!
In closing up the trilogy, Rule Breakers and Rule Makers is therefore the most "advanced" work of the three, which isn't to say that it's harder to read or any more complicated than the others. That is to say, however, that its contents are intended for more experienced investors, people willing to take greater-than-average risk to own the most dynamic growth stocks, and knowledgeable enough to evaluate that risk. It's also for serious business thinkers.
Indeed, this book is as much a "business book" as it is an investing book. Increasingly, we believe that the most successful investing strategy simply involves locating winning long-term businesses.
To become involved in the search (or just watch from the sidelines), we invite all readers to visit our Web site at http://www.fool.com
We both spend many of our waking hours to our site, which offers scads of articles and features about individual stocks and investing in general. The Motley Fool can now help you track your portfolio, buy a mortgage, and get answers to tax questions-the latter for free, via our Foolish CPAs. You can also follow our own investment strategies: David runs the site's Rule Breaker Portfolio, while Tom runs the Rule Maker Portfolio. Both are real-money portfolios, for which we provide daily recaps with our updated outlook and investment lessons. Each portfolio's returns are displayed and compared to the market averages, on a daily, monthly, annual, and historical bases. (And yes, both are kicking the market's @$$.)
Finally, if you would like to send e-mail pertaining either to this book or to getting online with The Motley Fool, just shoot us a line to:
Or you may write. Send snail mail to The Motley Fool, c/o RuleBook, 123 North Pitt St., Alexandria, VA 22314. (Consider visiting Fool HQ if you're passing through town!)
Foreword: O, for a Muse of Fire
In the character of King Henry V, William Shakespeare gave to world literature one of its brightest military heroes. He is the young king who charges across the English Channel, wins a shocking upset at Agincourt, and becomes heir to the French throne. He achieves these things by his eloquence, his guts, and his love of his men, all of which Shakespeare renders evocatively and, as always, quotably.
If you went back a couple of plays, however, you'd see another side of Henry. Henry IV, Part I introduces us to Prince Hal, a dissolute youth who wiled away his days hanging out with scapegraces and ne'er-do-wells at an Eastcheap tavern. Pranking with common thieves, carousing with bar wenches, cracking jokes past midnight in a seedy neighborhood... this was a prince most unprincelike. But from this acorn one could nevertheless envision the tall oak that would one day sprout: Prince Hal's love of fun, for instance, would come back as Henry's battlefield daring, while the low company he kept provided him with the common touch that he expertly applied as he led his men into the open ground between two woods that was Agincourt. That day, October 25, 1415, largely by dint of French ineptitude combined with the deadliness of the English longbow, Henry's forces slew almost seven thousand Frenchmen while sustaining losses of only a few hundred of their own. It was one of the bravest defeats in military history.
Even though the young Prince Hal takes an unorthodox approach to his princeship, he nevertheless knows what he was about as he states in Henry IV, Part 1:
I know you all, and will a while uphold The unyoked humor of your idleness: Yet herein will I imitate the sun Who doth permit the base contagious clouds To smother up his beauty from the world, That when he please again to be himself, Being wanted, he may be more wond'red at. (I, ii)
By the end of the play, Hal has indeed pleased again to be himself; he emerges, in fact, as a hero through his defense of his father's kingdom from rebellion at the Battle of Shrewsbury and by slaying his audacious rival Hotspur. In so doing, Prince Hal reasserts himself as the true heir - in both blood and temperament - to the English throne. He is the Rule Breaker ascendant. The comic irresponsibility that was so much a part of his charm early on has been replaced by an equally charming graciousness and generosity, demonstrated by the Prince's willingness to allow his Foolish old friend Falstaff to claim the credit for vanquishing Hotspur.
And by Henry V, Henry the Rule Breaker has become Henry the Rule Maker. He leads his men through his eloquence and his example, each by turns tender and brutal. Shortly after refusing to pardon from execution one of his old drinking buddies (Bardolph, who'd robbed a church), the King dons a cloak to disguise himself, in order to mingle among his troops the eve before battle and discuss with them the morality of war. Similarly, after victory he woos Catherine of Valois with words of great beauty, but then also at another point in the play orders the killing of his French prisoners. These are the actions of a Rule Maker, and a very good one. As the historian Rafael Holinshed (Shakespeare's source) wrote,
This Henry was a king, of life without spot, a prince whom all men loved, and of none disdained, a captain against whom fortune never frowned, nor mischance once spurned, whose people him so severe a justicer both loved and obeyed (and so humane withal) that he left no offense unpunished, nor friendship unrewarded; a terror to rebels, and suppressor of sedition, his virtues notable, his qualities most praiseworthy.
The Bard didn't always remain true to his sources, but he did here. Shakespeare's Henry is the best metaphor we could find for the precepts set forth in the book before you, because he begins as a Rule Breaker-Prince Hal--and becomes a Rule Maker-King Henry V. And that transformation, in a different context, is what this book is about.
St. Crispin's Day, October 25, 1998
Breaking, and Then Making, Rules
Many things, having full reference To one consent, may work contrariously; As many arrows, loosed several ways, Fly to one mark; as many ways meet in one town, As many fresh streams meet in one salt sea; As many lines close in the dial's center; So may a thousand actions, once afoot, End in one purpose, and be all well borne Without defeat. --William Shakespeare, Henry V (I,ii)
This is a book about Rules, how they are made and how they are broken.
In the business world, every industry has its rules, which are determined by the industry leaders. In order for a new business to come into existence or gain significance, it must consciously break those rules or be doomed to follow them, ever the pawn on someone else's chessboard. To survive and prosper, entrepreneurs therefore invent new rules or change the game altogether, and out of those efforts come competition, capitalism, innovation, and inevitable improvements in the standard of living. All great businesses begin by being Rule Breakers.
After a company has broken the rules, it enters into a middle stage, becoming what we term a "Tweener." Tweeners ultimately face one of two mutually exclusive destinies. The best achieve sufficient speed, size, and scope to usurp the throne and make the rules in their industry. These are the Rule Makers, which like kings are legalized monopolies. They maintain high valuations, wield outlandish power in their industries, and exert great influence over the business world at large. These companies make great long-term investments, and are of tremendous benefit to society in that they provide important goods and services at unparalleled combinations of high quality and low price. However, sadly, the vast majority of Tweeners do not manage to make the rules. For them, failure may come quickly, or it may come after many years of falling just short of becoming Rule Makers. When it become apparent that they will never be Rule Makers, the treatment they then receive from the stock market is rough, if not deadly, as they fall hard from high expectations and high valuations. We call this the "Tweener death rattle," which is akin to the treatment given by kings to failed usurpers. In most cases, fallen Tweeners never rise in any significant, sustained way again.
The aspiration of thousands of corporations to the throne is what fuels capitalism and, by extension, the general improvement in the standard of living. Without those aspirations, our world would be a far poorer place. Today, for example, many people living below the poverty line own a telephone and a television set, powerful devices completely unavailable--not to mention unknown--to the richest potentates of pre-modern world history. These technologies exist because somebody had a dream that turned into a design that itself in turn became a reality--because somebody broke the rules. And these products then become affordable, were improved, and were distributed across the planet because of the companies that made the rules. Again, these are the fruits of capitalism and competition.
Investors can reap raging returns by investing in Rule Breakers, young companies that hold out the possibility of copious moneymaking as they drop down onto the chessboard and suddenly, outrageously, put the King in check. In so doing, these upstarts also place themselves in danger of being quickly eliminated, which means that investors in Rule Breakers are taking on extreme risk--but extreme risk can bring extreme reward. Investing in Rule Breakers--in great companies at their infancy--is the subject of the first half of this book, written by David Gardner.
Investors can also reap royal returns by investing in Rule Makers, playing the Kings for profit as regularly and lucratively as medieval kings used to tax their own people. Investing in Rule Makers involves substantially lower risk, and lays the foundation for a lifetime of investing. Rule Makers make money at market-beating rates for years and years, like a tollbooth or the tax man. Investing in them--which should always be undertaken before and then in addition to investing in Rule Breakers - is discussed by Tom Gardner in the second half of this book.
Both Rule Breakers and Rule Makers can pay off handsomely by themselves, but the best investments of all involve buying a Rule Breaker and holding it all the way through to its becoming a Rule Maker and beyond. It only takes one or two of these in a lifetime to make an investor rich.
A lesson to all investors: business is as simple as changing the rules at the beginning, and making the rules at the end. This is a book about rules. On the face of it, it may look like an investing book, but it's a business book, too. And maybe something more.
Rule Breakers: David Gardner
The Rule Breakers section of this book originally came about to answer the following frequently asked question in our online area (http://www.fool.com): "Why did you guys buy America Online (or Amazon.com, etc.)? It doesn't seem to fit any of your parameters!"
First we should explain that when our interrogators said "buy," they were referring to transactions in our Fool Portfolio (now renamed the Rule Breaker Portfolio), the real-money online account whose holdings and results we publish online every day for all the world to see at http://www.fool.com/FoolPortfolio/FoolPortfolio.htm. (The Rule Breaker Portfolio is up 645 percent [as of the writing of this book] since its inception in August 1994, versus gains by the benchmark S&P 500 of 160 percent during the same period.) It was to this portfolio that we would occasionally add a new growth stock that did not fit our traditional parameters, which we laid out in The Motley Fool Investment Guide. There we almost went so far as to make them our set of rules for finding good growth stocks. Among other things to look for, the list included strong sales and earnings growth, meaningful insider holdings, and a cap on daily trading volume. When our latest addition to the Fool Portfolio seemed to break some of the guidelines we'd outlined, many people who had learned to evaluate stocks using our parameters tended to get bemused or frustrated. Rule Breakers, Rule Makers is, in part, meant to address their concerns and explain these very situations. (And I'm writing this section because this is the form of investing I most love.)
The results of this effort constitute the first half of this book. All Rule Breakers, I found, share six attributes, and I have dedicated a chapter to each. These characteristics can be tested for, applied like litmus paper to a given growth company, and only those companies that display all six requirements may be considered Rule Breakers.
While not every Rule Breaker will beat the market, most (in my experience) do, and they often do so magnificently. Look at the early stock performance of these classic Rule Breakers (all of which we'll be learning more about) and you'll see what I mean: America Online, Amazon.com, Amgen, Apple Computer, Cisco Systems, Iomega, McAfee, Microsoft, Nucor, Starbucks, Wal-Mart, Whole Foods Market, and Yahoo!. Ten-baggers all (these are stocks that have risen in value at least ten times), and some of them--the ones that have gone on to become Rule Makers--have made more than several hundred times one's initial investment.
To close, it's not surprising that the stocks we bought despite their breaking of our previously published dicta have wound up being our best ones. That's really the way it should be. If you're going to break your own rules, you better be justified in doing so! We thought then, and know now, that we were. But it's been very valuable to reexamine these various companies and identify the six attributes they all share, attributes which have contributed directly to their success on the public markets, and the riches they have created for their shareholders. I hope that in conceiving of this model, I have helped readers think in original and profitable ways, and contributed something new to investment literature.
In that order.
So let's spend a few hours together learning exactly why this has happened, and how in the future we can profit off of the narrow, though neverending stream of true Rule Breakers.
Rule Makers: Tom Gardner
The Rule Makers section of this book began with another question frequently asked on our Web site: "What am I to do if I don't want to risk my savings on upstart companies? Even if I did want to, I haven't' the time to research and track them. I don't want to buy mediocre mutual funds, but I don't have a lot of time each month to follow my investments."
That call for an investment approach focusing on the stabler yet still-flourishing businesses provided the impetus for the online Cash-King Portfolio (now the Rule Maker Portfolio) created to profit from corporations that systematically lay down the laws in their markets. These are the heavyweights with broad smiles, wooden forearms, and their competitors' lunch money; they're the companies that you know darn well will be around in ten years, probably inking masterpiece earnings reports while boxing the ears of any who would impede their growth.
As natural monopolies today, they will never deliver the awesome returns of the greatest Rule Breakers. Accelerated growth is for the first half of their life cycles and the first half of this book. In visual terms, the Makers more resemble a turn-of-the-century freight train grinding west across the Mississippi than they do the multistage, liquid-propellant rocket of a Breaker. They are portraits of patience and steady dominance, kings in untarnished crowns. And while they're unlikely to triple in size next year, they can still be expected to provide market-beating investment returns year after year--sometimes even for a lifetime. In fact, at the core of the Rule Maker thesis is the belief than an investor can build a portfolio around these stalwarts and hold it for a decade--without once waking his or her spouse in the middle of the night. The Rule Maker model is designed to be convenient and superior.
It's also designed to be accessible. Investing in Rule Makers provides every single American--regardless of age, race, gender, or income--with an entry into the public markets. Through online discount brokers, an investor with anywhere from $1000 to $100 million can build a portfolio of ten Rule Makers, to be held for ten years, for about $50--a fee substantially below the ten-year fees you'd pay for mutual funds.
And quite unlike (as well as far more lucrative than) owning a mutual fund, investing in Rule Makers gives you a direct stake in corporate America, helping you fulfill Alexis de Tocqueville's Foolish idea of self-sufficient participation, of economic independence as a necessary condition for intellectual independence. Tocqueville, a French political scientist, traveled throughout the United States in the 1830s and from what he observed concluded that democracy was working because America could be a land of property holders--a general public of owners. As individual stakeholders, the citizens not only had the right to influence the prevailing political system, they had a reason to do so--it affected them directly. Today, stock ownership of the world's leading public companies extends those same claims and interests to you.
After that jabbering, you may suspect that the second half of our book is going to be a preachy and stuffy evaluation of overlarge businesses, more apt to sedate than inspire. Let's hope not. As evidence to the contrary, I offer this: In 1995, www.fool.com published an unsophisticated, easily understood review of ten emerging monopolies. There wasn't anything magical about my selections--nearly anyone could have made them; they included businesses such as Microsoft, Dell Computer, the Gap, Cisco Systems, and Intel. They I suggested that these ten stocks could be purchased and profitably held for a decade--pure heresy to the movers and shakers on Wall Street. Three years later, the collection has taken on the confused appearance of some bizarre transport vehicle; half freight train, half liquid-propelled rocket. As a group, they've beaten everything in sight, generating returns of 440 percent versus S & P 500 gains of 100 percent. Regarded as past their prime by many investors, these locomotives were pushing forward, creating manufacturing efficiencies, and chugging into international markets, all the while broadly expanding profits for their owners.
How these corporations were selected, and how you can find your own collection of Rule Makers, is the subject of the second half of Rule Breakers, Rule Makers. Our focus will be on the real rewards deriving from long-term compounded growth, because while a $10,000 investment that doubles every two years is a thrill, the public market can provide so much more. The doubling of that double, and then the doubling of that doubled double, and then the tripling of the doubled doubled double is how stock-market wealth is accumulated over generation.
Wall Street will not inform you of this. With its market strategists, its brokers selling on commission, and its underperforming mutual funds loaded up with fees, the Street long ago stopped preaching the benefits of simply buying and hold stock in exceptional businesses. The Street's fee structure cannot tolerate patience and compounding. Accordingly, The Motley Fool stands in direct opposition to this present incarnation of Wall Street. We believe that, in time, democracy, the Internet, and an educated public will view the corner of Broad and Wall in lower Manhattan as nothing more than a quaint historical reminder of shortsighted commercial greed. The citizen's market lies ahead. Our aim here is to beat its average return.
And so now to the business of rule breaking, where we will focus on companies that break their industries' existing rules, to their shareholders' wild happiness.
Part I: Rule Breakers
Chapter 1: Rule Breakers Introduction: Evolution
I say the earth did shake when I was born. --William Shakespeare, Henry IV, Part 1 (III, i)
As Charles Darwin would before him, the celebrated Harvard paleontologist Stephen Jay Gould has made much ado--has filled whole books--about one of our society's common misconceptions regarding evolutionary theory. Namely, that many of us fallaciously view evolution as a process of continual improvement, as if our species--all species, in fact - were following a constant upward progression from less complex to more complex, from less intelligent to more intelligent, from weaker to stronger.
We tend to think this way because we all tend to place our own species (not without some cause, mind you) at the height of the "evolutionary pyramid." It is we, after all, who have developed self-consciousness, we who are capable of creating tools to build everything from fast cars to junk cereals, we who have thought things through enough to touch the moon. And we're the latest thing, as species go, the most recent arrival to the party. (Humanity has only been on the planet for the last 45,000 years, meaning our character's first appearance comes in the latest chapter, 100,000, of our planet's long-running drama.) Given all this, one can easily see how some might conclude that evolution must involve constant improvement: the most creative species of all has been the most recent development on planet Earth. Everything must have been a prelude to the Coming of Man.
Gould counters this fallacy by explaining that evolution doesn't necessarily mean something is getting better and better, only that it is continuing to adapt successfully to changing environments. He would argue that if global environmental conditions suddenly made it advantageous to be stupid, only the stupider among us would survive and eventually propagate--that's just natural selection, the principle at the heart of the theory of evolution. Of course, that's a silly example, but it's usefule in distinguishing what is "true evolution" from what isn't. Natural selection simply causes species to evolve in a way that best suits their given environment; it does not by definition result in species that are inherently and progressively "smarter," faster, stronger.
If you're wondering just what the heck this has to do with a business-and-investing book, wonder no more. Consider this: Natural selection, the crucial driving force of organic evolution, is the cleanest metaphor I can think of for what drives success in business--of extreme interest to business managers and long-term investors alike.
In the context of this book, what is being "naturally selected" are not advantageous genetic traits, but, rather, the advantageous characteristics of a business model or strategic plan, as well as those of a particular workforce capable of dreaming up such plans and executing them. The agents of natural selection in business are not, of course, environmental conditions, but rather customers and their needs. It is costumers who naturally select businesses, causing industries and economies to evolve with time. Some companies will win and some will lose, and what separates the one group from the other will be its ability to adapt to serving the needs of costumers in changing consumer and marketplace environments. If you understand this, you're already well on the way toward understanding what a Rule Breaker is.
Before progressing, let's make this really clear:
organic evolution = business evolution
competing species = competing businesses
natural environment = consumer environment
natural selection = costumer selection
OK, with that said, know the the evolution of the business world has fixed a number of rules which become so ingrained as part of the status quo that many of us take them for granted. Do these examples feel like rules to you? They do to me:
--Typewriters will never come back to displace computers.
--By virtue of their sheer global dominance, Coca Cola and PepsiCo cannot be dislodged as the #1 and #2 market leaders in soft drinks.
--What worked yesterday in fashion will be flouted today but could emerge tomorrow as the Next Big Thing.
--Home-cooked meals are yielding to eating out, take-out, and delivery.
--With its superior technology and near monopoly, Intel cannot be dislodged as the market leader in microprocessors.
These truisms and many others form the "rules" of our time; they define the way our world works, the way things are--the way that business has evolved. Most businesses did not have a part in creating this status quo, but they probably still benefit from it, as in some cases they work to supply the beneficiaries (the Rule Makers), or, in most cases, at least buy from them.
But the only constant, as we've heard again and again - quite truly - is change. And thus the changing needs of customers change the business environment and create opportunity. Indeed, it is when established industries fail to evolve that opportunities arrive for the Rule Breakers.
So let's make like Scrooge and spend some time gazing back at the rules of Business World Past. Do these sound familiar?
--Ma Bell telephony provides consumers with the cheapest, most efficient way to exchange information when not face-to-face.
--World markets are best understood by matching them with their political alignments; you're either NATO-aligned, Soviet-aligned, or Other.
--Superstores are the natural, most profitable, and emphatic endpoint to retail, concluding the transfer of power from mom-and-pop, to boutique and on through mall.
--The bubonic plague is uncurable.
At one or another point in history, each of these was a rule every bit as unwavering as our previous set of examples. Yet now, they are all in tatters. This list could go on and on, too: the horse-and-buggy--hello, Ford. . . the candle--hello, Edison. . . the ice-man came, then--hello, refrigerators!--the iceman went!
How does this happen? Remember the fallacy that Stephen Jay Gould points out in our ideas about evolution: most of these companies or industries are guilty of it. Once-successful companies that ultimately became unsuccessful believed in and focused upon constantly improving, rather than adapting. Their research and development money went to upgrade their existing products and their marketing money was spent on promoting these products; they were always looking to cut costs, and their competitive research was confined to the study of industry players who were playing the same game by the same set of rules. Companies like this are doing all the right things, but it may be the beginning of the end.
For in such circumstances, the original business solution that brought the company into being in the first place may suddenly be lost. But whether due to myopia, arrogance, fear, or sheer inertia--or a combination of these--the company's in too deep and can't turn back. Time for some competitor, some naughty entrepreneur, to come in and kick down the doors, and the one thing you can say for sure about capitalism is that this is exactly what will happen: someone's going to start breaking all the rules.
As an investor, you want your money riding on that entrepreneur. And as a businessman, you should aspire to be that entrepreneur. (And as citizens and customers, we will all benefit hugely due to that entrepreneur.)
This part of the book attempts to define, locate, and illustrate what sets these Rule Breakers apart. Each of the following half-dozen chapters will introduce and examine one of the Rule-Breaker's attributes, all six of which must be present in any true Rule Breaker.
Why Rule Breakers? Why bother reading on? Two reasons.
First, Rule Breakers provide investors with the most dynamically high returns achievable on the public markets--Period. Inspiration enough? OK, if not, consider this (we're thinkin' T-shirt here): "Rule-Breaking Investors Have More Fun." (It's true!)
Second, Rule Breakers provide inspiration and guidance to all business people, be they managers, planners, or executors. Rule Breaking is capitalism's special sauce, its tastiest and most necessary condiment. So let's spend some time together eating like gourmands and studying like chefs.
Then, be the sauce.