Brian Lund: When we announced our most recent buy, we discussed briefly the concept of "10x/5y" -- the notion that a stock under consideration should have the potential to appreciate 10-fold in five years -- as a factor in that choice and as a possible new criterion for the Rule Breaker strategy. What is the thinking behind that?
David Gardner: In our book Rule Breakers, Rule Makers, we say "Invest like a venture capitalist," and one of the things that a venture capitalist (VC) does is take a look at business scope and opportunity; management and its ability to maximize the opportunity; and asks, "How much could this thing be worth in five years?"
If you know any venture capitalists -- and I've come across a few -- you may have heard more than once the phrase, "I need to get my 10x." The guy is saying that his business model as a VC is predicated on obtaining a return of 10 times his money (10x). When you invest in Rule Breakers, you're taking on similar risk. You're evaluating an often incomplete business model, reading between the lines, filling in the gaps, assessing management, and asking, "How big could this thing get?"
So we're considering adopting the 10x/5y approach to the Rule Breaker approach, which means we would like to see the company's market valuation have the distinct possibility of increasing 10-fold over the next five years.
Brian: That brings us to an interesting question: How do you assess that possibility? Jeff, would you like to toss in your cents?
Jeff Fischer: Certainly. Rule Breaker investors are seeking companies with tremendous potential, and by focusing only on top dogs with great management and sustainable advantages, Rule Breakers are likely to find strong companies at least much of the time.
But that doesn't mean that they will be strong investments. Rule Breaker investors are also seeking large returns for the high risk they take. So, when we in particular do invest in something, we want to believe there is a great deal of potential for value creation. That idea is encapsulated by 10x/5y.
We don't NEED a company to appreciate at least near 10 times in value in five years, but if we believe it can do something close to that, we're suddenly much more interested in it as a possible investment. How you measure it is of course mainly subjective.
Brian: Ah, yes. How does one go about determining the potential for 10x/5y?
Jeff: We look at the overall market size potential. Amazon.com (Nasdaq: AMZN) is a great example. E-commerce. How large could it be one day? That's essentially what we asked in 1997 as we bought the leader, Amazon. We also look at the competition. If there is a very large market developing but dozens of viable leading companies, the attraction is much less because the potential for 10x is arguably much lower. So, you need to find companies that are getting ready to address very large markets with relatively few smart competitors and that have sustainable advantages.
Brian: Do you think it's necessary to project revenues and/or cash flows?
Jeff: I think it helps a great deal to project potential revenue at least loosely. In 1997 we projected that Amazon would have a billion in revenue in 2000. We were way off. It'll have near $2.8 billion. But yes, projecting sales is part of projecting how large the market may be. But of course one does it loosely by necessity.
David: I wanted to pick up on one thing Jeff said. We obviously don't EXPECT each of our companies to make us 10x/5y. Neither does any VC. Due to the nature of high-risk Rule Breaker investing, we will be investing in some duds -- companies that lose us more than 50% of our original investment.
Given that, we push the expectation bar up high for our biggest winners, shooting for 10x/5y. Obviously, we have to believe it can happen for a company at its present market cap to make the investment, otherwise we won't.
So our message is not "MAKE 100% ANNUALIZED ON YOUR RETURNS!!!!!! READ RULE BREAKER AND PROFIT!!!" We hope we do profit, but we know that any given Rule Breaker may not profit -- may in fact lose us a substantial amount of our stake.
Brian: I think that one of the most important things about 10x/5y is that it makes investors address their expectations. Rule Breaker investors are going for the home run. In doing so, they can benefit from considering more or less what it will take to get it.
I don't think it's necessary (or even possible, in most cases) to run a full discounted cash flow, or even really to guess a specific revenue number as a target. But giving some consideration to the magnitude those things might be after 10-fold growth can't hurt.
David: I agree. I am unsure, however, whether this deserves being a seventh criterion. Perhaps instead it should be an "additional consideration" before investment. Thoughts? (And we'd like to hear from our Rule Breaker readers and investors on the Rule Breaker Strategies discussion board.)
Jeff: I believe it does deserve criterion status, given how essential it was in our choice of Human Genome Sciences (Nasdaq: HGSI). HGS is a good example of 10x/5y thinking while embracing risk. The company doesn't have any real revenue today! But it has four drugs in trials and it will likely have more than a dozen in trials in a few years. If a few of those drugs are blockbusters, the company could grow well beyond its $8 billion value when we bought it, close to 10 times that in maybe six to eight years.
So, its potential is attractive enough for us to take the risk in a diversified port. But if we didn't use 10x/5y to think about HGS, I'm not sure we would have bought it.
Brian: And 10x/5y contributed to our shying away from Ariba (Nasdaq: ARBA), didn't it?
Jeff: You're right, Brian. The 10x/5y made us pass up Ariba at $33 billion.
David: Yes. And that is key. However, is this inherent to the nature of a Rule Breaker? Is a "Rule Breaking company" one that continues to hold 10x/5y promise and "Tweens" when that's no longer the case?
Jeff: No. Or, in my opinion, this is only a consideration when you bought it and in the first few years.
Brian: Exactly. Like any other criterion, we're talking about the time of investment.
Paul Commins: Rule Breaking describes the business model, or the stage of the business model; 10x/5y is purely a market criterion.
David: Yes... this is somewhat related to relative strength, which can change our willingness to invest, but does not change the fundamental nature of a company's industry and operational status as a Rule Breaker. (Although relative strength and 10x/5y do not exist in a pure vacuum, since they can and do affect a company's status in some secondary ways.)
Brian: Is it improper to have market criteria in investing? Rule Breaking investing offers a lot of business focus, but it exists in a market environment.
David: It seems as if we're really talking about two classes of criteria. I don't want to complicate RB investing, but this may clarify it. Perhaps we should have one set of criteria determining RB business status and another set of criteria (namely, relative strength, bearish media, and 10x/5y) determining RB investment status.
Brian: Doesn't 10x/5y smack of valuation? Haven't we avoided that in the past?
David: We have never "avoided" valuation. Valuation is de facto behind any purchase decision one makes. Our belief is that the market is mostly efficient at pricing stocks out for six months, with billions of dollars exchanging hands between willing buyers AND sellers on a daily or weekly basis. We are not going to call that money dumb, whether it "looks" richly priced or cheaply priced, because if a company were drastically mispriced, the market would quickly correct that. What would correct it would be your and my self-interest, and I personally believe markets work, and work this way.
So we have simply said that we don't believe we can get a "valuation edge" off of using traditional backward-looking metrics for companies that themselves often have very early stage business models! So yes, 10x/5y smacks of valuation in one sense, in the sense that valuation has always mattered to us, as it underlies all pricing in all markets and all purchasing decisions.
But what we're really doing with 10x/5y is we're "ballpark-valuing" off our vision of a future that is very uncertain. And yes, we do believe that is useful and helpful for investors deciding between Ariba at $33 billion and Human Genome at $8-$10 billion.
Jeff: We've always said that we're investing in things that are typically near impossible to value early on.
We'll continue our discussion of 10x/5y in tomorrow's column. Let us know what you think of the concept on the Rule Breaker Strategies discussion board. You can also help us by participating in the following poll:
Do you think 10x/5y belongs among the Rule Breaker criteria?
a) Yes, it fits perfectly with the notion of Rule Breaker investing.
b) Yes, because it adds an important, new dimension to RB investing.
c) No, because it unnecessarily brings valuation into consideration.
d) No, because it's an unrealistic expectation.
e) It's redundant. Something like it is implied in the current strategy.