[Yesterday, we began a discussion of "10x/5y" as a new factor in the Rule Breaker strategy. 10x/5y means that an investor considers whether it is likely a potential holding will appreciate 10-fold in five years.]
Paul Commins: David and Jeff, is the essential purpose of the Relative Strength criterion to allow the huge, efficient market brain to "validate" our risky pick? In other words, to say that there really is something here, as opposed to picking up an "undiscovered nugget" that might not be well-known enough by the market brain, or by us, to allow for such a risky selection?
David Gardner: It is an important confirmation. It is telling us that the market recognizes that this company does have an opportunity to shake the world, though of course the market can be fickle, and sentiment fleeting. But, even with that acknowledged, I consider it essential to be in place for a Rule Breaking investment.
Paul: Then, my concern about 10x/5y is that it puts us in a tight box. We can't go too early, or we violate the 90 Relative Strength criterion, one I very much like and agree with. We can't go too late either, or we run up against 10x/5y. It starts to look a little more like market timing than Rule Breaker investing. Just playing the devil's advocate.
David: You make a fine observation: It is a tight box. We acknowledge that.
Brian Lund: I don't think the box has to be all that tight. If we're looking for blowout companies, I think that there can be quite a healthy space of rapid appreciation with future 10x/5y potential.
Jeff Fischer: I also see Relative Strength cutting both ways. On the one hand, it is important validation. On the other hand, it can be fun to buy before it starts to run, but that doesn't happen much. It could have with Celera Genomics (NYSE: CRA).
David: I have an open mind. I'll just say that the best Rule Breakers I've ever bought had 90+ Relative Strength, which was scaring investors (and the media) away at the time, and yet those companies have given me my best returns. That's the dynamic.
Paul: It really comes down to what bias in the market we're trying to exploit. If the bias is "the market tends to undervalue the long-term potential of world-changing Rule Breakers," then 90 Relative Strength is perfectly appropriate. It goes along with David's short-term efficiency idea and against "picking undiscovered nuggets." If we want to pick "undiscovered nuggets," we're positing a lack of short-term efficiency in pricing, and that we have knowledge others don't (beyond the idea that the market rewards patient investors in true Rule Breakers).
Jeff: That is part of the argument, indeed. The market tends to undervalue true Breakers. That Relative Strength above 90 shows that the market currently believes in great potential. But, if it's a true Breaker, the market will have undershot it still. Take America Online (NYSE: AOL), for example. Was AOL a nugget? Or Amazon.com (Nasdaq: AMZN)? Those are our two best investments to date, and their names were two of the best known, even when bought.
So, I think Rule Breakers (remember the name, "Rule Breakers") are companies that are pretty well-known and very controversial, most times. The Earth shook when they were born, and all that...
Paul: I agree. This jives with how I think about Rule Breaking. You guys certainly didn't pick them up before they were well-known. Right?
Jeff: No, not at all. AOL was talked about all the time before the Fool bought it. But it was talked about as highly risky. The thing would swing 20% a day sometimes. I think the answer is: Rule Breaker investors are not looking for nuggets. We're looking for Earth-shakers that are raising eyebrows.
David: Tiger Woods is a Rule Breaker -- began that way, anyway. Lots of hype surrounding Tiger from his first tourney. Lots of value creation since.
Paul: So was that gal in For Whom the Bell Tolls. Did you see 10x/5y potential in "grossly overvalued" AOL that doesn't exist in, say... Ariba (Nasdaq: ARBA)? Is it really about the location of the "ceiling"?
David: Yes, because the scope of AOL's opportunity at the time wasn't reflected in the market cap.
Paul: OK, then I don't think the box is too small. But, I'm wondering why Ariba can't be squished into it? Not from a selfish perspective, of course, but from an "understanding 10x/5y" perspective.
Jeff: It was just hard to see Ariba becoming a $330 billion company in five years. Maybe we'll be really wrong on that, of course. But...
David: Five years might be tough... I wouldn't say 10 is impossible.
Brian: Hey, Ariba could grow 10 times in five years. I certainly wouldn't say that it couldn't. That's for Rule Breaker investors to decide for themselves. We, as a group, thought that there was more potential for Human Genome Sciences (Nasdaq: HGSI) to achieve 10x/5y. That's what helped us differentiate between potential investments.
Paul: Didn't people say the same about AOL and Amazon?
David: But in considering Ariba, we were balancing it against a few other companies we liked as much.
Paul: Is it the limitless nature of the industry (its ceiling) that's key?
Jeff: The ceiling on the industry and the current market value. Other people said the same about AOL and Amazon, yes -- that they were "overvalued."
Paul: Again, I don't want to focus too much on Ariba. It's the essence of Ariba vs. AOL/Amazon at the time of their pick (or not-pick) that interests me.
David: They were actually saying not so much that AOL and Amazon were overvalued, but that the businesses were going to be crushed like tin cans. That they would die.
Jeff: Yes, AOL was valued around $300 million when we bought it. Amazon was at $800 million.
Paul: I see. That is different. So, part of a Rule Breaker should be that naysayers think the industry or company might actually disappear, which is clearly not the case with something like Ariba. Is that right?
David: I'm not generalizing that point across all Rule Breakers, Paul, but your comment does reflect my thinking on the "grossly overvalued" nature of AOL and Amazon.
Brian: I don't think naysayers have to say that the industry might become totally extinct, but that the stock or industry isn't worth what people are paying for it, based on an inapplicable valuation model, without considering the blowout potential of the industry.
Paul: That strikes me as too generic. That's what people say about all Breakers.
Brian: Exactly. Now drill down to find the best in those spaces, the ones with the greatest potential. We need to wrap up. Should 10x/5y be a criterion? Why or why not?
Paul: I guess I still don't understand it, to be honest.
Jeff: I believe it should be a criterion to consider, but not one that is necessary, as others are. Some investors in Rule Breakers might not be shooting for 10x. That is, after all, a pretty monstrous goal in five years. But, it should be a criterion to consider. Consider the market opportunities, consider the competition, consider the market value of your potential Rule Breaker, and try to weigh the overall value-creation potential, loosely. If it's nearly impossible to do this, you might not want to invest after all, because it demonstrates you don't know much about the market potential. So, I think 10x/5y should be a criterion to consider, but the emphasis is on the qualities to consider (market cap, market potential, competition) more than the 10x, per se. That is up to the investor's discretion.
Paul: I think 10x/5y worked for us in our selection, but I'm having trouble generalizing the concept. 10x/5y is not a proper Rule Breaker criterion in the sense that it does not help us select world-changing business models. In this way, it's actually very different from Relative Strength, which I don't see as a market-related criterion, but as a validation of the business potential. 10x/5y, then, is just a way to select which potential Rule Breakers to buy in the stock market.
Brian: Yes, it's a way to sort through choices. But I think it's pertinent even if you're only considering one stock, because Rule Breakers take big risks. They require a big reward, or at least the potential for one.
Paul: All investing is about uncovering a pricing bias. Rule Breaking has always been about the market's inability to see long-term potential for truly ground-breaking industries. That's how we say we're different. 10x/5y is just a way to say we want to ensure that we're really different.
Jeff: Yup, good point, Paul. It doesn't help you find a company. It helps you sort through choices or decide about a company, in the end, once you've found it.
Paul: "The swallow might fly south with the sun or the house martin, or the plumber might seek warmer climes in winter, yet these are not strangers to our land." Dudes.
Jeff: And, on that, I think the chat is over!