Let's imagine that the Rule Breaker managers David Gardner, Brian Lund, Tom Jacobs, and I are immortal, even though the only one of us who truly is immortal is Mr. Lund, because he's a vampire. Now imagine that we've been running this portfolio for centuries.
In the last century, we would have almost certainly bought stock in automakers when they emerged. They were Rule Breakers personified. Perhaps we would have bought several auto companies, as we've done with biotech, while aiming to snag those that have the strongest sustainable advantages. At the same time, we might have shorted horse and buggy companies, where Vampire Lund would have been heavily invested.
Decades later, we would have recognized air travel as a truly Rule Breaking industry, and we almost certainly would have purchased at least one promising airline company. Maybe we would have shorted cars at that point, too. (To be honest, we would have done whatever Vampire Lund said.)
The point is, with both these Rule Breaking inventions -- cars and planes -- we would have needed to adjust our view of the world and invest accordingly. And with both industries, we probably would have lost money on at least some of our investments, if not a majority of them, or even all. The losses would have provided an invaluable lesson.
"Cool" doesn't usually make for a good investment
Imagine Tom Jacobs in the 1960s as he eyes our lagging airline stocks that still aren't earning profits: "How can this be?" he'd say in a sing-song tone. "These investments are so coooooool! Airplanes, man!"
Yeah, airplanes were groovy. Still are. Just as automobiles were cool before them. And trains before them. And, lately, wireless, fiber optics, and telecom were cool, and still are.
The Internet was cool with a capital 'K,' and, as with planes, trains and automobiles, the Internet was (and is) Rule Breaking. First mover Internet companies were destined for the stars in the minds of all but the most individualistic skeptics. (For the record, we wrote here during the peak of excitement in June 1999 that most young Internet companies would fail, but people still see us as being part of the enthusiasm that helped fuel Amazon (Nasdaq: AMZN) higher, as well as AOL (NYSE: AOL) starting in 1994. We'll accept those claims, on both counts.)
So, we had cars, planes, wireless, the Internet -- these were among the most exciting and promising inventions and industries to emerge in the past 120 years. True Rule Breakers.
Let me remind you what happened to them.
Most of the hundreds of early young automakers failed, and even the few giants that remain in business today fight an uphill battle to earn profits, let alone thrive. Faring even worse, as a whole the industry of commercial airline carriers has not made any money since its inception. Few large airliners outside of Southwest (NYSE: LUV) have found ways to consistently earn a profit. The business is cost heavy, competitive, and complex.
Internet and telecom businesses absorbed billions of dollars in venture capital, but have failed miserably at creating anything near that much value in return. It's fairly apparent today that, but for rare exceptions that prove the rule, the Internet is not a great wealth generator for the vast majority of companies. It is something else to people -- many see it as a handy tool, but only when it's free. Meanwhile, telecom reminds me vaguely of airliners: Expensive infrastructure, expensive equipment upkeep and replacement, debt and intense competition.
So, industries that first represented the very epitome of Rule Breaking and are vitally important have, for the most part, failed as investments. What can we learn from this?
An investing lesson to remember
Many of us, myself included, are drawn to flashy businesses with cool sounding names and missions, often involving technology, and we get swept up with the excitement that comes with new things. "Airplanes -- amazing! Fiber optics -- mind blowing. The Internet -- it'll be huge! Where can I buy some stock?"
Well, no more. We need to change our habit of being wowed first and asking the question that really matters later. That question: "Will this business consistently make higher and higher profits?"
That isn't an easy question to answer. In fact, with young Rule Breakers you typically don't know if a company will become profitable at all, let alone consistently grow its net income. However, we still need to make an estimation of eventual profits. To help do so, ask yourself these two key questions:
- Is this going to be a capital-intensive business, meaning will it cost the company a lot of money to keep operations going?
In the case of autos and airplanes, the answer was a resounding yes. These were obviously expensive businesses from the start. With telecom, the answer was yes but not as much so. With the Internet, people thought it'd be less expensive to run an online business than it has proven to be.
What about software two or three decades ago? When software emerged, could you have determined that it'd be a good business in which to invest in the leaders? I think so. A business writes a software program once and can sell it millions of times. The packaging was cheap even in 1980. And the value proposition to customers was clear (unlike many Internet sites). That said, competition was thought to become fierce. That leads us to the second question, a topic that we've covered many times but that you can never cover enough:
- What are this company's sustainable advantages? How will it protect its long-term ability to generate higher and higher profits?
This is a more difficult question than the bullet point above it. However, a company that could be the poster child for sustainable advantages, in my opinion, is eBay (Nasdaq: EBAY). It will be difficult for a competitor to dislodge eBay's immense community of buyers and sellers. What is the competitive advantage of an airline? Few have carved one out. United (NYSE: UAL) offers Starbucks (Nasdaq: SBUX) coffee, and while some friends -- hello Mary! -- have said that they fly United just for that reason, I doubt millions do.
Southwest carved out a low-cost competitive advantage. Smart. That works. What about telecoms? How do they get competitive advantages? In a regulated industry, it's hard to gain any. That and the fact that telecoms are capital intensive might have been enough to make you avoid the industry when others were rushing to throw money at it.
Summary of questions to ask
So, instead of being excited by the sound of novel, cool businesses -- for example, moon tours in the future as a business -- check your giddiness at the door and first ask: "How will this business consistently make more profits?" To help answer that question, ask, "Is this an expensive business to operate? And second, what are the company's competitive advantages -- why will this company succeed for years when others won't?" Ask these questions especially in the case of Rule Breaking industries, because those industries will attract the most competition. Look at cars and airliners, not to mention telecom.
A closing word on barriers-to-entry. These measure how difficult it is for a new company to enter an industry, and therefore they are supposed to tell you how strong or safe an existing company's business might be. Far too often, though, high barriers-to-entry are a deceptive way to measure an industry's investment quality.
Both the auto and airline industry are brutally competitive despite the fact that barriers-to-entry in both industries are extremely high. (How many of your friends are starting airline companies? Compare that to how many people started Internet companies.) So, even though barriers-to-entry are enormously prohibitive in these large industries and others like them, the companies already operating in the industries hardly enjoy the benefits of those barriers. This is because much more important than barriers-to-entry are the questions that we asked above: The ability to profit, the cost of continuing operations, and sustainable advantages.