Finding the Next Rule Breaker

Founding Fool David Gardner has made a career by bucking conventional wisdom with his Rule Breaker philosophy of stock selection. David finds companies that the market considers overvalued, but which enjoy game-changing advantages over their peers.

Luckily for us, he's laid out six signs of the perfect Rule Breaker stock:

1. A top dog and first mover in an important, emerging industry.
2. Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors.
3. Strong past price appreciation.
4. Good management and smart backing.
5. Strong consumer appeal.
6. A documented history of being viewed as overvalued.

Talk about a needle in a haystack
While most of these traits are qualitative in nature, two of them could be considered quantitative. This can help us mere mortals get started by setting up a screen to winnow out clear non-Rule Breakers.

We can find strong past price appreciation by screening for stocks that are up at least 100% over the past year. To zero in on stocks considered overvalued, I looked for one-star stocks as rated by CAPS, as well as for companies with a P/E greater than 40. One-star stocks are clearly out of favor in our Foolish community, and many prudent investors would resist paying for a stock that trades at 40 times its earnings.

When I ran the screen, I got six companies that weren't already Rule Breakers, and which had a market cap of more than $200 million:

Source: Motley Fool CAPS.

Now we can use the rest of David's qualitative criteria to narrow down our field:

1. Top dog and first mover in an important, emerging industry
I immediately eliminated three of the above companies. Abercrombie, with its overpriced clothes, is hardly in a new and emerging industry. Cost Plus, though it has appealing offerings for new homeowners, is also in a well-established market. And Retail Ventures' signature DSW shoe stores fit in the same bucket -- they're in a mature market.

2. Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors
All of our surviving companies passed this test.  Ariba has serious momentum at its back. Some 94 Fortune 100 companies currently use Ariba software.  Shutterfly, too, with earnings growth of nearly 200% over the past year, definitely has momentum pushing it forward. Virgin Media is showing itself to be far more agile than its inept main competitor, British Sky Broadcasting.  Though Virgin’s market cap is but one-ninth the size of British Sky, Virgin has higher EBITDA and gross margins. 

3. Good management and smart backing
This is a more difficult characteristic to judge quickly. For brevity's sake (before you make a final decision, you'll want to dig deeper), I looked at whether the founders still play a role in the company they started. None of Ariba's original co-founders serves as a director or major executive. Virgin Media is the result of several mergers, first between NTL Inc. and Telewest Global, and later with Virgin Mobile UK. Suffice it to say that the company has become so diluted, it won't pass this test.

Though Shutterfly founder Jim Clark is no longer with the company, I'm going to give them a pass on this one. First, Clark says he resigned back in 2007 because of the -- as he stated -- unfair rules of the Sarbanes-Oxley Act. Furthermore, he represents "smart backing" as he was the founder of Netscape back in the 1990s, earning him a fortune.

4. Strong consumer appeal
Shutterfly has recently been doing everything it can to become all things social. The photo-sharing site tries to differentiate itself by allowing an unlimited number of pictures to be downloaded. They've also designed "Shutterfly Share" sites, which function as a photo sharing, blogging, and social-media site all wrapped into one. Needless to say, with the IPO of social-media site LinkedIn (NYSE: LNKD) going so well, I'd say this has strong consumer appeal.

That leaves just one stock 
Shutterfly passes all of David's tests, but don't count me in on the stock. If I didn't know any better, I would think that we were actually talking about ... Facebook. Yes, while the older generation might still prefer photo-sharing sites to joining Facebook, I just can't see how Shutterfly will be able to compete over the long term with the social-media giant. With shares trading at 115 times last year's earnings, I'm going to go ahead and say this is a sucker's bet.

Going forward
The numbers I chose to use in my screen are by no means absolute. I used them as a starting point to turn up ideas for my search. I encourage you to jump on our screener and input slightly different numbers, dig into some of the companies that pop up, and share your finds below in the comments section.

Add Shutterfly to My Watchlist , which can find all of our Foolish analysis on it and all your other stocks.