I love the Rule Breaker concept. As a matter of fact, the original real-money Rule Breaker portfolio is what first attracted me to The Motley Fool. The basic goal is to catch the next Microsoft, Cisco, or eBay long before it becomes Microsoft, Cisco, or eBay. Theoretically, the astronomical gains from just a few hits would carry a portfolio for years by more than offsetting losses from the high-risk stocks that don't pan out.
But while we label the Rule Breaker strategy as "high-risk," that doesn't necessarily mean that investing in Rule Breakers has to be an all-or-nothing proposition. That said, here are three things you can do to reduce risk in your Rule Breaker portfolio:
- Focus on quality.
- Focus on companies that make money.
- Focus on value.
Focus on quality
Just because it might take only one or two winners to make a portfolio, that doesn't mean that you have to buy every company that looks like a Rule Breaker. Stick to the few quality companies that truly fit your standards. As it happens, the Rule Breaker criteria has built-in components that account for and reduce business risk.
Every Rule Breaker features a strong, sustainable competitive advantage and top-notch visionary management.
A competitive advantage -- such as a strong brand or a cost advantage -- is the foundation for business growth and a defense against competition. For example, consumers will pay a premium for Coke- and Starbucks-branded beverages rather than accept a generic product, a condition that also leads to higher margins. eBay has both powerful network effects and a powerful brand to go with a wonderfully scalable business model. Meanwhile, Dell has thrived on cost advantages attributable to its business model.
Astute management is key. At Overstock.com (NASDAQ:OSTK) -- both a Hidden Gems and Rule Breakers selection -- CEO Patrick Byrne fits the bill as a Foolish, shareholder-friendly manager with a value-oriented investment background. Over the past several years, we've discussed Byrne's quarterly Buffett-styleshareholder letters, the company's growth story, and the eventful conference calls.
Alternatively, resort hotel and casino operator Wynn Resorts (NASDAQ:WYNN) was handed billions of dollars to build the new Wynn Las Vegas based on its visionary leadership alone. Steve Wynn has a track record for raising the bar on the Las Vegas Strip with properties such as The Mirage and Bellagio (before selling Mirage Resorts to MGM Grand). Based on that track record -- Wynn Las Vegas, the company's first property, doesn't open until this spring -- Wynn Resorts was also granted concessions to open a property in the red-hot Macau market, just west of Hong Kong.
Sticking to high-quality businesses run by high-quality managers is an excellent way to reduce risk.
Focus on companies that make money
I don't know why it seems like such a novel idea, but look for companies that actually make money. Chasing unprofitable firms like XM Satellite Radio (NASDAQ:XMSR) or Sirius Satellite Radio (NASDAQ:SIRI) isn't necessarily wrong, but it certainly is more risky. For every Amazon.com (NASDAQ:AMZN) that reigns king in an online Rule Breaker portfolio, there is an eBay and a Starbucks that offer solid returns even after turning profitable.
By sticking to profitable firms, you reduce the risk of having your company go broke. In addition, your company is less likely to have to raise capital to keep the business afloat, an event that comes with costs -- the most common of which is shareholder dilution.
Focus on value
"Growth" and "value" might seem like contradictory terms, but the fact is that even growth investors look to buy a stock for less than it is worth. Take it a step further, and the growth investor will realize that undervalued stocks are inherently less risky.
It doesn't happen every day, but it is my personal Rule Breaker dream to find a company that has rule-breaking attributes, makes money, and is available at a value price. Here's one of them.
IAC: A Rule Breaker at a value price
InterActiveCorp (NASDAQ:IACI) is an example of a Rule Breaker that actually generates free cash flow -- over $1 billion in both 2003 and 2004. IAC -- the portfolio of businesses run by media mogul Barry Diller -- owns a couple of mature cash-generating business in Ticketmaster and the Home Shopping Network, as well as the world's largest online travel website in Expedia. The company has parlayed that cash flow by acquiring other rule-breaking businesses such as Hotels.com and LendingTree -- a former Rule Breaker portfolio holding and TMF Select pick. IAC also owns such properties as eVite, Match.com, Citysearch, and TripAdvisor.
IAC is such an intriguing company because the cash flow makes the businesses it acquires less risky and more likely to succeed. These businesses have virtually unlimited access to the capital they need to grow and compete.
More intriguing is that just about any way you cut it, the stock is dirt cheap. Accounting for dilution, the stock trades at 17 times trailing free cash flow. And pretty much every sum-of-the-parts valuation I've seen has yielded values between $30 and $40 per share.
The upsides of IAC's Rule Breakers are probably debatable, though several of them are expected to bear fruit this year. That said, I think that at under $23 per share, the stock has limited downside and plenty of upside -- even just to fair value. If you're interested in IAC, I would take a look at the company's simplified fourth-quarter earnings, as well as how the company's plan to separate IAC Travel and TripAdvisor from the rest of IAC will unlock the stock's value. And if you're interested in other rule-breaking companies, why not take a free 30-day trial to the Motley Fool Rule Breakers newsletter service?
Fool contributor Jeff Hwang owns shares of eBay, Starbucks, Overstock.com, and InterActiveCorp. The Motley Fool is investors writing for investors.
