In 1992, I was 26 and already spending my fair share of time online. For several years, I'd been a satisfied customer of America Online. Although I liked the service, I decided not to buy shares of the company at the initial public offering that year. I thought I'd wait awhile. Idiot.
I kicked myself for two years while the stock quadrupled. In the spring of '94, I followed my instincts and became an AOL shareholder -- in spite of an article in a major financial publication that declared AOL grossly overvalued and predicted that the stock would decline by 35%.
The following year, the stock dropped 25% or more three times. And then in 1996, shares absorbed a hit of minus 65%! Despite these setbacks, the company went on to wreak havoc on the business and journalistic establishments, en route to putting up some of the best returns available during a decade of great investment returns. Even with all the temporary downturns, and even though the stock (now known as Time Warner) is today down from its all-time high, my initial investment has still increased 37 times overall -- $10,000 in stock at that time would now be worth $372,128, which amounts to an annualized return of 38.93%.
We'd all love to find the next AOL or Microsoft
But how can ordinary investors like you and me -- just a couple of regular Fools -- find the next great company? It's not impossible. If you can train your eyes to spot innovative companies breaking the rules in their respective industries, you increase your odds dramatically.
You can't score if you don't shoot
The Wise of Wall Street would chalk up AOL's 38% annualized gains to luck. "No one can really identify the great companies of the next generation," they'd say. Growth stocks are too risky; it's best to avoid that style of investing altogether and let a Street "expert" manage your investments.
I disagree. Investing in great companies early on in their high-growth stage and then holding them for the long term will provide the highest possible returns. Period.
We call those companies Rule Breakers. Our investment service of the same name seeks out the great growth stocks of tomorrow -- the potential AOLs -- before the Street catches on.
Think big, but keep an eye on the basics
Boiled down, I look for six signs of a potential Rule Breaker:
Sign No. 1: Top dog and first-mover in an important, emerging industry.
Top dogs are active, fast-moving market leaders. In 1994, AOL was a top dog. Some years earlier, Microsoft and Dell
Rule Breakers are not hidden; they are right there before our eyes, bringing a disruptive technology, clever and effective marketing, or a brand-new business model to this little backwater planet of ours. They rattle our capitalistic foundations.
Sign No. 2: Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors.
Can the company protect the advantage it obtained from its first-mover status? eBay, for example, pioneered the online auction space. Does it have a realistic competitor today?
Sign No. 3: Strong past price appreciation.
Sometimes, the best investments appear overvalued. I bought AOL after it quadrupled. Amazon.com and eBay both doubled within two years, yet they made late-to-the-game investors huge profits. Was Tiger Woods unknown before he joined the professional tour and started winning majors? Was No. 23 unheralded when he joined the Chicago Bulls after his junior year at North Carolina?
In our real-money Rule Breaker portfolio, we put out a public "buy" recommendation on eBay in January 2001. At the time, the stock was trading at a now split-adjusted $13.50, more than 100 times earnings expected by the end of the year! Since then, the stock is up more than 178% vs. a down market. (Yes, Virginia, you can pay 100 times earnings and still about triple your money in four years.)
Sign No. 4: Good management and smart backing.
This is the most important attribute of all -- and it might be the most difficult to get right. Few would disagree that visionary leaders are behind the greatest companies of our generation: Microsoft has Bill Gates, Amazon.com has Jeff Bezos, Dell has Michael Dell. Investors should also be prepared to learn about the venture backers of a young company. If the very best venture capital firms are behind a company, maybe you should be, too.
"Everything matters" -- Starbucks' way of creating a good consumer experience -- also speaks truly to how we as investors should analyze companies. If everything matters, and it does, then you are well-served to study the management and venture backers of any young company you're researching.
Sign No. 5: Strong consumer appeal.
Rule Breaking companies provide products or services that improve the quality of people's lives. Dell, for example, provides affordable PCs for ordinary individuals. Netflix delivers movies straight to your home without the late fees, and its consumers are incredibly loyal as a result.
Sign No. 6: You must find documented proof that it is overvalued according to the financial media.
This is the easiest one of all to identify. Every day, the Wall Street poohbahs declare that this or that stock is overvalued. Netflix misses earnings and its shares are deemed 50% overvalued. Google shares begin trading publicly and the naysayers predict another tech "meltdown." (Checked either of those stocks recently?) If a company is growing its earnings and, as a result, has an increasing valuation, there will be someone somewhere who will argue that the company is overvalued. The reason this is valuable is because it keeps people out of a stock; later on, as the company proves out its position as a profitable, even dominant, leader, then the skeptics all finally buy -- which is what can give you serious appreciation as an early investor in Rule Breaker stocks!
Before they were blue chips
So there you have it. Those are the characteristics I look for in tomorrow's landscape-changing companies.
Essential to our strategy is identifying great companies early on in their growth cycles. And then we hold for the long term. Indeed, many of the best examples of Rule Breakers are today's blue-chip companies. You may recognize a few:
Each of these companies had the six signs of a Rule Breaker at one point in its growth cycle -- and they each posted fantastic returns as a result. There are other not-as-famous companies out there -- hundreds of them -- that once were poised for the limelight but now are forgotten. In most cases, the flameouts and the fakers significantly lacked one or more of the signs we pointed to above.
There is no trade-off
With detailed information about more than 9,000 publicly traded companies, the stock market can't help but be fairly efficient. But the market doesn't have all the information, does it? Many people insist on following the book laid down by Wall Street or by the latest "this is the way to invest" fad investment book, regardless of how banal or unsuccessful these prescribed rules behave in practice. There's our opportunity.
My team of analysts at our Rule Breakers newsletter service obsessively searches for these opportunities. Among our 20 recommendations thus far is a Rule Breaker in the area of electronic trading that is up almost 100%. Another selection, still poised to make a run, offers a non-invasive surgical procedure that promises to become common practice in the not-too-distant future.
These are just a couple of the companies we think will be the industry leaders of tomorrow. So far, three of our selections are up more than 40%. And 14 of our picks are beating the index. I think the other eight represent excellent opportunities for investors looking for a growth stock at a reasonable valuation.
If you'd like to read our analysis of all 22 potential Rule Breakers in greater depth, join us for a free 30-day trial today. You can cancel your trial at any time -- you have my word. Click here to learn more.
And one last thing. As big-time Rule Breaker Steve Jobs recently told Stanford graduates: "Stay hungry. Stay Foolish."
This article was originally published on June 23, 2005. It has been updated. In recent days, our analysts have been examining each of these signs in greater depth. After the series has run its course, you should be able to identify Rule Breakers for yourself. Here are the first two articles in the series:
Fool co-founder David Gardner owns shares of Time Warner, Amazon.com, eBay, Starbucks, Microsoft, Amgen, and Netflix. Netflix, eBay, and Amazon.com are Motley Fool Stock Advisor recommendations. The Motley Fool has a disclosure policy.