The 13 Steps to Investing Foolishly
Step 11: Consider Rule Breakers and Small Caps"Rule Breakers provide investors with the most dynamically high returns achievable on the public markets -- period.... Rule Breakers provide inspiration and guidance to all business people, be they managers, planners, or executors. Rule Breaking is capitalism's special sauce, its tastiest and most necessary condiment." -- The Motley Fool's Rule Breakers, Rule Makers
*Warning: Rule Breakers are for the most bold and daring of investors. Those who are brand new to all this investing stuff should understand the risks involved.*
Now that we've captured your attention with the big bold lettering -- let us explain a bit more about the types of companies that end up being called Rule Breakers, and what the risks and rewards of investing in them can be.
Investing in Rule Breakers involves consciously taking on lots of risk, with the possibility of
seeing the highest rewards available in the markets. Rule Breaker stocks should make up only a part of any portfolio -- and investors are warned that they should be prepared to lose the money they invest in these companies.
We do think we can offer some useful tips on how to find outperforming stocks from the field of the thousands of small company stocks that are out there.
Well, that's not very encouraging, is it? Perhaps a review of the performance of our real-money Rule-Breaker portfolio will help though. It ended 1998 up a mind-boggling 199%, compared to the S&P 500's very respectable growth of nearly 29%. In its history (since August of 1994), the Portfolio is up a bit more than 1,100% (as of Sept. 13, 1999). During the same go-go period, the S&P 500 galloped ahead 194%.
We're the first to admit that we don't expect these heady returns to repeat forever, and that we'd be quite surprised to ever see a year like 1998 come along again. But we do think we can offer some useful tips on how to find outperforming stocks from the field of the thousands of small company stocks that are out there. Here, in very brief form, are the six main characteristics of Rule Breaker companies.
The company should be a top dog and a first mover in an important, emerging field. In other words, being top dog in the left-handed scissors industry isn't enough. The left-handed scissors industry just isn't really "emerging" -- ya know? It's pretty mature -- and it ain't going anywhere in the near or distant future. Electronic commerce, though, now there's something that's emerging, and Amazon.com is the top dog and first mover in that category. Similarly, in direct retailing of computers, Dell Computer was a Rule Breaker. Starbucks has been the first-mover and top dog in the gourmet coffee field for a while.
- The company needs to demonstrate sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors. Examples of these include Wal-Mart (with business momentum that featured net income gains of 25% during much of the 1980s), Amgen (enjoying patent protection of its drug formulas for many years), and Microsoft (with visionary leadership that benefited from Apple Computer's regrettable decision not to license its technology).
- The market should have recognized a Rule Breaker's promise by rewarding it with strong price appreciation. A good indication of this is a relative strength rating of 90 or above. (You can check up on company relative strength ratings in the Investor's Business Daily newspaper.)
- Look for good management and strong backing. Like the steel company Nucor (yes, steel!), led by Ken Iverson, which became a world-class powerhouse by revolutionizing steel production processes. Or Scott Cook, whose singular focus on serving customers drove the success of personal finance software giant Intuit. Also consider the "backing," or supporters of a company. eBay was backed by Starbucks and Sun Microsystems executives.
- Also important is having a strong consumer brand. Again consider Starbucks, and how its name recognition is so much stronger than competitors such as&ldots; um, like&ldots; (get the point?).
- We also consider it a good sign when the financial media, not seeing the big picture, calls a company overvalued. (Perhaps the greatest single contrary indicator is Barron's lead editorialist. When Barron's is asking about America Online: "Short on Value?" Good. When Barron's leads with "Sell now!" -- excellent.)
As with Rule Makers, the best place to analyze whether a company that you're interested in qualifies as a Rule Breaker is on the Rule Breaker message board, where Fools gather 24 hours a day to trade ideas. To learn more and get more comfortable with Rule Breakers, read the first chapter of The Motley Fool's Rule Breakers, Rule Makers, and the daily portfolio recaps. Another good place to search for ideas is in our Internet Report. Rule Breakers are by no means limited to the Internet stocks, but these companies are often known for breaking the rules -- and some may present terrific investment opportunities for Rule Breaker investors.
If you're thinking of jumping onto the Rule Breaker bandwagon, we recommend making these stocks just a part of your overall investment strategy. A completely nutritious Foolish mix might include Dow approach stocks, a bunch of Rule Maker stocks, and a few Rule Breakers thrown in to spice things up.
The Beauty of Small-Cap Investing
Whether or not you decide to look for emerging companies the Rule Breaker way, you should give serious consideration to including a number of small-cap companies in your portfolio. Why do we advocate small-cap investing? Well, there are a number of reasons, but perhaps the biggest one is that it gives the individual investor a chance to beat the Wise to the punch.
You see, due to the size of most mutual funds, the way they are set up, and a pesky SEC regulation, fund managers have a hard time establishing any kind of
meaningful position in small-caps. In order to buy a position large enough to make a difference to their fund's performance, they have to pick up at least 10% or 20% of a small-cap (which they're frequently restricted from doing, by their own guidelines). Before they can do that, though, they have to file with the SEC. That is, if they haven't already tipped their hand to the market and inflated the previously attractive price by buying the first 5% of the company.
The fact that the big boys can't play these small-cap reindeer games is a great asset to the individual investor.
The fact that the big boys can't play these small-cap reindeer games is a great asset to the individual investor who has the ability to spot promising companies and get in before the institutions do. That's because when institutions, like mutual funds, pension funds, and that ilk do get in, they'll do so in a big way, buying many shares and pushing up the share price with their demand.
Also, lots of small-caps are "closely held" -- that is, the management owns a sizable percentage of the company. Since most of their potential for wealth is tied to the stock, you can bet that they'll be working very hard to get the stock price up.
The final (and probably the best) reason to buy small-cap growth companies is because they grow -- sometimes rather quickly. Small companies are in a much better position than their larger brethren to expand their business. And rapidly multiplying earnings often translate into quick growth in share price.
The Downside of Small-Caps
Small-caps aren't for everyone, though. You should know your way around a balance sheet, and a few laps around the investing block doesn't hurt, either. Novices should steer clear for a while. You wouldn't go up in a lunar orbiter without prior training, nor should you try small-cap investing until you've cut your teeth on some large- and mid-cap issues.
You should also stay away from small-caps (all stocks, really) if you're ponying up your mortgage payment (or any other much-needed funds) to make the purchase. The money you invest in small-caps should be money you can afford to lose.
Time is another dissuading factor, or rather, the lack of it is. Finding good small-caps is a lot of work, and takes even more attention after you've made your purchase. If you don't have the time, energy, or inclination to keep up with the news on your portfolio, you're better off in the Dow Investing Strategy or an index fund.
The last reason to stay away from small-cap growth stocks is if you have a natural aversion to risk. Small-caps are more volatile than large-caps. If the mere thought of a 5% down day gives you an ulcer, you're better off saving your stomach. Everyone has her own risk tolerance, and there's no reason why you should make any investment that makes you feel uncomfortable. There are some great Dow strategies that will give you respectable returns and keep you off the acid-blockers.
Now that you've got small caps under your belt, proceed to Step 12, where even more advanced investing issues are confronted.
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Next Step: Advanced Investing Issues |
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