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Book Review

Rule Breakers, Rule Makers
by David & Tom Gardner
reviewed by Marco den Ouden

Originally published at About.com - 4/23/99
The article is also available at Stocknowledge

"I met a fool i'the forest, A motley fool."

- As You Like It

If you're going to read just one book on investing this year, make it The Motley Fool's Rule Breakers, Rule Makers. It may just change the way you think about investing.

This third book from the Brothers Fool explains the basis for two portfolios they track at The Motley Fool website. They use very different criteria for each. One, their Rule Breaker Portfolio, looks for stocks in companies that are innovators and are revolutionizing the world of business. These aggressive entrepreneurial enterprises succeed because they break the rules of the game. They offer something different - either a different product, or a different way of doing things.

It is the rule breakers who create progress in our capitalist system. In the words of David Gardner, "rule-breaking is capitalism's special sauce, its tastiest and most necessary condiment". And it produces the investor's richest rewards.

Successful rule breakers go on to a "tweener" stage and sometimes graduate to become rule makers. These are the billion dollar businesses who set the standards for their industries. These titans, like old man river, just keep rolling along, producing generous and stable returns year after year after year. And, of course, they form the basis for the Motley Fool's Rule Maker Portfolio.

The rule breakers are riskier, are a little more difficult to discern, but produce superior and unparalleled returns. The rule makers are stabler, involve less risk, and produce solid but not earth shattering returns.

In this fascinating book, the Gardners give a detailed explanation of how to discover these gems. David covers the first subject, the Rule Breakers, and Tom covers the Rule Makers. Their methods, and their styles, are quite different, as are the kinds of companies discussed.

Rule Breakers

David Gardner is a very literate writer with a passion for Shakespeare. In fact, the Fools were inspired by Shakespeare in the first place to create the Motley Fool. Shakespeare's Fools were actually wise men who the King consulted. Because they were fools, they could, with impudence, speak unpleasant truths to the King, and so were wise counsel. The name is taken from these lines in As You Like It: "A fool, a fool! I met a fool i'the forest, A motley fool.. . .Oh noble Fool! A worthy fool!"

Gardner continues the Shakespearean theme in this book, with a quote or two from Henry IV heading each chapter. But he also draws on history - comparing Christopher Columbus to an innovative entrepreneur and the Spanish monarchy to venture capitalists. And he draws on science and art, citing the work of Isaac Newton and Andy Warhol to explain fine points in his analysis.

Lest you think this might make the analysis dry, rest assured it is quite the opposite. It makes Gardner's explanation of the qualities of Rule Breaking companies particularly fascinating and relevant.

For example, he explains the power of brand names using Warhol. Mention Campbell's Soup and you may think of the chubby kid in the chef's hat. Mention Marilyn Monroe and you might think of her dress flying up over a subway grate. But mention both of them together and you instantly think of Andy Warhol. So strong is this connection that most people cannot think of Campbell's and Monroe together without thinking of Warhol. That is the power of branding.

He gives examples: think coffee - Starbucks. Think hamburgers - McDonald's. Think runners - Nike.

One of the more intriguing suggestions Gardner has is to consider any of today's brands in the context of Andy Warhol. Warhol made his name by painting the commercial and popular icons of his day. Campbell's Soup. Brillo. Marilyn Monroe. And as we were reminded last week - Wayne Gretzky. So look at a brand today and ask yourself, "Would Warhol paint this if he were still alive?" If you think he would, chances are you are looking at a name brand with substantial market power.

There are six criteria in all for true rule breakers. They are:

  • the company must be "top dog in an important emerging industry"

  • it must have a "sustainable advantage gained through business momentum, patent protection, visionaries, or inept competitors"

  • its stock must be appreciating at a rate in the top 10% of all stocks

  • it must have strong management and good backing

  • it must have strong consumer appeal, i.e. branding power

  • and my favorite - at least one media pundit must declare that the stock is "grossly overvalued"

I like this last one because I really get ticked off by negative nellies who like to trash world beating stocks and invoke horror stories about "tulipomania".

David Gardner explains all of these concepts clearly and with style. Sometimes he invokes erudite references to Newton or Leibniz, sometimes common ones to Mark McGwire and Sammy Sosa. In all cases he draws on fascinating case studies of actual businesses to clarify what he's talking about. This first section of the book was a joy to read as much for its stylishness as for its content.

Rule Makers

Tom Gardner handles this section of the book and it is quite different than David's contribution. Where David is the philosopher investor (a nobler creature than a philosopher king by far!), Tom is an analytical investor. He relies heavily on financial data, particularly the Income Statement and the Balance Sheet.

This is not to say that Tom is boring where David is interesting. Rather they are dealing with two very different kinds of stocks. The rules for discerning rule makers just don't work with rule breakers, and vice versa.

In fact, while I found David's section a more interesting read, I found Tom's a more useful read as numbers are something I can get a firm handle on. Whether a company has a sustainable advantage or strong management is, to a certain extent, a very subjective call. A company's cash to debt ratio is not.

Tom, by the way, doesn't eschew Shakespeare or other interesting references. His chapters each start with a quote from Henry V. And he invokes Pavlov and Hercules to make his points. But mostly he invokes your basic first year university accounting text book.

So what are the criteria of a rule making company? Tom breaks it into four different categories with five to seven rules each. That's a lot of rules so I won't enumerate them here. Suffice to say that the first set of rules are somewhat subjective like the rule breaker criteria. They deal with the company's relationship with the consuming public. Or as Tom puts it, "Are they creating the love?" This may sound schmucky, but it is actually a very important concept and involves such things as whether the company projects itself with humor and optimism. It is intimately connected with the concept of branding.

That is the only really subjective part of Tom's discussion. The second set of criteria are quantitative analyses and include gross margins, net margins, sales growth, cash to debt ratio and a novel concept, the Foolish Flow Ratio.

This ratio turns some commonly held beliefs about financial statements on their heads. On balance sheets, inventory is counted as an asset, as are accounts receivable. The Fools do not consider them to be assets at all.

What good is a warehouse full of stuff you can't sell, asks Gardner. What good are debts owed to you if the debtors can't pay up? Unsold goods are a liability, not an asset, and uncollected bills are a liability, not an asset.

Similarly he rejects the notion that current liabilities should be as low as possible. His rationale is that a rule making business, a business with clout, ought to be able to dictate terms to its creditors. They can wait for payment while the cash sits in the rule making company's bank account earning interest! Low current liabilities show that the company's suppliers are calling the shots. Some rule maker!

And hence the Foolish Flow Ratio = (current assets - all cash)/current liabilities. This ratio should be as low as possible and below one. It measures "how tightly a company manages the flow of its supplies and finished products, as well as how carefully it tends to the cash that moves into and through the business".

The second set of criteria, though, measures static quantities at a specific point in time. The third set of criteria measures momentum. Are margins rising? Is cash outgrowing debt? Is the flow ratio declining?

The fourth and final set of criteria for rule making companies measures the business against its competitors. The rule maker should have gross margins and net margins 5% greater than its nearest competitor. It should have a 25% better cash to debt ratio. Its flow ratio should be 25% lower than its closest competitor. And finally, somewhat more subjectively, its products should be more accessible to the public than its competitor's.

Tom Gardner assigns point values to each criterion with the maximum points that can be earned as 60. He gives case examples for each criterion comparing two or more companies. And he concludes with an appendix of a variety of well known American companies. The strongest company in America by Tom's reckoning, with 59 out of 60 points is - surprise, surprise - Microsoft. Others include Cisco Systems - 55 points; Coca-Cola - 54 points; Pfizer - 50 points; and America Online - 50 points.

The Brothers Fool are value investors. And in this book they teach you how to find and measure value, whether in an upstart that promises to change the world, or in a rule-making titan that just keeps rolling along. And they are rebels on Wall Street as well. They see themselves as rule breakers in that they go contrary to the Street's relentless urge to trade, trade, trade. Pick your stocks wisely (or rather Foolishly), they say. And hold on for the long term.

Foolish advice indeed! Advice that may make you as wealthy as any king. Read this book!


Contents copyright Marco den Ouden       All Rights reserved
Typewriter graphic courtesy Stockfreeimages.com