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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!
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