Rule Breaker Investing

Since, I started my investing advisory cum brokerage business, things have changed rapidly (they seem to keep on changing all the time). Ever since the internet made its presence felt in the brokerage business, there have been two business models in the investment world that have proved to be revolutionary. These are the subscription business of The Motley Fool and the more recent brokerage business of Robinhood. Of these, the time tested model is that of The Motley Fool and this business model has been mimicked widely and successfully, all over the world.

The title of this post - Rule Breaker Investing is a concept espoused by Tom and David Gardner of the Motley Fool. The Gardner brothers, as they are popularly called, have managed to establish a very successful subscription and advisory business and are now well respected. Their six rule breaker investing rules are the same for the last 22 years; but their tactics have evolved is what they say. (Disclosure: I don’t subscribe to any of their products or services and neither am I affiliated in any manner whatsoever with The Motley Fool).

Since, the Motley Fool has stood the test of time, I thought it worth my while to understand the investment philosophy of the Gardner Brothers. What follows is tidbits of the same, picked up from various interviews that they have given over the years and are freely available online. My comments, if any, are in italics:

They say that the first and most important decision that they make is the selection of the pond in which they want to fish. This is similar to what Charlie Munger says: Fish where the fish are, makes a ton of sense to me.
Using the words investing and long-term is a tautology because investing, by definition should be long-term. This is a question of ones investing mindset. There is a dichotomy here; their investing mindset is that of momentum investors. It is true that momentum has been the winning strategy for the last decade, but nobody knows if momentum as a factor will continue to work and for how long. They seem to suggest that momentum investing is a long-term strategy and I don't agree, simply because history doesn't seem to bear this out.
Their checklist for what constitutes a Rule Breaker Business are:

Top Dog and first mover in an important, emerging industry.
Sustainable advantage gained through business momentum, patent protection, visionary leadership or inept competitors.
Strong past price appreciation.
Good Management and Smart Backing.
Strong Consumer Appeal.
Grossly overvalued according to financial media.

This is momentum investing in disguise.The last point (number 6 above) is the one that I found most strange. But, here too their philosophy seems to be that investors should defer to the market and not be influenced by firehose media. If one were to frame it in this manner, it does make sense for the most part. Basically, price discovery is a function of the demand for a stock and the supply of the stock, nothing else matters. The problem is in forecasting these two parameters over extended periods of time. As much as we'd like to believe otherwise, the market is a voting machine over the short-term. And hence the adage that the ‘pros follow the flows’. And the ‘pros follow the flows’ because they are more interested in ‘not underperforming’ rather than ‘outperforming’, their stated benchmarks. The most dangerous aspect of this ‘pros follow the flows’ theme is that at some point the market price acts as a justification for a buy or sell decision, and that turns out to be the ‘tipping point’ for a change in directionality.

If you find a business that has trait numbers one to five above and the media thinks it is overvalued, then it is a key dynamic. So, you are constantly overpaying. They seem to suggest that one should act contrary to media opinion. Again, the theme is the same, play the momentum - defer to the market. But, this can fail miserably over the long-term, since shifts in momentum are sudden and enduring.
Buying low and selling high are the most harmful words, they look to buy high and never to sell. A rule breaker should be willing to lose a lot. This is the Venture Capital mantra. The magnitude of gain matters, not the frequency of winners The problem is that most investors aren't wiling to lose at all! Most of us, me included, have inverted risk preferences, which is to say, we are risk averse when we are in the money and risk seeking when we face losses.
Sell discipline: What you buy matters more than your sell discipline. They don’t spend much time thinking about selling and they don’t sell very often. Hence they have many losers. Adding to their winners and not doubling down on their losers is their strategy. The reasoning is the portfolio weight of losing stocks tends to fall with the fall in the stock price. And the opposite is true for winners which they add. When one of the companies in their portfolio gets bought out and it’s an all cash deal, they sell. Unethical behavior by a company, and if their investing thesis is broken in a horrific manner, they sell, but they will be one of the last ones to sell. There is a lot to unpack in this. Adding winners and not doubling down on losers is akin to what the legendary investor Peter Lynch has said: ‘Selling your winners and holding your losers is like cutting the flowers and watering the weeds.’ This is contrary to the other wisdom which says that 'it never hurts to book a profit'. I am inclined to agree with Lynch. Also, the part about the portfolio weight of losers is mathematically accurate. But, I don't agree that not having a sell discipline doesn't matter, it does.
FANG’s score: FANG as an acronym is silly - they don’t think in this manner. How long have you owned the names is what matters. So, you total up the number of years that you’ve held these four stocks and that is your FANG score! This is my biggest takeaway from their interviews. FANG for those who aren’t aware, is an acronym for four U.S. listed stocks which are Facebook, Amazon, Netflix and Google. They are right, acronyms like these are silly. We had a BRICS acronym that is long forgotten. BRICS represented the Emerging Markets of Brazil, Russia, India, China and South Africa. No one uses this anymore, so using acronyms is silly. The more interesting point is that I had never thought of the concept of a FANG score. Practically every investor that I interact with says that he or she is investing for the long-term. Almost all of these so-called long-term investors check their portfolios multiple times every day. If I were to ask them to score their holding period, I find that there are very few names that have been held for even 3 years.
How do they think of industries or sectors to invest in? They go anywhere, no restrictions. But they have a feel for internet businesses. Who is the innovator in that market place and in that industry is what they try and pick each time. The beauty is that a lot of time people are skeptical about the innovator. This is another way of saying that they are looking at businesses that have a ‘first mover advantage’, since many times internet businesses are ‘winner takes all’.
Going forward, which businesses are the next rule breakers.They don’t have any special insights on this. They don’t try and predict which businesses will be the rule breakers of the future. They just try and recognise these kind of businesses near about the time the business achieves scale and then they invest. They don’t try and time the market, neither do they want to forecast outcomes. No crystal ball gazing. Makes a ton of sense to me.
They have six tactics that a Rule Breaker investor should follow. These are:

Let your winners run. High.
Add up, don’t double down.
Invest for at least 3 years.
Remember the four tenets of conscious capitalism - Purpose, Culture, Leadership and Stakeholder.
Maximum 5 percent allocation per stock. He doesn’t agree that we should have just 22 or 25 stocks in a portfolio, he thinks the more the merrier. There is no magic number of stocks that one should have in one portfolio.
Aim for 60 percent accuracy. Accuracy means beating the market.

All these make sense, except Rule number 5. I don't know why an investor should own hundreds of names. In an age where innovation is the mantra and longevity of businesses is falling, I don't agree with this one. The optimum portfolio size based on studies and research papers (and considering the fact that nobody has unlimited capital) is twenty-five names. Secondly, if one were to add to the winners, the 5 percent cap would be a hindrance, so this partially contradicts one of the earlier rules.

And lastly, why do they call their business ‘The Motley Fool’? Their answer is: Our name is an homage to the one character in Shakespearean literature – the court jester - who could speak the truth to the king and queen without having his head lopped off. (“A fool, a fool, I met a fool i' the forest, a motley fool,” says Jacques in Act II, scene VII of As You Like It.) The Fools of yore weren’t simply stand-up comics sporting belled jester caps, they entertained the court with humour that instructed as it amused. More importantly, the Fool was never afraid to question conventional wisdom, particularly when popular thought was detrimental to the kingdom’s people. The Motley Fool’s purpose is to make the world smarter, happier, and richer. We consider everyone who is on this journey with us to be a Fool, in the best possible sense of the word.

So, there you have it, the Motley Fool investment philosophy. Hope you enjoyed reading it as much as I enjoyed writing this one.

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