9 Investing Lessons From “Breaking the Rules With David Gardner” Podcast

I recently listened to the “Breaking the Rules With David Gardner” podcast hosted by Trey Lockerbie of We Study Billionaires.

David Gardner is the co-founder of The Motley Fool, an organisation that I had the chance to be part of when it operated in Singapore from 2013 to 2019.

Here are some of my key takeaways from the interview with David Gardner.

Link to podcast on Apple Podcasts

(A huge thank you to The Investor’s Podcast for providing a transcript of the interview, which helped me in my note-taking.)

Six Attributes to Find a Rule-Breaking Company

David Gardner first touched on how he picks stocks.

He has six traits he looks out for in a rule-breaking company and they are listed below with Gardner’s explanations.

1. Be a top dog in an important emerging sector

“So the first attribute is probably the most important one, being a top dog and a first mover in an important emerging industry. So I love to find the companies that are the leaders, if you’re not the lead Husky, the view never changes. And so we’re always asking, who’s the leader? But not anywhere, not in big oil today or telecom, I love important emerging industries. That’s where most of the great stocks come from, the ones that make you money for 20-plus years.”

2. Have a sustainable competitive advantage

“Number two, we’re looking for a sustainable competitive advantage that takes many different forms. Examples would be, we’ve got Jeff Bezos, you’re down. So the founders, the human capital and companies. Certainly within the world of biotechnology, there’s patent protection for 20 years for your successful new drug, that’s an example of a competitive advantage. And others’ competitive advantages, if everybody else is inept and you’re not smartest guy in the room, kind of a thing.”

David Gardner went on to explain:

“Because truly, a sustainable competitive advantage means so much more to me than an attractive looking price to sales ratio. It’s so much deeper, it’s harder to earn, and it’s so much less ephemeral. It will stand the test of time in a time where people are memeing stocks up and down like silly, and it’s all so short term, and it’s not really going to create sustainable wealth for people playing short-term games.”

3. Have strong price appreciation

“Number three, strong past price appreciation. This one goes against a lot of people’s instincts, and even my own human instincts initially. We love stocks that have been amazing already.”

4. Have good management  

“Number four, we’re looking for good management and smart backing. It’s the people in the end, not the product, not the service, not the industry or the competitive set or whatever, it’s the people that are making the decisions.”

5. Have strong customer appeal

“Number five, we’re looking for companies with strong consumer appeal. I love to find the great brands. Turns out Starbucks, yeah, Apple, yeah. The great biggest brands of our time are also the greatest, biggest performing stocks if you really look at it over meaningful periods of time, and that is not luck, that’s a one-to-one. So the strength of creating a great brand, really a good thing to look for in your stocks.”

6. People saying stock’s overvalued

“And then number six, the final one, is we’re looking for companies that people think and call out as over valued. Again, that goes against our instinct, just like trait number three, which we talked about strong past price appreciation, we’re talking here about the stocks. A lot of those six attributes I just shared with you are about the company, not the stock, but number three, and number six are looking at the stock.”

In summary, if the company is a top dog and a first mover in an important emerging industry, has a sustainable competitive edge, and possesses strong past price appreciation, good management, smart backing, and strong consumer appeal, but people are saying that it’s crazy overvalued, it’s usually a great signal in David Gardner’s books.

He said the traits don’t work in isolation; they have to come together.

“Because the whole framework hangs together, if you just isolate one of those factors, like that last one you mentioned, it doesn’t work every time. There are things that are crazy over valued and that you wouldn’t want to buy, but when you’re seeing the full integration of the model and you’re saying, “Yes, yes, yes, yes, yes,” in those first five, and everybody’s saying it’s overvalued, that really does work.”

How David Gardner Discovers Stocks to Buy

David Gardner has never used a stock screener to look for stocks. His style is more inductive than deductive.

He went on to explain:

“So it’s grassroots, flip up a stone, look what’s underneath that stone. Oh, that’s interesting. And once you flip up enough stones, you start to get some pattern recognition about what’s working and what’s not, or what are the interesting companies or what’s not. So it’s just one stone after another that you’re flipping up because you’re learning, you talked about that earlier, you’re learning as you go. It’s so helpful always to be learning machines in this world. So you’re learning a lot, but I will say that it’s really important to me not to try to deduce or be the really smart guy, because it sounds so smart, Sherlock Holmes sounds so smart, but it’s not really a way to successfully invest, I don’t think.”

The Rule-Breaker Approach to Investing Doesn’t Work Every Time

There’s no perfect way of investing as we all know. The rule-breaker way of investing is no exception.

David Gardner said:

“It doesn’t work every time, by the way, and when it doesn’t work, you can lose dramatically. And we’re going to talk, I know, about losing dramatically and what that really means. … But for me, the math of it is so wildly in our favor when we can find companies that have these great attributes and everybody is not believing in, because what happens on the market is as is often said, “Great stocks climb a wall of worry.” And so if everybody thinks in 1997 that Amazon is crazy overvalued, is near bankruptcy, is never going to make it, then those people don’t own the stock.”

It’s in the holding through the ups-and-downs that fortunes are made and lessons are learnt. Gardner went on to say:

“Because Amazon went from three when I first bought it, to 95, and then in the wreckage of 2001/2, it went back to seven. That hurt a lot. We had a 30 bagger, and then it basically lost almost all of that, but we kept holding, and we kept holding all the way through. So I’ve held all the way through and it has been an incredible front seat lesson into what really works if you take the rule breaker approach. I also want to just hasten to add that there are many approaches to investing. The one I’m giving you, that I’ve shared in many ways for 20-plus years is just mine.”

Being a Rule-Breaker Investor Is Not Easy Psychologically

The rule-breaking investing way is never easy and it goes against human’s instincts.

And there will be losers.

David Gardner said he’s very comfortable losing. And the beauty of losing in investing is the most you can ever lose is 100%. This is unless investors are doing something really silly like using margins (which Gardner has never done).

He went on to say:

“And then also, I want people to know that it’s okay to stomach volatility and to realize that you’ll have some losers alongside these kinds of companies. But as you said earlier, when you have a stock like this [referring to Nvidia], it powers your portfolio to market beating returns on its own. So this is really what investing is. And to me, this is Rule Breaker Investing, and this is often not taught and certainly not practiced by most of the institutional traders today. And it’s just one approach, but I can’t think of a better one.”

On Selling Stocks

David Gardner explained when he sells stocks:

“I do sell. I don’t do it very often, I don’t think I’ve sold a stock that wasn’t bought out that I had to sell out for a few years now. And I’m just talking here about my own personal portfolio. I basically do in public what I do privately, which is, I just find great companies to buy and hold them. When do I sell? I sell when thesis is broken, I sell when I love the company still, but somebody else came around with something better. There’s a better mouse trap or a new approach, there’s disruption happening. I’m a big Clayton Christensen fan, The Innovator’s Dilemma and that thinking.”

On Knowing the “Sleep Number”

If we are able to sleep well at night, we have won more than half the battle in investing.

David Gardner said:

“And so taking that different angle, you have to be comfortable winning and losing, and you have to recognize, especially, that loss is overrated if you’re willing to show resilience and if you aren’t doing silly things. And I earlier mentioned not trading on margin, a lot of people are doing crazy stuff or they have everything in one stock. I’ve often talked about the importance of knowing your sleep number, which I define as the percentage of your portfolio that you would put in your biggest holding, that you would allow your biggest holding to occupy as a percent of your allocation and still be able to sleep at night.”

On the Topic of Optionality 

David Gardner is looking for a company with infinite possible futures.

He went on to explain:

“Andy Cross, our longtime chief investment officer at The Motley Fool and firstly, a great friend Tom and to me, Andy once said about me. He said, “You know, David, what I realized is Buffett is looking for companies with one future and you know what it’s going to be. It’s still going to be car insurance, five, 15 years later. It’s still going to be chocolates, it’s still going to be The Washington Post back in the day. He loves the certainty that this company is going to do its thing. And you are looking for companies with infinite possible futures as a directly different approach.”

Gardner used the example of the technology company Alphabet:

“And I was like, “You’re right, I am looking for companies that have lots of possible futures.” That means they have usually lots of irons in the fire, you think about Alphabet. It was initially Google, but these days, it’s Alphabet partly showing the optionality of one powerful business idea and what else it can lead to. But you see companies morph over time when they have possibilities. It takes two things primarily to have this kind of optionality, which is the word that we use, I use a lot for describing this. The first thing it takes is capital. You don’t have a lot of optionality even if you have a cool new app or a cool business idea, and you don’t have any money in the bank, you don’t have cash on the balance sheet or you’re beholden to lots of debt.”

He went on to say how the internet provides an excellent platform for optionality to happen:

“So the number one thing you really need to be optional and to have new possibilities is you have to be able to screw up a bunch because that’s what we do as innovators and humans, we screw up a bunch. You need to be able to spend the money through that, to get to the right idea or the next hill to take for your business. And so that’s the first thing you need. Of course, the second thing you need is you need an open-ended context. The internet is an incredible platform for optionality.”

What Is “Risk” in Investing?

Risk is not equal to the volatility of a stock as many would perceive it to be. Risk is about having a permanent loss of capital.

David Gardner said:

“I define risk as the chances that holding this instrument over a long period of time, you would suffer in the end a dramatic loss. That’s the risk that I try to avoid. If it’s just beta, like how much does the stock bump up and down, I don’t think that’s a very satisfying approach to risk. That’s like using batting average, going back to baseball, to evaluate who’s a really good valuable hitter in baseball. It’s intuitive, in some ways understandable, but how much does stock bounces around, is not really, to me, what risk is about.”

Gardner has a 25-point checklist for risk that he uses when picking stocks.

Every time the answer to a question is “Yes”, that’s good. But every time you say “No” to the question, that’s bad, and you add a point.

If there are 25 “No”s, that’s 25 points, giving the riskiest imaginable investment. Therefore, the higher the rating, higher the risk.

Here are some examples of what the 25-point checklist contains:

  • “Was the company profitable during the previous quarter and past 12 months?” 
  • “Does the company maintain a high standard of disclosure consistent with SEC guidelines in the US?”
  • “Would an intermediate level investor find the company’s financial statements and management ownership disclosures relatively easy to sift through and understand?” 
  • “Would potential new competitors face high economic technological or regulatory barriers to entry?” 

What is Conscious Capitalism?

David Gardner touched on the important topic of conscious capitalism and why it’s important as an investor.

He said:

“For me, it’s just a better way to practice capitalism. Capitalism is much maligned and there are all kinds of examples of excess and failure and greed that have been part of the American story. And the worldwide story of capitalism run a mock in years past. And Enron, which was a stock that I had in one of my portfolios at one point would be a good example of poster child a lot of us can relate to, but there are many examples of failed humans who are running businesses or failed enterprises. And that’s not what we’re talking about when we talk about conscious capitalism, because most of those failed enterprises were either really short-term oriented, which tragically Enron really was, just trying to look great for a little while.”

Gardner went on to explain:

“And the ones that really get that and do that well, I would say the conscious capitalism enterprises out there, the employees know that and feel that. It’s authentic, it’s not green washed or pasted on by a CEO or a private equity firm that bought the company. It’s why it was started, it’s why you started your business, Trey, out of a vision of making the world better, a product or service, a guy who had a light bulb and the guts to start something.”

As investors, we have to consider whether the company is making the world a better place to live in.

Because at the end of the day, we would want to invest in companies that take care of the world.  

As David Gardner famously says:

“Make your portfolio reflect your best vision for our future.”

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