Introduction

Patrick: [00:01:21] The investment strategy discussed in this week's episode is diametrically opposed to my own value tendencies, but it is still one that has done exceptionally well. My guest is David Gardner, co founder of The Motley Fool. He's unique in that he's both a pure investor, a true stock junky, and an entrepreneur. His energy is remarkable. His positive vibes are really something to behold. You'll hear it over audio but it's even more palpable in person. Our conversation is about finding companies which are breaking rules in the right way and reshaping industries. David's goal is to find these companies early in and hold them forever. If you love investing, you are going to love this regardless of your prior beliefs. Please enjoy my talk with David Gardner on rule breakers.

Rule Breaker Investing

The experiments I'll call them that you've run in your podcast, sort of things that you keep returning to, themes across the episodes, which of those has been the most surprising to the upside? What's the one that you've enjoyed the most?

David: [00:02:14] Well, the one that I've enjoyed the most has got to be when I pick stocks. So, Patrick, that's something that I try to do every 10 weeks or so. So two and a half months. And what it is ultimately is it's a sampler of what I'm doing on our services because for Motley Fool Stock Advisor, which is our largest service that's been going on since 2002, and then for Motley Fool Rule Breakers, which is a big service for us since 2004. And I've just been the same person getting the batter's box every single month over those years, and I pick one stock for Stock Advisor and two for Rule Breakers. So if you put that together, that's three stocks a month times 12 is 36 stock picks a year times 15 or so is roughly how many stocks that I have picked. And I tend not to sell. So this creates a large universe of picks, and what I try to do that I really enjoy doing on my podcast is pick five as a sampler and just put it out there and score it. And then I come back a year or two, three later and say, "What do we learn?" So that's been the most fun.

Patrick: [00:03:09] How much overlap is there when you're talking about a stock? Is it ever the same stock, or are those always distinct, new picks?

David: [00:03:15] It might be the same stock. So in the services that I led off with, those are our premium services, which is really the main way we butter our bread of the Motley Food business is subscription-based relationship that we have with members we hope a long period of the time. So for those, I will typically pick a new stock, but maybe out of those 36 picks a year, maybe eight or nine of them will be a re-recommendation of a previous pick.

Patrick: [00:03:38] You're kind enough to send me an advanced copy of the third addition I believe of the book, which lays out in some very interesting detail this rule breaker mentality, strategy, mindset that you have for pouring through the stock universe. And I want to explore that in some detail. I was struck by the I just love rules-based frameworks and structures, things that you consistently look for where obviously the individual stories are going to be very different. But you're looking for sort of a DNA as you pour through stocks. I'm assuming that's how you deal with the podcast as well.

So I would just like to start there and do a fairly deep exploration of that framework. I'll let you begin with just sort of at a high level how you would describe the rule breaker mentality that you look for.

David: [00:04:20] So a rule breaker is a company that comes along and breaks the rules of how business is being done. It's usually started by a rule breakers CEO, somebody who is an innovative thinker, and there's a lot of kind of Clayton Christensen disruptive innovation laced through here. And these are usually they start off as crazy sounding companies. Think about Tesla building an electric car when the, at least on my Netflix queue, I remember seeing Who Killed The Electric Car, a documentary I didn't watch. But that was the perception that electric cars had been tried before, wouldn't work. Or Netflix, which sounded so silly when I first heard about it, mailing DVDs back to Netflix as opposed to just dropping them off at my local video store seemed silly.

So these are kind of the disruptors of our time, and if they play out... And they don't always, and that's an important part about rule breaker investing. Indeed, as you all know, investing overall. It doesn't always pan out. So I have a lot of losers, which I guess something that I take pride in. But when it works, these end up becoming the world beaters because they have visionary CEOs. They have usually a big, addressable market and a fascinating product or service that has innovated, and it has broken the rules of the rule makers of the businesses that dominate our time. Walmart, Microsoft, the rule makers.

So these are the rule breakers, and yes, I have six attributes that I look for. Not every so-called rule breaker would hit on all of them, but the six together when it does feels really good. And even if it just has one, two, or three, I still would be interested in a stock.

Patrick: [00:05:52] As I was reading the specific chapter on rule breakers, it made me think a lot about venture capital, private, early stage investing where their checklist might look very much like yours does for public markets. Before we get into those six criteria, I'm curious if that's an area of the investing ecosystem that you've personally explored given the kind of overlap in criteria?

David: [00:06:13] So thank you for noticing that, and I do often think of the approach I take as kind of venture capital but for the public markets. Of course venture capital is associated with private markets, usually with startups but investments that most of us can't participate in. I don't have any venture capital money sitting anywhere. So I don't get an early piece of Uber or that kind of a thing. But turns out the good news is you can take that same mentality and you can apply it to public companies. Now they won't be early stage startups, but some of them are still quite early stage. And my aim is to get in ahead of most of the rest of the world, and then-and this is the key-keep holding well past most of the rest of the world. So that means that I own Amazon at $3.21 a share, and I still own it.

But it also means that I have stocks that I'm always the last to sell out of as it's falling apart, and everyone else left it six months or three years ago. And I'm still holding onto the stock thinking, "Maybe they'll come back." It's not an emotional thing for me. It's just a habitual thing tending not to sell, which is what I've done for a few decades now.

Patrick: [00:07:19] This is a really important feature of this style of investing. So I'm just going to kind of skip right there. My friend Matt Batnick has done a really interesting study on some of the best basically benefit of perfect hindsight, isolating the best performing stocks, some of them you've already mentioned-Netflix, Amazon, over the years. And then calculating the frequency magnitude of drawdowns that those stocks experience versus say the broad market or a more typical stock. And it's incredibly emotionally wrenching. I mean, 50% plus drawdowns are the norm among these names that go on to produce the best overall results.

Now drawdowns are telling you that the market has started to extremely dislike something about the prospects of this business. So we're going to get through the criteria of how you find a stock in the stock pick. But what are the criteria? How do you gain the conviction to hold these things? What do you need to see to not sell Amazon in one of those 50-70% drawdowns?

David: [00:08:16] So I have indeed witnessed those over and over again with Amazon.

Patrick: [00:08:19] Lived them.

David: [00:08:20] Netflix, Tesla, Priceline, these are all have been my best stocks. In fact, when somebody coined the phrase, and I don't use it myself, but FANG and FANG stocks, which I've actually lampooned on my podcast. But when somebody did that, I said, "Rather than create an acronym for whatever the big stocks are of our time, calculate this. What's your FANG score?" I said. And your FANG score is nothing more than if you want to take Facebook, Amazon, Netflix and Google, which is now Alphabet, so that's why FANG doesn't even quite work. But if you want to do that, how many years have you held each? Total that and that's your FANG score. And then let's talk. So I'm all about increasing my FANG score in life.

I do happen to have all four of those companies, and I think the one that I've held the shortest time was Facebook for eight years since it's public. So I have a very large FANG score, and it's based on not worrying too much about the stock but looking at the businesses themselves. So what we always describe ourselves as at The Motley Fool, we're a business focused investors. I know you are too. And I don't know Matt Batnick, but it sounds like he gets it too.

It's amazing to me... I'll give a quick example of the story of Nvidia, which should be a new N, but I don't think it's in that acronym. But it's been a pretty great stock. I recommended it in 2005 at six. It went to 40 two years later. It dropped to five one year after that. I didn't feel very good about that. Watching my six bagger fizzle, and then it kind of crawled back to 28 through the wreck that was 2008, '09, and into '10. You can look at the chart. Anybody can look this up. The chart looks very different now looking backwards over these 11 years. But from there, 2011, it sat for about five years at about 28.

So here we are now at the start of 2016, basically I've held this stock for 10 years. It's a multi-bagger, but it was so further up in the second year of holding it. And in 2016, as you'll know and history will show, it was the top performing in the S&P 500. The stock tripled, and so that was awesome. And then at the start of this year, I mentioned how I re-recommend stocks from time to time, and part of the sauce there for me is I try to re-recommend winners. I specifically look for companies that have already done great, and I re-recommend them, which I think goes against a lot of people's psychology.

So I decided everyone thinks that it's played out for Nvidia. They think it tripled last year. You've missed it. So I re-recommended it in January of this year, and I'm happy to say, last I checked, it gone from 105 to 165. So it's been another tremendous year. So we bought at six. Today it's 165. But you had to go six, 40, five, 28, nothing for five years, 28, and then 165 about a year and a half later. So this is kind of what you have to be used to.

And what I'll say is really to answer your question, Patrick, and give a quick direct answer, the business of Nvidia didn't change anything like that. When you're a business focused, you're looking at the earning statement. You're seeing the top line sales, the bottom line margins. Yes, it's a more cyclical company as a semiconductor, but these companies never experience anything like the death defying drops that stocks like Amazon have had, not at all with their actual performance.

Stock Picking Criteria

Patrick: [00:11:32] I don't know who the quote is from, but it's something along like, "Price fluctuates much more than underlying fundamentals and therein lies the opportunity." I love the FANG score of a true long-term focus as perhaps the last true edge that exists in public markets. We know and we've watched... I know personally a lot of the guys that are driving this competition. The competition to predict next quarter's earnings and trade around it is viscous. That is a game that I guarantee anyone listening, myself included, will lose with maybe a few exceptions. But the ability to have a stock selection strategy that's rule's based, repeatable that is oriented towards the long-term is perhaps an advantage that will never go away or is one of the greatest remaining edges. So that brings us to your actual list of criteria because I think without this list, you wouldn't be able to build the conviction that you would need to hold for that long.

So let's start going through them, and the more examples that you can give as reference points, the better because I think that even though traditional stock picking is something that has come in and out of favor. I would classify it as very out of favor right now for the understatement of the year.

Let's start with the first one, which is this notion of top dogs and first movers.

David: [00:12:49] So top dogs and first movers in an important emerging industry. So this is the number one criteria, and I think it's probably of the six, most important. And there are not that many companies that start important emerging industries or represent the top dog or move first, and sometimes they move second. You find out there's this tiny little startup that had the same idea but failed.

Patrick: [00:13:10] My experience is Facebook or something like that.

David: [00:13:12] There you go. That's it. In terms of getting to the public markets and actually getting there and being the leader, these again, I think are some of the great companies of our time. It's not easy. It takes so much. And I know I'm speaking in an entrepreneur, and I'm an entrepreneur myself. It takes a ton just to get a company public. It's by no means the end of your story. It's the first day of the rest of your life if you're long-term minded. But I so deeply respect that. So if companies like... Well, we've already used a number of these names, but Tesla, Netflix, Amazon with eCommerce. There are a number of different companies these days in the area of biotech that are doing... Within car T technology for example. I mean, the list goes on of...

Starbucks back in the day. I remember when Starbucks came public in 1992. Everybody thought it was going to be a fad. I might've even thought it was going to be a fad. People are like, "Where are all the coffee houses over the course of American history that showed that this is anything more than a crazy fad? And who's really going to pay $5 for a cup of coffee when you can get it for free at your office?" But this was a top dog and first mover and important emerging industry.

So it's one thing to be a top dog and first mover, but if you're not really doing anything of real consequence or with an impressive addressable market, then it's not a rule breaker. But when you are, even Starbucks, to take that example, again, coffee houses might not sound like an important emerging industry until you realize now looking backward over the last 30 years, it really has been. Howard Schultz at the time, the visionary CEO and founder of Starbucks was saying things like, "We're the third place." You probably know this. But for any listeners who don't, the idea is your first place is your home, your second place is your work, but where's your third place that you have that you can meet friends or that sort of thing? And very self consciously, Howard was talking about how Starbucks was the third place. So I would say that was an important emerging industry at the time, and so Starbucks is...

Now I want to mention that for anything that we can talk about that worked, there are any number of ones that didn't that sounded great to me. I'll give a quick example of this. So At Home was right around the year 2000 or 1999 was the top dog and first mover internet broadband. So At Home looked great to me. A problem with At Home was that it was a consortium of cable companies owning it. So it wasn't really a company that had its own destiny in mind, and second, it kind of got merged with X-cite for those who may remember that early on search engine. So it became X-cite At Home, and that top dog and first mover kind of flamed out. That was kind of a loser pick of mine. Again, I have a lot of loser picks, but I hope I gave enough examples and kind of underlined the importance of this criterion.

Patrick: [00:15:37] What do you think it is underneath that first mover, top dog that drives the long-term investing? Is it that the markets under price or under appreciate reinvestment potential? What are the real underpinnings of it that drive long-term returns?

David: [00:15:52] Great question. So the reason I say it's a great question is because you're going deeper and forcing me to try to think harder than just rattling off my list. So I think there are two things, and by no means are these the only things. I'd love to hear your viewpoint. But two things that present themselves as meaningful for why this works as a criterion. I think the first is that often we find out that the companies themselves have more optionality than we originally thought about. Amgen, if you think about Amgen, was a company that invented Epogen, which is basically a blood substitute, and it's a biotech company. And it was initially approved for one instance, and then all of a sudden... This sometimes happens with biotech. It turns out it works in another instance as well.

Or maybe the ultimate example would be Amazon. I still have my mousepad. Earth's biggest bookstore. Turns out they could sell other things than books, but the market doesn't see that initially. It doesn't rate that. It's not that I see it. I mean, I think I actually did see it with Amazon, and I don't think it took a genius necessarily, especially in retrospect, to see that. But it is very powerful when all of a sudden it turns out there's a second, third, fourth, fifth business line or possibility, and especially in such a tech drive world where new technologies are coming up all the time, and everything's speeding up and evolving. You have to be nimble. You have to be able to be flexible and adaptive. When you have optionally, you really can do that in a way that if you don't, you're kind of locked into one potential future.

Our chief investment officer at The Motley Fool, Andy Cross said... This helped me insight about how I think about 10 years ago. He said, "Buffett looks for companies with one definite future. It's like See's Candies. It's Geico."

Patrick: [00:17:35] No change.

David: [00:17:35] Yeah. And that's what he loves, and that's why he says, "I don't invest in technology," because he doesn't know how it plays out. And he said, "By contrast, Dave, you basically love coming to an infinite possible futures, and I think that that was apt." So I've used that line since then to talk about how I love to find possible futures. So number one is optionality. I think that's a big thing. We don't recognize just how much when you're the leader. Another of my favorite lines, when you're the lead husky, the view never changes. So I love the companies that are the lead huskies because they take our Iditarod sled and they take us off in whatever direction, sometimes crazy directions, off into the forest where no one thought you should go into the forest. Turns out there's a shortcut in the forest or a better approach. So I love the companies that are the lead huskies because they take us other surprising places, especially when they have a great visionary person whacking the whip and getting the dogs moving because we're able to go places no one ever thought you could go before. So optionality, optionality, optionality.

The second one is probably just that, and this is a key dynamic with the later one, but when a company is the leader and it's in an emergent phase, it almost always looks over valued and that's a critical dynamic to recognize. Early on in my career, I didn't get this, and then I started to realize it. And I've made it a big thing for the last 20 years or so is I love it when people call something over valued. It's a great buy indicator. And as you well now, Patrick, a lot of these companies may not even have profits.

A big question was how will Google even make money? It's a free search engine. That was the big dark cloud that was hanging over Google stock back in the day or Facebook, how will they actually make money? Which now seems comical to look at those companies in retrospect, and I can't say that I was the brilliant visionary that saw the power of how much advertising they could drive. But I think that these companies looked over valued to people. They either don't have earnings or they have huge price earnings ratios, and that is a beautiful thing.

Patrick: [00:19:32] It brings us to the second point, which is this notion of visionary leadership. And all, maybe not all, but most of the companies that you mentioned, I could've, for example, name Nvidia's CEO. But all the other ones have CEOs who are incredibly famous. I think the consensus is that they are indeed visionaries, and again, back to this notion of compounding your wealth with very long holding periods, these are all competitive, emergent, a lot of it's technology fields, which tends to be fiercely competitive, over priced. I would say over priced as you pointed out, very high statistical measures of price to earnings, price to sales, whatever your preferred metric is.

But they have, even though it's a competitive field, they've got this kind of embedded culture, which I think is the platform that provides that optionality you described. So tell me about the components of what you look for in leadership. You use that term visionary, but what very specifically, getting down to the nitty gritty, how do you separate the gold from the fool's gold when looking at these leaders of the emerging companies?

David: [00:20:35] Well, first of all, I love entrepreneurs. And I deeply respect them. In my mind, these are the people who create jobs and really the best jobs. You're going through the war as an entrepreneur just to get something to scale. You're only going to succeed if you have a product or a service that helps enough of the people that they actually want to pay you above your costs for it. It's a tough trick a lot of the time. But the people that actually do that who bring a company that they founded to the public markets I believe are among the great heroes of our time. When I took a history class, it was all about political leaders or generals, people who won wars. But I think that if I were trying to innovate within the academic space, which I'm not, I would start specializing on corporate histories and stories because how Apple was founded.

I would say the increasing fascination with startups these days suggest to me that we should, and I love going and looking and researching stocks. Old Dominion Freight Line is a recent pick of mine in Motley Fool Stock Advisor. I love just going and seeing who started that company. Sometimes you're amazed by how a company started and then what it actually became. So I want to start by saying I just deeply respect entrepreneurs, and even if you're not the top dog or even if you're just a copycat entrepreneur, I still think you're probably pretty cool. I don't think you're cool if I don't like you, and I believe that as Henry Cloud, an author that I've enjoyed a book or two in the past has said, character always wins. So for me, I want to find people that I really respect and/or love or would love if I could actually hang out with them, which I often can't.

So somebody like, and I know we're broadcasting, as you do from your beautiful apartment here right above Union Square Park. We were talking about Danny Meyer before you turned on the microphone, and there's somebody that I deeply respect. Somebody who's character I love and I think you do too. So this is really critical for me. When I find somebody who gets a great concept and company to the public market and I think they're a good guy or gal, I deeply respect that woman or man who's actually made that happen, that's when I get excited.

And then I think the last component, and there's a lot more we could talk about. We could fill a whole podcast just with this point alone, but we got to keep moving. So I'll just say that Robert Frost from one of his poems pulled a line and put it on his gravestone. And it's, "I had a lover's quarrel with the world." And I love that line. I always have, and I think that that often describes the best CEOs. They basically enter an industry, and they're like, "You know what, I tried to buy an engagement ring, and it was a pain. I didn't really know how to score the ring, and then they're always trying to say... You go into Tiffany or maybe your local jewelry... You just feel like your total information disadvantaged."

So Blue Nile was created out of that, a company that wasn't a great stock. It was brought out a few years ago. It was like one of those 10 year holds that wasn't rewarding for me, but it's a simple story of somebody had a bad experience and thought they could create something better. And that happens over and over again. I mean, Netflix in a lot of ways was created out of a hatred of Blockbuster late fees. Those of us who were paying those back in the day can relate to that.

So people who have a lover's quarrel, in this case not with the world but specifically with their industry. So they're reformers, but they have often a better business model, product, or service, and these are the people that are awesome that we want to own stock in. So yes, you're owning the jockey a lot of the time when you take this approach to investing.

Patrick: [00:24:04] The second piece of that second criteria is smart backing. Can you describe what you mean by smart backing?

David: [00:24:10] Absolutely. So certainly where our money comes from matters. While I don't spend a lot of time in the venture capital world, there are various firms and people that I respect. Pretty sure Patrick, you know a lot more people in that world than I do. So this is not something that I would describe myself as authoritative about, but I do respect, for example, Kleiner Perkins, the great Silicon Valley venture cap firm or somebody like Marc Andreessen. I think these are really bright people. So when I hear that money to fund our visionary entrepreneur is coming from somebody that I respect or a firm whose name I recognize, then that's also a great indicator.

And usually it's true that the Facebooks of the world get venture capital from some of the very best firms, and it's kind of becomes this self-fulfilling prophecy a little bit. By the way, it doesn't always work, otherwise everybody would enter the venture capital world and everyone would have their own startup. Turns out it fails the majority of the time as we well know. And out of all my stock picks that I mentioned, three a month now for 15 years or so, I think only about half of them have beaten the market. And I premise everything I do on beating the market, but the good news is the ones that beat the market, as you well know, wipe out actually in full, just a few picks wipe out all of my losers taken together. So this is a really important mathematical point that a lot of people miss.

But yeah, venture cap, baby.

Patrick: [00:25:29] This is one of my favorite little nuggets of quantitative research, which is that when you look at public market stock returns, the best returns come from stocks that begin their run in the most expensive statistical bucket. But the most expensive statistical bucket as a group is by far the worst performer. So the-

David: [00:25:50] Beautiful. I didn't know that, but I get it.

Patrick: [00:25:52] The notion of diamonds in the rough really does hold true here, and a big reason why that is true is because of some points that you've already made, which is that typically these companies are in very competitive industry and the amount of change makes sustainable competitive advantage very difficult. Which brings us to the third point, which is competitive advantage. So given that your dealing often in these emergent industries, companies run by visionary leaders, as we've already described, how do you think about moat, about sustainable competitive advantage given the high degree of competition versus say a See's Candy that you mentioned earlier that Buffett... Where it never changes. It's the same candy as it was decades ago. So how do you think about handicapping or evaluating a company's competitive advantages?

David: [00:26:42] So first of all, I don't have any numerical way of doing this. I'm sure we could probably develop a system, and I wouldn't be surprised if it could happen. Maybe O'Shaughnessy's already done it or has thought about it.

Patrick: [00:26:53] Tried.

David: [00:26:53] So you can create proxies for things and invent a scoring system. I've done that for risk, for evaluating the risk of a stock. I've created my own 25 point system, and we talk about some other time. So I like that kind of approach, but I haven't actually done it for sustainable advantage. But what I do look for are some key attributes or traits that I think are powerful in creating sustainable advantage. I think we've already identified a few of them just in the first few traits we've talked about because when you are the top dog and first mover, there's a huge amount of momentum behind you. And everyone's playing catch up, which is what we're seeing with Tesla right now. Everyone's got an electric car it seems like, and I think that's pretty great. In the same way I think that Starbucks has helped a lot of coffee houses by popularizing the concept of a coffee house. Our local one hasn't been put out of business by Starbucks. Seems like they're doing pretty well over there at Misha's in Alexandria, Virginia.

So you have to understand that just being the top dog and first mover in important emerging industry... When you're Amazon, everyone's trying to figure out what to do now. So that's often very sustainable, much more so than we think. But other examples of sustainable advantage for me, I mean, brand name. I mean, the great thing about See's Candies is it's See's Candies.

In New York City a while ago, I was trying to get orange juice. So I just opened up the random 7Eleven wherever it was, somewhere in the city a few years ago. I can't even remember. But open it up and I just grabbed an orange juice and bough it. And then I checked myself as I walked out the door. I was like, "It's really interesting. I just picked out Tropicana." And I was like, "Let me go back briefly to that fridge and just see what was there." And right next to Tropicana, there was something called Just Pikt. P-I-K-T. Which maybe in the south I hear might be a company that's been around for awhile, but for me it was a brand that meant nothing. So I just reflectively, mechanically picked out Tropicana because it was a brand I recognized.

So when you create a brand and a brand association with people, that is deep. In this choice filled world where now we have so many choices of just toothpaste... I mean, there's so many different ways just to get toothpaste. It used to be just Crest or Colgate from my standpoint, but now it's like would you like whitening or tarter control or this... Or by the way, would you like the tube, the pump. You go into the toothpaste section, there's like 95 different skews for toothpaste, and that's just one quick decision that we're supposed to make a Safeway let's say. So just think about all those choices out there and therefore how powerful brands are to give you the shortcut. Keep your life simple. As long as you like the brand, you trust it. So that's another example.

And then maybe one final one is... There's so many, but how about that you have Jeff Bezos, that you have Reed Hastings. We don't. So we just talked about buried in that previous attribute of great visionary leadership, and I love it when the world starts betting against them. That's a really big thing. So if you think about Tesla being barred from selling its car in various states around our nation. I would say states that have not done themselves proud by saying, "It's illegal for you to have a showroom in our state to sell your product." Think about that. In a pretty enlightened capitalistic world that we live in today how shocking that is that a made in America car that is a beautiful product, that has basically been named the safest car of all time, that performs amazing. It's illegal to sell it. It was a few years ago in the state of North Carolina and some others too. So that is also a beautiful sign of competitive advantage because it means that people are trying to stop the man. The man in this case was Tesla, and the car dealers are trying to prevent that. And I would say that kind of pathetic-

Patrick: [00:30:33] Good sign of disruption.

David: [00:30:34] Yeah, efforts through corona capitalism to seal out competitors will never work. It never does work, and it's usually a great sign as well. So these are all sustainable competitive advantages in ways that maybe wouldn't be textbook.

The Motley Fool

Patrick: [00:30:47] Given out intimately related it is for you, I want to push on that concept of brand by kind of turning it around and talking less as an investor, more as an entrepreneur about The Motley Fool itself. So talk about to what extent it has been deliberate the development of that brand. What do you try to foster in the brand of The Motley Fool over the years?

David: [00:31:09] So I think when we first started, I picked the name out of a book of quotations to figure out what to call the newsletter for our parent's friends, which is how The Motley Fool started in 1993. A newsletter for our parent's friends. It was for anybody but only our parent's friends would actually pay us $48 a year.

Patrick: [00:31:23] So I want to get into even more detail here. So where were you? It's you and your brother. How did the original idea... What is the moment of conception for this idea?

David: [00:31:32] Okay, I appreciate that. So I had just quit the only job that I've ever had because I don't consider what I do today a job. I love what I do. So I had a brief stint at a financial newsletter in Alexandria, Virginia. It was writing for Louis Rukeyser who at the time-

Patrick: [00:31:47] Big name.

David: [00:31:47] Yeah, big name. Was very successful Wall Street week television show on PBS. The longest running show on PBS. I didn't actually work directly with Rukeyser. He lived in Greenwich, but we were in Alexandria doing the newsletter for him. And as it turns out, it was kind of a deadening culture. It doesn't reflect on Rukeyser, but I just didn't like the job at all. And I'd waited a couple years after college to go get a job in the first place and gotten married, and the reason I could get away with that trick is because my dad had invested for me when I was zero. And when I turned 18, he said, "Here you go, David," and my brother Tom and my sister Maggie. "This is all you're ever getting from me. Anything else that I have left when I die is going to your kids." Skip a generation. "So I taught you about the stock market. Don't screw up." So at the age of 18, I managed to get my own portfolio, and good news, he done well enough that I had a measure of independence relative to my peers as I graduated college. I didn't have to go right out and get a job.

But ultimately I married. I wanted to get a job. I take this job at the age of 25. I then quit the job after eight months saying I don't want to keep working there. So in my mind, I'm now technically unemployable because I've only had one job. I held it down for less than a year. I started when I was an odd duck at the age of 25. So my brother's friend Erik Reidholm … Tom and Erik went to Brown University together. Tom's two years younger than I am. Erik was a sports producer at a television station in Washington DC. And he said, "Dave, I heard you just quit your job. Listen, I went to Brown. I'm from a very wonderful family. I have a great job. I don't know the first thing about the stock market. I never really learned it at all. Could I come over one night and you just teach me what you know about stocks?" So we did it for one night at my house in Alexandria, Virginia, and then he's like... We didn't get through it, so he's like, "Can I come back the next night?" So we did that.

And then at the end of that second night, he's like, "Okay. I get it. I really like it. I'm going to start. Why don't we start our own newsletter? You just left a financial newsletter. Your brother Tom, my good friend Tom is in Montana at graduate school. He can write some. I'll do some. We'll start a newsletter." And so that night I started flipping through a book of quotations going, "Okay. What are we going to call it? What are we going..." The Penguin Book of Quotations. Act two, scene seven of As You Like it, Shakespeare's wonderful best scene in Shakespeare about fools. "A fool, a fool. I see a fool of the forest, a motley fool." And that phrase having studied as an English major, Shakespeare in college, I was like, "Love that phrase now that I think about it."

It's a great position to be coming from because we're going to make mistakes. As entrepreneurs, as stock pickers, it'll never end. We'll screw up. So at least we told you ahead of time we're fools. We didn't take ourselves so seriously. At the same time, when you do succeed, it's kind of fun because you can go, "Well, there's other wise guys. But we're fools." So that's the origin story of the company. I guess I should just advance a little bit. I know this is not an entrepreneur focus-

Patrick: [00:34:25] Oh, it is. It's everything.

David: [00:34:26] You're right.

Patrick: [00:34:26] So let's get into it.

David: [00:34:27] Okay. All right. So we started the newsletter for our parent's friends. About a few months in, turns out I was starting to use the online medium at the time, which was not the World Wide Web. The phrase World Wide Web was not in currency at all.

Patrick: [00:34:43] It's like CompuServe.

David: [00:34:44] Yeah. It was CompuServe, America Online, and Prodigy. And I know people who are older than I am, I'm 51, already know this. But I hope you're listening to Patrick's podcast at the age of 21 because that is so awesome to get started compounding returns early. So for younger listeners, you may not know that you used your telephone to dial up servers somewhere in the neighborhood, and your computer would be attached to the telephone. And all of a sudden you'd be online.

What I found fascinating about it as a writer is that you could write something, think of it as a discussion board post today, a forums post, and other people would read it. They would react to it. That was magic for me. I had been a freelance writer or tried to the couple years after college, and was used to getting slammed all the time and never approved. I didn't even know if they were reading my stuff, but I would dial in online in Charlottesville, Virginia where my wife was in grad school and we're in first year of marriage. Dial in and just see, "Wow. It's called an online BBS, a bulletin board system." And people ready my thing, and they liked it or didn't like it or thought this. So I was fascinated by that medium.

So basically, Patrick, we were starting to use the medium more than we cared about our paper newsletter, and we were using specifically America Online and Prodigy. Without going too deep, we basically pulled an April Fools joke on Prodigy, which at the time was IBM and Sear's co-owned online service. A private service you'd pay a subscription to. Actually, I think it was free. Whereas you would pay AOL like $4 an hour. But anyway, we played a practical joke because there was a huge pump and dump penny stock scam scheme going on on Prodigy, and we didn't like that at all. So we decided that we would lampoon it by creating our own hypster with a made up stock on a made up exchange and hype it for a few days, specifically over a weekend so people couldn't see whether the stock was trading or not since it didn't actually exist. And it was a pretty hilarious story. It ended up getting picked up on the Wall Street Journal on the front of the second section where there's a funny article in the bottom left over the years. So we're written up there an a couple other places.

And then America Online starts going, "Hey, these are the guys who are just our paying customers over in the finance, and they have this thing called The Motley Fool. It just got written up in the Wall Street Journal."

Patrick: [00:36:54] Amazing.

David: [00:36:55] So they said, "Let's go have lunch." It happens that America Online was based at the time in Northern Virginia, and I grew up in Washington DC and that's where we were in Alexandria. So went and had lunch, opened up Keyword Fool later that summer, August 4th of 1994. It was not fool.com back then because the internet didn't exist. And I could talk more about how we got written up in the Talk of the Town in the New Yorker about a month later. So now Simon and Schuster came to us and said, "Would you like to start a book?" We started a radio show. All these kinds of things that grew out. This is all a really long, shaggy dog answer to the brand and what The Fool means.

What I want to say is what The Fool meant back then, and it's evolved a little bit over time, but the heart and soul is still there. It's still in Shakespeare, it always will be far after I'm gone from this planet. But finding conventional wisdom. I don't like conventional wisdom. I like conventional wisdom when it's right, but I really love when it's not right and we take a rule breaker-y approach. Rule breaker-y. Rule breaker-y approach and start to realize the incredible value of not paying attention to the conventional, was not following the rules of everybody else is, and getting outsized returns as a consequence. And I'm not just talking about in terms of stock market returns, although that can happen. You can get outsized returns in life by taking a different approach or as an entrepreneur by taking a different approach. So that's what foolishness is.

I would say also that we were a very anti-Wall Street at the time. The Motley Fool's Main Street, and then there's Wall Street. And there were good reasons to be anti-Wall Street. Things like high commissions from firms that don't even publish their commission schedules. Brokers turning people's accounts. A lot of things have been cleans up and improved. Back then you couldn't even listen to the quarterly earnings conference call for public companies. You were barred. Only Wall Street got to ask questions of the CO or even listen. We mounted a call-in campaign against Starbucks to say, "Please open up your call. As shareholders, we're technically part owners of our company. Could we listen to Howard Schultz give his spiel with his CFO at the start and then answer questions. Might we be allowed humbly to do that?"

So those absurd to us, absurd things were happening back then. The world has improved a lot today. So I don't think you're going to find The Motley Fool kind of anti-Wall Street per se because I would say that even though 2008, '09 happened and there's still a lot of things broken in the financial world. It's amazing how much companies like Wells Fargo are paying in fines for bad things that they've done. But I don't think that there's as much gusto there for our brand these days, but there always will be for fighting conventional wisdom in whatever form it takes.

Patrick: [00:39:27] There's a very specific part of what you do that I want to dive in a bit on which is writing. I've heard many people say that good investing is often very much like good journalism. That doing research, collecting those thoughts, trying to bring them together into a narrative, a story, an understanding of some stock or industry is a great way to think about markets. Talk about writing, what it means to you, and maybe the ways in which you've gotten better at it since the founding in 1993.

David: [00:39:54] Well, thank you. And I know I'm speaking to a writer. And Jim O'Shaughnessy has written a wonderful book, as we're all well aware. So I know about the power of the word, and I was an English major going back to my University of North Carolina-Chapel Hill undergrad degree, the only degree I'll ever have. But I just think that words are so important. So I was a freelance writer coming out of college, and I did get a couple things published on baseball statistics at the time. And back then the conventional wisdom was things like batting average is the best way to score a batter, and that was the ubiquitous number that you'd see everywhere. And I was a big early Bill James fan for those who care about baseball or might know Money Ball. So I got a couple pieces published basically just supporting James in a couple Random House Doubleday books because I loved that.

But at a certain point, I started to realize the baseball world is kind of a tough nut to crack. Whereas I could instead develop my energies in future to the stock market because the beauty of the stock market is we can all get down on the field ourselves. And we can step up to bat, and we can pick stocks. And we can score our wins and our losses, and we can see whether we beat Fidelity Magellan last year or the S&P 500. Nobody has to green light your way into the world, which would be the case of baseball. If you want to be a general manager or the beat writer for the New York Yankees. No. You can actually just go down and play the game right there yourself. So I started to devote all of my effort and focus toward the stock market.

We've written a number of books over the years. I guess part of the reason why I'm in New York City this week is because we're promoting The Motley Fool Investment Guide, which you were very kind to mention. I mean, it's not a make or break deal for our business today. We're a much different business than when we started. Turns out as I know you know but a lot of the world doesn't, when a book's published, the publisher takes about 80 or 85% of the money. So it's really their product, and in this case, it's our revised addition, which I'm so happy. We're now at 2017-18 book again. First time in 12 years. I was almost embarrassed when people would pick up The Motley Fool Investment Guide two years ago because it's so dated. So now it's fresh and written for today. It's only like 12 bucks. We make like two bucks.

But really, to round out the question, Patrick, I have written essays over the years for Motley Fool Stock Advisor and Rule Breakers for more than 12 years writing the opening essay. 450 words. I would usually try to pick a theme or come up with a new idea or group of stocks or whatever, and I would just write. And I think we think as we write. We write to think, and I'm happy to say we've had some wonderful writers that have come out of The Motley Fool over the years. I know you've had Morgan Housel. Before Morgan is somebody that we worked with from early on and for a long time. Another great journalist before Morgan who was at The Fool was Jim Surowiecki who wrote-

Patrick: [00:42:41] Oh wow. I didn't know that.

David: [00:42:42] … Wisdom In The Crowds, and happened to me by-

Patrick: [00:42:44] I know him well.

David: [00:42:44] … happened to be my North Carolina friend. We were both Morehead scholars at the University of North Carolina. He's in my class. So when it came time to start The Motley Fool online, I hired Jim because Jim's so bright, as you well know. So these are people that are deeply able to use words to express, in this case, business and investing insights. And a lot of the time business and investing in particular have jargon. Whether it's talking about what return on equity is or some crazy phrase like FANG more recently. Whether it's business or investing, there's a lot of jargon out there. So people who can cut through jargon, who use plan English and who use it well, I will always have a heart for. And I definitely try to do that myself.

Criteria Continued

Patrick: [00:43:29] My favorite conversations are when we stray far from our original list, which we just did. But I will bring us back. So there's two criteria left that we haven't discussed. One of them is effectively price momentum. The way you phrased it in the book is stocks that have already done extremely well, which again sort of like your point about loving when people say it's really over valued. It's kind of another angle on that same thing. So talk about that notion of focusing on companies that have momentum behind their back.

David: [00:43:56] So I think the worst phrase ever invented for the stock market and for advice and for investors is buy low, sell high. And here again, we have some conventional wisdom. So I don't have my belled cap on today. I certainly could have brought it. If you insisted, I'd do so, Patrick. I have a bunch of them. But I'm definitely shaking my jester bells here at the phrase buy low, sell high. It's conventional wisdom I don't like.

First of all, the idea of buying low causes many people, most people in my experience to think that you need to look at the 52 week lows, not the 52 week highs when it comes to selecting your next stock or to wait for the dip. A phrase that I've lampooned before, one of my essays that I've enjoyed republishing occasionally is dips, buy on dips. Waiting for the dip is so silly to me. It's like I'm waiting for a statistical study. Maybe Matt Batnick or somebody can do this because I'd be really curious. The assumption is when a stock dips, it's about to rise or when it's risen, it's about to drop. And I would challenge that assumption. I'd be interested at least for the ruler breakers, which is what I've focused on. When a stock makes a 10% gain, I wouldn't be surprised if it turns out it's much more likely to make another 10% gain.

Patrick: [00:45:13] Oh, for sure.

David: [00:45:14] Then not. But most people don't get that. So they're looking to buy low. They're looking for the value stock, another phrase I don't like. I don't like phrases value investing, growth investing. I don't use that myself. I also, by the way, I believe that the phrase long-term investing is a tautology because I believe that investing is by nature long-term. So if you ever hear me, this is one of the things on my podcast or on a media interview like this or anytime if you ever hear me say the phrase long-term investor or long-term investing, you're allowed to give me a dead arm because I didn't mean to say it because I don't think we should be saying it because the opposite of investing is trading and that's short term.

But investing, which comes from the Latin investire comes from the root to put on the clothes of, which means that to me investing is like putting on that home jersey that people do at sports games. They got their New York Rangers jersey. They've got their Yankees jersey. They're wearing the home team colors, and you don't change that shirt just because you had a bad day, week, or month. You stay by your team. Very similar for what I call investing, the way we should behave with our capital. So to put on the clothes of is right there baked in the word invest and investing.

Pull me back here. Pull me back, Patrick, because I'm losing my initial thread. Right, right, right.

So buy low, sell high. All right. What else is horrible about that phrase? Sell. Right away as soon as you bought low, it has you thinking, "Okay. When do I sell? What's my target price? I need to have..." And this is another, as long as we're going to have fun as people who love words and just attack conventional wisdom. I'm going to go after the phrase sell discipline. There's a lot of people will say, "What's your sell discipline?" I always love that because first of all, very few people ever say buy discipline. And frankly buying is so much more important than selling. And the idea is that you're really disciplined because you have a sell approach, and I guess that sounds good if you're a financial planner or broker and you got your suit on and you're talking about your firm and your Saab. You got to sell discipline. But for me, the sell discipline is don't sell. If you want to be disciplined and successful as an investor, I have a buy discipline.

So buy low, sell high, and high sounds good. That's the one-

Patrick: [00:47:22] You're with us on that one.

David: [00:47:22] … of the four words that I'll say. But unfortunately it was shot full of holes through the first three words. So strong past price appreciation in my experience, this is not just true of investing. It's also true of business. It's also true of life. The winners keep on winning. In fact, if we're just going to keep tar and feathering phrases that I don't like.

Patrick: [00:47:45] Let's do it.

David: [00:47:45] Thank you. You're open to it. I appreciate it. I mean, I don't really like the phrase the rich get richer because it causes invidious distinctions as if it was wrong. Of course the rich get richer. You're rich if you have capital. You don't have to have a ton of capital. I know people who are way, way richer than I am. But turns out when the stock market rises 10% a year, when capitalism lifts all boats over time, of course everyone gets richer. The poor get richer too. People these days who are below the poverty line in the US, as often pointed out, have things like a refrigerator. Technology that didn't even exist 115 years ago.

So we have to understand that, to take it back to strong past price appreciation, I think the winners keep on winning, and this is a powerful thing that a lot of people don't get. I think they think that the stock market is like a parabola. So it goes up and it's going to come down. So you better sell high before it goes low again. But no, look at the graph of the DOW Jones industrial average over the last century. Looks more like a hyperbola to my fifth grade math eyes than a parabola.

So understand that typically the winners keep on winning. There's the Isaac Newton, I think it's the second law of thermodynamic motion, but it's basically objects that are at rest will tend to stay at rest and objects in motion will tend to stay in motion. And I believe that's true of the stocks. If you just look at, we talked maybe over two hours ago now at the start of our podcast about Nvidia going from six to 40 to five to 28 and now... Now look at the chart of Nvidia since 2005 when I first picked it at six. You don't see any of those ups and downs. It actually just looks like this big swooping hyperbola upward in the last two years.

Anyway, so I believe that, and I know we're going to go to the final attribute shortly, and a key part of this is that these things all hang together.

Patrick: [00:49:36] Sure.

David: [00:49:37] So if you isolate any one of them, it may not be great advice. For example, we all know that sometimes strong past appreciation doesn't work. We can look at any number of examples where things drop over time after they rose. And I have a lot of those stocks too unfortunately. So it's more when you take these six in concert that I think you find some of the best investments of our time, and build your FANG score.

Patrick: [00:50:01] Love it. So the last one we've hinted at a few times, but it's effectively that you love when people are saying statistically this is incredibly over valued. And it ties to another, a great line in the book. I think it was in the book. I just got it in my notes, which is something like a rule breaker test, which is, "If a company disappeared over night, would anyone care or notice?" And I've liked that little litmus test for everything. We were talking before the podcast about business, investing, and life being the kind of three areas of interest for you, which is exactly the same for me. You can kind of apply that to everything. And if the answer's no, well maybe you shouldn't invest there. Maybe you shouldn't do it. So talk about, there might be a tenuous or loose connection between those two ideas, but for whatever reason those two kind of hung together for me. This notion of is something valuable to people if it disappeared, would it be bad, and this notion of everyone's saying it's over valued.

David: [00:50:56] So I call that, the phrase that I use for what you just described is the snap test. So you snap your fingers, and instantly over night something disappeared. Did anyone notice? Did anyone care? So I think that if we snapped our fingers for a number of the companies that we've talked about over the last two and a half hours, we would be like, "Yeah, -"

Patrick: [00:51:17] Really only 51 minutes in.

David: [00:51:18] That's pretty awesome, by the way. That's good. So I think everyone would notice if Amazon disappeared. So that's a huge buy indicator for you and for me. Again, assuming we're investors, which by definition is over the long-term. If something is that deeply ingrained in us and just thread through not just our neighborhood or our country but the world, I think we want to own that for a long period of time.

Patrick: [00:51:46] Now that I'm thinking about it live, it's one of my favorite super condensed versions of a test for a moat. So people always talk, there's a lot of different dimensions of moat. I've talked about it with some really part people. We've already talked about brands, switching costs, things like this, network effects, et cetera. But kind of all of those things the snap test applies. That if you could just pull something out and very easily replace it for whatever function it fulfills -

David: [00:52:12] Fungibility.

Patrick: [00:52:13] Fungibility. That's probably not a good thing. Unless, from my perspective, it's like a deep value stock, which empirically tend to do, can do very well. But I love that snap test, and it does seem to pair quite nicely with this notion of over valued because alpha if you will or strong investing returns is all about getting something more right than the market has discounted. And it seems like the problem amongst these more exciting, I'll call them growth stocks. I know you don't like the term, but they certainly grow fast. So maybe the term is okay. Is that all of those names you've mentioned have spent almost their entire public market history over valued or in that very expensive category. So that's talking about bucking conventional wisdom, I think that definitely qualifies.

David: [00:52:58] They're like three or four different directions I want to go right now. So pull me in, but I guess one thing I want to say is I love the snap test. In fact, in our Motley Fool Rule Breakers, Rule Makers, a book we wrote more than a decade ago. I wrote the Rule Breakers section. My brother wrote the Rule Makers section. But I think that I quoted Glendower, one of Shakespeare's thunderous characters who at one point says, "I say the Earth did shake when I was born." And he's kind of bragging. I use that phrase to say those are the rule breakers. The Earth does shake when they're born. When Facebook is born, you may not have noticed it really at the time, but really the Earth did shake. And now think about how it really is shaking the Earth with two billion people using Facebook every day or every month, whatever their numbers are.

I also want to say about the snap test that it doesn't always work. Anything we've talked about doesn't always work. I keep waiting for one of my failed stock picks to do better. Twitter. For me, if you snap your fingers and Twitter disappeared tonight...

Patrick: [00:53:58] That's a huge problem.

David: [00:53:59] I think the world would notice. And yet, it hasn't worked very well. And there are other factors, of course. One of my big things in life is context and understanding when context is different from one thing to another. So a weakness of a rules based approach that any of us might practice can be when context kind of makes it clear to you that maybe you shouldn't have applied the rule or that attribute in that particular context because of other factors that a simple system might miss. So let's not talk about Twitter, but I did want to point that out as one of many examples of the failure the other side of the coin when it doesn't work for me and for the snap test, I point to Twitter.

Again, the story's not over. So I remain long. You've already heard. I tend not to sell. So we'll see how Twitter plays out.

But let's get back to over valued. So over valued is probably the most rule breaker attribute of all. I did say the first one, top dog and first mover's maybe the most powerful or important, but the real special sauce... If there's any magic that I brought to the world when Earth shook in a much less meaningful way when I was born, I think it might be that I realized how beautiful the conventional wisdom of over valued could help an investor, an individual investor like me.

So there are two dynamics I want to speak along. The first is what over valued even means, and the second is why this works so well for rule breakers. So the first one is basically what is over valued? How do we establish value? How do we all agree on the certain valuation techniques or attributes that we deem to be the proper way to value and therefore there are over and under valued things. I grew up with a dad who weaned me on the stock market. I already talked about that, and Value Line, we would subscribe to. So I grew up in the big, black tomb of Value Line, and they always had their timeliness ratings for the stocks. And I think Value Line proudly will say that those ratings have beaten the market over the course of time. But my dad always encouraged me not to really pay attention to the timeliness. But he did teach me things like price to earnings ratio, price to sales ratio, other ways of valuing stocks, how much cash is on the balance sheet, debt to equity, these kinds of things.

But as I started to age more than anything, as I started to pick stocks online in front of people who came to AOL and then the web and followed what I said and did, and then in time actually paid me because early on The Motley Fool was a free site. We were free, and that almost sunk us as a business. But once people are really following you, it's incumbent upon you to learn and to figure out what works best and to change and evolve and adapt over the course of time.

So I started to realize... I'll give my quick classic example for me. Yahoo. Back in the day when Yahoo was an amazing company and a golden stock, I had it calculated to be worth something like $25.62. And at the time, it was trading at 29. So I said well, Yahoo is "over valued" and when it hits 25, I will buy the stock. It never did hit 25. Split adjusted. It in effect went from 29 to approximately 1000. That wasn't the first time I had seen that. It had happened to me a few times before that, and I determined at that point I am never going to do that again. That is ridiculous. And it was over valued because I had my classic, traditional valuation technique.

And I don't want to talk anymore about Yahoo. I want to move on to the more important points. But what is establishing the proper way to value things, and the key insight that I've had is that most valuation techniques are numerical, based on relationships, on the financial statements of companies, and involve ratios and comparing those against other such companies. That's the heart of the way valuation is often taught.

Again, I'm an English major, so I never got an MBA or anything. Certainly won't ever have a CFA. So maybe I'm wrong about this these days, but in my experience-

Patrick: [00:58:08] You're right.

David: [00:58:09] … people are doing it that way. But my key insight is all the really important things that determine what wins in business, not all, many of those things are not captured on the financial statements. Few quick examples. Redundant with some things we've already said. Where's Jeff Bezos on the financial statements of Amazon? Where's competitive advantage, sustainable competitive advantage? Where's the number for that that I can do a ratio off of? Is there an assumption that all CEOs add value, or are some CEOs subtractors? Should you be docking numbers on the statements if that CEO's the CEO as opposed to that other CEO as the CEO?

Maybe most important of all, and what I would say is the single defining word for my approach to investing-innovation. Who's innovating? And by the way, where is that captured on the balance sheet or the cashflow statements? I'll throw out one more, which is very important to The Motley Fool as well, culture. Do people like to work with this company? Do people love to work at this company, or is there a very high turnover? Are people flaming their company? Do people say they hate their company?

My brother has done some great work in this area, and the way Tom often puts it is when you look at corporate America and you think of a canoe with 10 paddlers and the canoe is a company and the paddlers the employers and these are the ratios of employers, approximately three and 10 are paddling forward. About four or five or six are just sitting there. And one or two are in the back paddling backward. And that's average corporate America.

By the way, corporate America's better than a lot of other corporate blanks if you look at other countries in the world. It is hugely powerful when you actually have seven people paddling forward and no one paddling backward. So where is that captured on the earnings, cashflow, or balance sheet statement?

So the key insight I think, Patrick, is that all the things that really matter, there's no number for them. Instead, people are using what they can do ratios off of, and then build trading algorithms off on top of that. And they're totally missing, and I know this as an entrepreneur, they're totally missing how important the vision and the CEO is. The culture of the company, can it innovate or not, et cetera. And in a world where everybody wants to plug numbers into their spreadsheets and then start automating stuff, it's amazing. You said earlier, one of the great edges left to us is being long-term. I agree with that. And I also think that one of the great edges left to us, or at least some of us, is that you actually use the right side of your brain or you look at the other side of things. In this case, qualitative, not quantitative, and it's much easier to do if you're an entrepreneur and you're actually living that and doing that yourself.

So I said that there are two angles I wanted to do over valued, and that's one of them that all of the metrics that people are using are missing the most important things that actually determine who wins over time.

Patrick: [01:01:17] I would love to get one example, and I'll just let you pick the company. Morgan told me to ask you about Netflix, but you can choose Netflix or anything else.

David: [01:01:25] Okay.

David's Stock Evaluation Process

Patrick: [01:01:26] To describe your actual process. So you're sitting outside of DC in an office, what are you actually doing? What is the process that you use to find a stock that you want to explore? When you find one, what do you actually physically doing with your time that ultimately leads to that buy discipline that's so important? And told through the example of any stock of your choosing I think would be a fascinating kind of final window in our conversation into your process.

David: [01:01:55] Okay. So let's go with Netflix. I mean, the reason it's good to go with an example is because there's not a single process. There are probably three big buckets that I pull my ideas from. One is my own use of things, classic Peter Lynch.

Patrick: [01:02:08] Peter Lynch style.

David: [01:02:09] And the good news for me is that I tend to be an early adopter type. So I buy lots of gadgets that I end up having a closet that didn't end up working out. But the ones that do are big. So as I said earlier, my aim is to kind of get ahead of the mainstream and use my own tendency to buy stuff and use stuff as a proxy for people once they figure it out after. And by the way, I'm always behind all the bleeding edge people. There are people in Silicone Valley right now building stuff that I won't even hear about for three years, but if it comes public and I research it as a stock, often most people haven't at that point tried Netflix yet. So that's a big bucket where I get it.

Another big bucket is our community, The Motley Fool. I mean, our discussion boards, we have a site called The Motley Fool Caps where people have come on and rate stocks themselves. And how many ideas do I get from that? I mean, it's just tremendous or just discussion board postings. We built up a community online with our discussion boards of tens of thousands of people over the course of time who talk about that they just went into Chipotle and it was empty or not. And so that kind of I guess scuttle butt boats on the ground research, the internet enabled, and we've harnessed that. And I've always used that. I've loved that. So those are ones that don't come from me. Those are ideas I've never heard of before but I've found out through some kind of community member at The Motley Fool.

And then probably the third bucket would be just looking at the world and saying, "Where are things going?" And holding my finger up. So for example, the internet of things, as a recent example, that's like a really important thing to me. So while I didn't have personal experience with it and I'm now seeing somebody on our discussion boards talk about it, I started saying, "That seems really big. Machines talking to machines. Let's get involved in that."

So the process, in this particular case, Netflix was me doing the first of those three. Me trying out the service. In fact, I got to hear... I was at an Allen and Company, the investment bank, conference years ago and saw Reed Hastings speak. And I got up and asked him the skeptical question of, "Really? Are people really going to do this with DVDs, mail them in?" And he was like, "Yes." And then I found that I was within a year or two of that. Twitter, really? 140 characters. You can build a whole platform? Turns out, yes. And while it hasn't been a great stock, it's been amazing business -

Patrick: [01:04:21] Sure.

David: [01:04:21] … entrepreneurship that made that happen. And then what I do is I assign that to one of my analysts. I have supporting analysts in each of those two services: Motley Fools Stock Advisor, Motley Fool Rule Breakers. I have five analysts on each team. And if you were one of them, and I'd be honored if you ever were, but we'll never be able to afford you, Patrick. But if you were, I'd say, "Patrick, could you write me up Netflix?" And I'd design my own template of how I want you to research this stock, which might not look like how Value Line would present. So you know that as one of my analysts, so you conform to that and submit it. I've also sent four others to four other analysts each month. So I take in all five. And then I just kind of read them through, and I make comments. And I share them back with you at the end of the month. I'm like, "Patrick, I really liked your work on Netflix. I appreciate it. I think we're going to go for this one."

There's probably far more focus on the business and the competition than there is on the valuation, for example. Very, very business focused. I generally believe that the markets are pretty efficient. I don't think that you're sitting out there seeing things mispriced. I think it's actually arrogant to sit there and say, "Actually, that stock is worth $47.69 and right now it's trading at $38.34." I just think that's silly. I think that the markets are too dynamic and smart to sit there and let something be dramatically mispriced by $11 right now. Because instantly if that were true, buyers would be coming in and buying that up to the price that... No, buyers and sellers every day are shaking hands right now as we speak on the prices of companies. I don't sit there saying they're wrong. I'm right. I'm a value stock guy and this is the target price that I have. I'm much more right now we can buy some of this business. Let's look five, 10 years forward. Is this going to be big? Are we going to be really happy that we bought Yahoo at 29? Overpaying for that over valued stock. And turns out when we are, we're right enough that it's dramatically more competing, and we rack up lots of alphas.

So Netflix, and I'm not even sure I did a good job answering your question. But that's an example for me. And it's all about buy discipline, and it's then about just holding and holding through quackster. Buying before streaming was a thing and thinking about are we the top dog and first mover in streaming and lots of other factors. So Netflix, I bought in 2004 and I've held it ever since. It's been just an absolute, huge winner. It tapped over the 100 bagger mark for Motley Fool Stock Advisor last month. So members who bought and have held, and I wish everybody did, and sometimes they don't. But they're really happy. There's a lot more prosperity as a consequence.

And I always say for any great stock pick, while you and I might be stock pickers, good for us. The truth is we can never have great stocks without great companies, and you'll never have great companies without great entrepreneurs and ideas, risk takers, rule breakers. So there's always sitting from a humble position, any stock picker I think saying, "Thank God I lived during a time when Amazon existed, Netflix did, Facebook," the list goes on. Pinch yourself that we had the opportunity to actually, as public market investors, you didn't have to be off in the VC sellout when we buy Netflix as it comes public.

And I sense we're probably wrapping up, but I think you may want... But I guess I wanted to just briefly speak to over valuation if I can just as it all hangs together. This is kind of a concluding thought for me. Of course, we can keep going. I'm having a lot of fun. But I did want to say that earlier I said you have to take these rule breaker attributes, which we've gone over. You have to take them in concert together, and once you do, you see how beautiful over valued really is. Because if you can find the top dog and first mover in an important emerging industry with the sustainable competitive advantage, smart leadership, visionary leadership, smart backing that has strong past price appreciation, and a strong brand; if you can find all five of those things and somebody on the staff of Barron's is putting on the cover that this stock is over valued, that is such a beautiful buy sign. Because you basically found one of the great companies of your time, and when people say over valued and say Amazon. Bomb on the cover, I guess I saw a Netflix on the cover of something bearish. I don't actually read Barron's, but I love that it exists.

And by the way, they get a lot of things right. But rule breakers, my experience, the Alan Abelson's of the world and a lot of so-called, and I don't use the phrase much, value investors don't get these things. When they say in a big way that this thing is over valued, that keeps a lot of people on the sidelines. And so it creates that wall of worry where people don't want to buy at the start. But stock starts to go up a little bit, the company proves itself. Turns out people may mail their DVDs into this company, have a queue, and by the way, there are no late fees. And by the way, this company is so disruptive that it has a new business model. You're subscribing. You're not paying per movie or any late fees. You're fundamentally changing how people pay. And then one thing plays out. Slowly people start to believe and convert. They're like, "Well, I do like Netflix. I'll now buy the stock."

So over the course of time, that so-called over valued thing, which by the way, that was the single best indicator you could get to buy the stock in the first place. It proves its valuation. Indeed, it proves well beyond my wildest dreams in some cases of the valuations that these market caps of these companies get.

So the key is, again, if you can find those first five attributes present and then a journalist tells you that it is over valued or the world agrees, that is beautiful.

And by the way, if you and I sit down in front of these microphones a few years hence and it turns out everyone has agreed with me and believed and we're all now doing that, and I would say there's a lot more people who do believe that now than when I was doing it buying Netflix in 2004 or AOL, my first grade stock in 1994. Then I'll start to change my tune. We'll have to approach things differently. We'll have to evolve and adapt. If everybody believes in rule breakers, maybe I start going in different direction because that's ultimately...

My biggest passion in life beyond my family and my business that I haven't talked about, and we won't do it now, is board games. And some of the best strategy games, the way to win is by taking the approach that other people aren't. They're all competing for these resources but over here, you're just doing your own thing over here.

Patrick: [01:10:33] Can you give me an example within one of your favorite games?

David: [01:10:35] Sure. I mean, Agricola is one of the great board games of our time. Most people haven't heard of any of the board games that I talk about. Although if you are a geeky person like me, you're like a gamer, than you know Agricola. But this a very geeky crowd. By the way, my second favorite website-you know my favorite website-is boardgamegeek.com where people like me hang out and talk about games. But Agricola is a brilliant... It takes a couple hours to play. It's a farming game. So you have the O'Shaughnessy farms over cross the table from me. I have Gardner farms, and we got a few others. It plays two to five. And you have a hand of cards at the start of the game, and it has improvements that you could make to your farm. And it's set in 17th century. So there's simple things. It also has people that you can hire and bring on. It's a hand of cards, and there's about 300 to 400 cards. Every single one of them is unique, and you get dealt 14 at the start of every game. It gives you an opportunity throughout the game to play those or not, depending on whether you want to or not. So there's incredible replay ability to the game of Agricola.

Anyway, there's a bunch of different resources you're competing over. And if you start taking an approach and somebody else does, then I'm going to be well rewarded usually by taking a different approach.

So now to get back quickly to the stock market, if the world starts believing that breaking the rules and rule breakers are the way to go, then my reaction will be to start to change. However, I'm pretty confident that the world's not, at least in my lifetime, I'm 51, is not going got do that because I'm pretty sure most people don't want to take the risk of buying stocks that have already risen and then buying them some more or buying things that are over valued or early stage. It's just there are a lot of people who will, but there's too much human psychology that doesn't want to lose. As you well know, psychologists tells us the pain of loss is three times the joy of gain. And the beauty for investors like me is that the joy of gain is infinite times the pain of loss mathematically because the pain of loss at it's worst is minus 100%. But when Netflix tipped the scales at a 100 bagger, which means that it basically went up 10,000%, at that point... Or technically 9900%. At that point, that's so much bigger than a minus 100. It takes out about 90 minus 100s, and you're still pretty happy with that investment over the course of time.

So the math of it is that you're so rewarded for owning long and staying long all the time, and the worst thing that people live in fear of, people come to the Fool.com website, join our services. Their first stock goes down 10%, they're like... Some people are on the discussion where it's going, "Oh my gosh. I've lost money." And that really is hard. And I empathize with them because I understand that. But the reality is the worst you can ever do, and I've still never done that minus 100%. The best you can do, Priceline's an 80 bagger. Amazon's has gone from three to about 1000. It's about a 300 bagger. I mean, these things just absolutely wipe all the pain. So it reverses what psychologists know of our physiognomy, and that's why it works. I think it's going to be hard for humans to adjust that quickly in the next 25 years, at least I hope so.

Patrick: [01:13:46] I have so enjoyed this because people hear me talk a lot about this notion of blind spots, and everything we've talked about today is basically the one massive blind spot of the quantitative approach to investing, which by definition mostly has to live within price and financial statements. And there are certainly strategies that work extremely well there have historically and have in real time, but there's no way of seeing everything that we've talked about today. It's a great discussion of how there are many ways to approach markets, to approach investing, and that those things should very much suit the person's personality. Because just like you talked about, you can quantify culture. Culture lasts, so does character and personality, and therefore an investment strategy should fit that personality because then it will last through difficult times.

It brings me to my closing question, which is always my favorite that I ask everybody, which is to ask what the kindest thing that anyone has ever done for you is?

David: [01:14:43] I would probably say just that my father invested for me because it's lead to everything else that I've been able to do. So he was not an investor professionally himself. He was a lawyer. His dad had invested in the stock market, and he did. And he did very successfully. The Washington Post company. I grew up in Washington DC, that's where Tom and I were from, was a tremendous stock. He held it for a few decades. Warren Buffett was on the board. The Grand Family was a great company, and it was our hometown newspaper. But dad took the time to save money, a hard trick for many people, many Americans that do. And to forego spending that on something that he would've enjoyed and put it into a kid who is just born into his account and added to it over the course of years. And then didn't just build that, he then taught it and sat me down. While the other kids were playing whiffle ball, we're there going over Value Line and learning what a net profit margin is, which is a really great thing to know.

So kind, it's a beautiful word. It can mean many things. So maybe I can even think of better answers, but when I think of the effort that he made and how profound that was in my life and then how I've tried to magnify that through starting a company and then reaching as many people as we can about the stock market, I have to think of that as my knee jerk.

Patrick: [01:15:59] Fantastic. Well, this has been really one of the most enjoyable hours I've spent in some time. So thank you for your time, and I hope we can do it again in a couple years.

David: [01:16:07] I had a great time, Patrick. Thank you. Keep up the great work.

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