3 Ways to Better Growth Stocks

3 Ways to Better Growth Stocks
By Rick Aristotle Munarriz (TMFBreakerRick)

When David Gardner developed the now-popular Rule Breakers investing strategy in the 1990s, it wasn't very conventional. Placing a greater value on an innovative company's ability to create a disruptive technology over tried-and-true valuation metrics? Heresy! It was considered outrageous then, but it led David to unearth some lucrative diamonds in the rough like Starbucks (Nasdaq: SBUX) and Amazon.com (Nasdaq: AMZN), back when folks figured that no one would pay $3 for a cup of coffee or buy books online. People thought it was a crazy approach. Many will argue that it remains just as outrageous today, too.

So let's see whether I can demystify the process a little. I'll review what I consider to be the three keys to achieving superior market returns -- without having to whip out a calculator.

1. The toastier the sector, the prettier the Phoenix
Some of the greatest growth stocks have come from the most moribund of industries. Starbucks came out at a time when folks seemed perfectly happy forking over $0.49 for a cup of joe at Mickey D's. It turns out they wanted something more. Amazon launched its site when the public seemed perfectly content to leaf through books in gargantuan superstores. Turns out they were clamoring for something else then, too.

Show me an industry that appears to be running dry on inspiration, and I'll keep an eye out for a real gusher ready to break free. If there's a niche so out-of-favor that it's being neglected by the mainstream market-watchers, be on the lookout for a revolutionary investment.

2. Follow the product cycle, and keep going
When Apple Computer (Nasdaq: AAPL) rolled out the now-ubiquitous iPod five years ago, it didn't get a lot of credit. The stock didn't really start moving until a few years later, even though the iPod was becoming the "must-have" accessory in the portable consumer electronics space.

Traditional investors failed to see how a hit product could invigorate Apple in many ways. The iPod had lower gross margins than the company's flagship desktop and notebook business, but the brand's ubiquity resonated with users; when PC users needed to upgrade their systems, a Mac suddenly made perfect sense. Apple had spent the previous decade losing market share in the computing realm, but one smash-hit product in a somewhat unrelated field was enough to reverse Apple's fate. 

3. Be the optimist in a roomful of pessimists
Let it rain. Let the worrywarts fret. There's money to be made when others are obsessed with trailing earnings and industry standards. Does that make Rule Breaker investing a contrarian philosophy? Does it matter?

Marvell Technology (Nasdaq: MRVL) has had to climb that wall of worry not just once, but twice. As a chip stock, it was regarded as a commodity broker. Then it began focusing on higher-margin specialty chips and found its way into everything from Apple iPods to hot video game systems. Feast for Marvell. Then Apple rolled out its nano line of iPod players, which didn't require Marvell chips -- they stored tunes on flash memory instead of small hard drives. Famine for Marvell? So the market thought at first, until Apple rolled out its high-end video-enabled iPods, which still require hard drives.

Putting it all together
It doesn't seem like much of a growth investing strategy, does it? Mature sectors, product cycles with longer-term payoffs, and a contrarian mindset? Yet that's what has often led David Gardner to some of his best investing ideas.

In the early '90s, AOL was entering an online services field littered with lackluster offerings powered by stodgy behemoths like GE, Sears, and H&R Block. Then there was eBay (Nasdaq: EBAY) in the late '90s, injecting new life into the flea-market and consignment-store businesses.

Few saw hospital operating rooms as a growth industry when David recommended Intuitive Surgical (Nasdaq: ISRG) to subscribers 11 months ago. The surgical-robot maker has trounced analyst estimates every quarter since, and it's gone on to more than double.

Steiner Leisure (Nasdaq: STNR) has been another winning pick, nearly doubling since its recommendation. The operator of luxurious shipboard spas has been a bright spot in the sleepy travel industry by riding two hot vacation trends at once -- cruising and spa treatment.

Not all Rule Breakers have performed that well. Since the newsletter's launch 17 months ago, the average pick is up just 27.2%. However, that's considerably better than the 6.7% average market return in that time.