FOOLS RUSH IN . . . : INVESTOR BROTHERS SHARE WISDOM ON ONLINE STOCKS.

Byline: Deborah Adamson Daily News Staff Writer

The Brothers Fool have done it again.

David and Tom Gardner have gone against conventional wisdom to argue why some Internet companies with out-of-this-world valuations are actually good buys.

The Gardners, founders of the online investment forum Motley Fool, find gold in the leading Internet stocks that Wall Street gurus have long dismissed as being grossly overvalued. It's a case of fool's gold being the real thing, they say.

Consider money-losing online bookseller Amazon.com: It's worth 15 times more on Wall Street than Barnes & Noble, even though Barnes & Noble has actual storefronts and makes a profit (two things Amazon.com doesn't have going for it). Amazon's market value is twice that of Nike and more than three times greater than that of the New York Times Co.

Unbelievable? Yes. Incorrectly valued? No.

In their new book, ``Rule Breakers, Rule Makers,'' the Gardner brothers attempt to explain why companies such as Amazon.com are such hits. These are companies they call Rule Breakers.

They say the trick in finding these potential gold mines is not to focus so much on traditional gauges like price-to-earnings ratios or profits but on sales growth and visionary leadership, among other less quantitative factors.

``Keep in mind that even when the market bids up an unprofitable company, it is doing so with the expectation that future earnings streams will develop and will be significant,'' said David Gardner, who was given half of the book to explain the Fools' logic of Rule Breakers. ``The same was true of Wal-Mart throughout the '70s, which always looked overvalued, or Cisco and Amgen since the late '80s.''

Instead of focusing on the numbers, such as whether the company beat Wall Street estimates or brokerage ratings, they argue that young Rule Breaker companies busting out of the gate should be judged on broader factors since they are ``nearly impossible to analyze using traditional valuation criteria.''

That's why it's more helpful to look at a company qualitatively - such as its brand name and leadership - than at its earnings or P/E multiple. More critical are strong sales growth and past stock performance, they said.

But such thinking disturbs Robert Gardiner, portfolio manager of the Wasatch Micro-Cap Fund, which was ranked first in its category by Lipper Analytical with a three-year annual return of 25 percent.

For one thing, he's not quite ready to discount a company's earnings growth.

``In every study we've ever done, (stock) price has followed earnings,'' said Gardiner, whose fund focuses on growth in earnings and P/E.

Gardiner said he has missed out on some quick profits because he did not join the Internet stock frenzy, but he prefers to stick to a proven strategy that he believes will pan out in the long run. After all, Internet stocks also can go down astronomically.

``Everybody thinks there's a new rule to make money, (but) . . . a lot of stocks are going to crater,'' he said.

Indeed, his colleague Karey Barker said, when the biotechnology industry was hot in the late 1980s, the stock prices of companies going public ``got pretty crazy.'' The same thing could be said of Internet companies, but at a greater level.

``It's not the company's profitability or any economic value driving the stock up. It's more of who's a greater fool,'' said Barker, the portfolio manager of the Wasatch Mid-Cap Fund. ``There's something going on here that can't be sustained. . . . It's completely momentum.''

Barker cites the '80s bullishness of Japan's leading stock market index, the Nikkei, which had traded at a higher P/E multiple than the Dow Jones industrial average. The length of its run led to several books explaining why it's justified. But the bull ran out of steam this decade, and now the 225-company average remains in the doldrums.

Barker also parallels today's Internet frenzy with the biotechnology craze, during which several books were written justifying the stock price momentum. History shows the books were wrong.

``Just because (the ascent of Internet stocks) worked for a couple of years doesn't mean it's rational . . . (especially) if it's not based on real earnings,'' she said.

Buying Rule Breakers can be risky, the brothers admit.

``Rule Breaking investors will sometimes be dramatically wrong, just as venture capitalists are. The idea is that you only have to be right a few times,'' David Gardner said. ``If you buy and hold as a Rule Breaker investor, you expect to beat the market handily, largely through the profits you make by being right a few times - which will way outdistance what you lose in being wrong.''

And yet, the Brothers Fool make a convincing case. They've identified important characteristics a Rule Breaker should possess, and they're pretty picky.

First, the company must be the top dog and first mover in an important and emerging industry. Top dog, first banana, the big cheese, whatever. The idea is that this company is the undisputed numero uno firm in the industry.

One clue: It's got the highest market capitalization in its industry even if its sales approximate those of its biggest rival. For example, the Gardners point out that Dell is worth $25 billion more than Compaq, even if its sales are $12 billion less.

Because the Fools believe the market prices companies at their true worth, Dell is seen as much more valuable than Compaq - a real top dog.

As a first mover, the Rule Breaker must have been the first to do something. Amazon.com was the first major online bookseller. As such, it enjoys a big head start on its competitors. Barnes & Noble still is playing catch-up.

A Rule Breaker also should be in an important industry, which the Fools roughly define as one that everyone would miss if it disappeared tomorrow. It's also preferable if that industry is still in its early stages.

A Rule Breaker should carry sustainable advantage through business momentum, patent protection, visionary leadership or inept competitors. That means these breakthrough businesses should have strong sales growth (the Fools single out the early Wal-Mart as an example), legal protection for their creations (Amgen), and possess strong leadership or bungling rivals (Microsoft).

Furthermore, the company's stock price should have appreciated greatly in the past - it must have outperformed 90 percent or more of its peers.

A Rule Breaker company achieves its status through smart management and good backing. Smart management is hard to quantify, the brothers admit, but you'd know it if you see it. Simply, it's doing something right. Obviously, if the company is a top dog in the industry, management can't be slackers.

Another sign of a budding Rule Breaker is its backers. A smart backer is a company such as Kleiner Perkins Caufield & Byers, venture capitalists from Menlo Park in the Silicon Valley.

They've invested in the early Netscape, America Online, Compaq, Amazon.com, Excite, Sun Microsystems, Intuit and AtHome.

The Brothers Fool also believe Rule Breakers sell a product that appeals strongly to consumers. They singled out Starbucks.

Finally, if a company's shares are called overvalued by the financial media, there's a good chance it's a Rule Breaker's stock, they say.

The Gardners say the company is doing ``many things right'' to have an upward effect on the stock. So ignore cries of high valuations, they advise.

``Rule Breakers, Rule Makers'' is the fourth book from Motley Fool. To date, the brothers' books have sold more than 875,500 copies in both hardcover and paperback form. Their newest book will be in wide distribution by Feb. 2.

FOOLS' WISDOM

The Motley Fools wouldn't be the Motley Fools without off-the-cuff comments. Yes, even in their best-selling investment books.

Here are some duds, er, gems from the latest, ``Rule Breakers, Rule Makers'':

Land of Mo: When stocks are cruising in the Land of Mo-mentum.

Short-Term and It'll Be Mismanaged Capital Hedge Fund: Fool's name for Long-Term Capital Management hedge fund, which lost billions even though two Nobel laureate business professors created the fund's investment model.

Mackie: The Fool gave this name to behaviorist Ivan Pavlov's pooch. Mackie is also the name of their sister, who ``has yet to finish one of our investment books.''

Ding!: When readers should take notice.

We want dat performance number to be over da 89: Reiterates that ``Rule Breakers'' should have relative strength performance of 90 or greater.

AREA `RULE BREAKER'

So who's a ``Rule Breaker''?

In the Motley Fools' world, one of them is biotechnology giant Amgen of Thousand Oaks. The company's two main products are Epogen, which stimulates production of red blood cells, and Neupogen, which boosts creation of white blood cells.

Last month, the Motley Fools added Amgen to its Rule Breaker portfolio.

Here's how the Ventura County company stacks up, according to the Fools' criteria:

Top dog and first mover: Amgen is the world's largest and most successful biotechnology company, one with no equal, the Fools say.

Important, emerging industry: Biotechnology by its very nature is a ``Rule Breaking'' industry, in which breakthrough drugs are being developed.

Sustainable advantage through business momentum, patents, visionary leadership or inept competitors: Amgen's Epogen drug doesn't lose its first patent until 2004, with others coming in 2012 and 2013. Neupogen has patent protection until 2006. Collectively, these drugs comprise 92 percent of revenues.

The Fools believe that Amgen can sustain its lead because it spends $575 million in research annually, more than most biotechs earn in their lifetimes.

As for future products, Amgen has more than 200 clinical trials in the works for over a dozen compounds.

While Transkaryotic Therapies and Hoechst Marion Roussel are developing a competing product to Epogen, the Fools don't think that it'll be superior.

Good management and smart backing: Because of its successful past, it's a safe bet that Amgen's got good management and research teams.

Even while Amgen was an unknown, it was able to obtain a licensing agreement with Johnson & Johnson. Amgen currently has alliances with Roche Holdings, Kirin Pharmaceuticals, AmCell, Guilford and Yamanouchi Pharmaceuticals.

Stock price outperforms 90 percent of its peers: Amgen's relative strength is 90, reflecting the strength of its stock in the past 12 months. (A 100 score would be the strongest company in America; a 1 the weakest.)

Good consumer brand: In the drug business, it's not that important that the average Joe knows the Amgen name. After all, he doesn't write his own prescriptions. However, Amgen has a strong trade and professional brand name.

Called overvalued by financial media: An Everen Securities analyst on Microsoft's MSN Web site had a target price for Amgen that was 35 percent below its current record level.

By Deborah Adamson

CAPTION(S):

Photo, 2 Boxes

PHOTO (Color) no caption (The Motley Fool's Rule Breakers, Rule Makers book cover)

BOX: (1) FOOLS' WISDOM (See text)

(2) AREA `RULE BREAKER': AMGEN (See text)