Why owning Xero FPO NZ breaks all the rules

XERO FPO NZ (ASX:XRO) ticks all the boxes as a perfect 'rule breaker' company.

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Having some rules for investing is a great way to beat the emotional perils of investing. 'Never buy or sell on an empty stomach,' for example.

A lot of investing rules are based on conventional wisdom. But rules, as they say, are only for the guidance of wise men. Motley Fool co-founder David Gardner knows this better than most. He runs the Motley Fool (U.S) 'Rule Breaker' investing service and looks for six simple, but crucial, characteristics when hunting for long-term winning companies, some of which break common investing wisdom.

XERO FPO NZ (ASX: XRO) is a perfect example of such a company, a company David Gardner himself would love. Here's how Xero stacks up against Gardner's 6 criteria;

1. A "top dog", "first mover" company in an important, emerging industry

Gardner's first criteria fits Xero spot on. Xero was one of the first to seize on the potential of cloud storage – an important, emerging industry – to enable small businesses to cost effectively manage their accounting.

Since then Xero has grown subscribers rapidly, recently pushing past 540,000 to become a 'top-dog' locally and in New Zealand while spreading throughout in the U.S. and U.K.

2. Holding a sustainable advantage

A sustainable advantage, says Gardner, can be gained through "business momentum, patent protection, visionary leadership, or inept competitors" and again Xero punches above its weight.

Xero's operational momentum has been snowballing as subscribers grow and the company gains big name supporting partners like Apple, Microsoft and Google.

Founder and CEO Rod Drury continues to drive his vision for Xero and while perhaps not "inept", local competitors like Myob Group Ltd (ASX: MYO) and Reckon Limited (ASX: RKN) are being left for dust in the cloud accounting space, if they are trying at all.

3. Strong past share price appreciation

Here is where traditional investing rules start to go out the window. David Gardner's 'rule breaker' criteria looks for companies which have a history of strong upward share prices. This goes against the common 'buy low, sell high' philosophy of many investors, but in Gardner's own words "We think the winners generally keep on winning."

Between 2013 and 2014, Xero's share price rocketed from $5.90 to as high as $41. Shares have fallen back since then, but Xero's business remains stronger than ever.

4. Good management and smart backing

Visionary Rod Drury has built a strong team around him to drive Xero forward and is backed by some of the most savvy minds in tech today.

Add to this having billionaire PayPal co-founder Peter Thiel as an investor, and ex Salesforce executive Graham Smith on the Board of Directors and Xero doesn't miss a step.

5. Strong consumer appeal

Strong consumer appeal is about giving customers a positive experience to generate repeat business. Before Xero I don't think many entrepreneurs or small businesses would have enjoyed the accounting experience, but the company has turned this perception around with its 'Beautiful accounting software'. Users are smitten with the brand and experience, and that's an incredibly powerful position for such a young company.

Xero's quality product and appeal brings valuable pricing power which is another sustainable advantage.

6. Documented proof that the stock is considered overvalued according to the financial media

Gardner's final point, similar to number three, goes against conventional investing wisdom. Being labelled over-priced, he argues, is less relevant if the other five 'rule breaker' characteristics ring true because great, long-term companies regularly command high valuations. Gardner cites Amazon as an example which was labelled 'over-valued' back in 2000. Since then Amazon shares are up over 3,700%.

A quick web search for "XERO overvalued" is all we need to tick this one off the list. Most criticisms revolve around the company not producing a profit, a strategic move to win customers and generate long-term reoccurring revenues. An approach which certainly seems to be working.

I asked Rod Drury about this recently at the company's investor update in Auckland, where he noted that Xero "can swim to the side of the pool at any time" in terms of profitability.

Motley Fool contributor Regan Pearson owns shares of Xero. The Motley Fool Australia owns shares of Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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