When Models Explode

How many times have you underestimated a company's potential? You have probably done so a lot more than you realize. Too many times it's easy to thumbtack a company against the corkboard of stagnancy based on where the entity has been rather than where it may eventually be.

Let's consider XM Satellite Radio (Nasdaq: XMSR  ) . When it was facing another massive quarterly loss last year, I warned about taking the company's business model for granite. It would be naive to sum up the potential market for the satellite-streaming upstart, multiply that by the company's $9.99 monthly subscription fee, and assume that was all the company would ever be good for.

Yet that's exactly what pundits were doing. It doesn't make sense when you think about it. No one values a cable or satellite TV provider based on the cost of basic programming -- even if they may have at one time. There is too much meat in the premium channels and pay-per-view offerings to ignore. That's why folks who assume that the future will be a rerun of the past miss the mark.

Investing based on the past is no present
Naturally, XM picked up on the premium content angle. It expanded its offerings beyond 100 digital channels and now offers subscribers the ability to pay $2.99 more a month for Playboy (NYSE: PLA  ) Radio as well as $1.99 a month to tune into notorious shock jocks Opie and Anthony.

Yet that's not all. In two weeks, folks will be able to subscribe to XM Radio's 70 music channels streamed online. Satellite radio subscribers will pay $3.99 a month for this service, while those who aren't XM-enabled will be charged $7.99 a month for access to the company's commercial-free music over the Internet.

And let's not sell rival Sirius Satellite Radio (Nasdaq: SIRI  ) short on potential either. While the company is including its NFL coverage with its basic $12.95 monthly plan, if it goes well, what's to stop the company from taking a page out of the DirecTV (NYSE: DTV  ) playbook and start charging a premium for its football game broadcasts?

Sirius has also tested streaming cartoon videos over its satellite service. The way more cars are coming equipped to entertain the backseat kiddies, it certainly has to give a short seller pause.

Yes, Sirius and XM are putting out some bone-ugly income statements these days -- and the balance sheets aren't any prettier to look at -- but these are open-ended situations that haven't even begun to skim the surface of their potential as operating entities.

I know there isn't a saying about pigeonholing pitfalls and pigeon droppings, but there should be.

Breaking all the rules
This month we are launching our Rule Breakers newsletter, which, like Opie and Anthony on XM, is a premium service. It just won't be as loose-lipped and controversial. Yet seeking out ultimate growth stocks involves not just understanding where a young company has been but where it is going.

Every stock recommendation in the newsletter goes into the catalysts behind their potential appreciation, and that's a highly misunderstood and underrated X factor in assessing any quality upstart's rocket appeal.

How many people were caught shorting Yahoo! (Nasdaq: YHOO  ) based on ridiculously high price-to-sales and infinitesimal price-to-earnings and price-to-cash flow ratios, only to see the stock surge even higher after the company went on to master online dating and employment services and paid search arenas?

Who was caught bashing Amazon.com (Nasdaq: AMZN  ) as an overpriced bookseller? There's always something else to consider. Just because you don't see its oar in the water doesn't mean that a company won't eventually paddle through a new revenue stream.

Shares of Netflix (Nasdaq: NFLX  ) had been in a funk, weighed down by new entrants in the booming mail-order DVD rental market and the threat of video on demand speeding up the delivery process. Then the stock perked back up last month when Newsweek reported that Netflix and TiVo (Nasdaq: TIVO  ) were rumored to be working together on a service that would deliver flicks directly into TiVo boxes. It shouldn't have come as much of a surprise since TiVo's chief sits on the board of Netflix. Yet, once again, we see the problem of assuming that the past will always mirror the future. I mean, come on now. We know that the future will always laugh back at the mirror, mocking the dated wardrobe.

Just because a buggy whip maker didn't start making automobile air fresheners doesn't mean that today's companies are incapable of adapting to change -- if not flat out steering a predictable sector into a refreshingly lucrative new direction.

Once you break the rules, there is nothing to stop you from breaking the next set of rules -- even if they were your handiwork. So what's the pitfall of pigeonholing? It's failing to look up and away long enough to dodge the pigeon droppings.

Looking for extraordinary long-term returns? In Motley Fool Rule Breakers, David Gardner digs up the exciting growth companies that can deliver. Afree trialis yours for the asking.

Longtime Fool writer Rick Munarriz would never short tomorrow's sunrise. He owns shares in Netflix. Rick's stock holdings can be viewed online, as can the Fool's disclosure policy.


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