Will You Recognize the Next Apple?

How did Apple do it? My son recently asked me for an iPod for his birthday. I figured he really meant to say that he wanted an MP3 player of any type, and I asked him if he wanted to try a Zune or maybe another PC-based player. "Oh, no, Dad," he said in response. "It has to be an iPod."

And that explains why no other company has been able to crack Apple's vise grip on the MP3 industry. It simply has to be an iPod.

But is the iPod really that superior as a product? Or is this more a result of great marketing and first-class product design? Or perhaps a combination of those factors elicited his response. Whatever the case, Apple has managed to build up a sustainable competitive advantage for its iPod, and this has played a big role in delivering 89% annual returns for its shares over the past five years. How do we find similar growth stories for the next five or 10 years?

Recognizing the best
One way to consider if a company has a sustainable competitive advantage over its competitors is to consider the trend of its return on invested capital (ROIC) over several years or so. Growing ROIC might indicate that the company has a superior product or service that has temporarily insulated it from competition. And such an advantage may result in outsized returns.

The following table looks at ROIC and annual returns for six companies, each with varying degrees of success in relation to its rivals. In the cases of Apple, Deckers Outdoor (Nasdaq: DECK), and Coach (NYSE: COH), increasing ROIC resulted in blockbuster annual returns over the same period. Great products can indeed result in great returns:

Company	FY 2003	FY 2004	FY 2005	FY 2006	TTM*	5-Year Annualized Return
Apple	0.3%	4.4%	16.4%	17.6%	22.5%	89%
Deckers Outdoor	12.4%	22.8%	22.5%	22.8%	24.4%	111%
Netflix (Nasdaq: NFLX)	2.7%	9.0%	3.6%	12.6%	12.6%	37%
Garmin (Nasdaq: GRMN)	20.7%	20.1%	20.2%	25.5%	29.8%	55%
Coach	38.5%	35.1%	39.4%	40.0%	40.9%	33%
NutriSystem (Nasdaq: NTRI)	(13.1%)	8.7%	45.4%	73.5%	82.1%	87%
Nokia (NYSE: NOK)	21.8%	17.6%	20.7%	26.5%	30.5%	18%
Polycom (Nasdaq: PLCM)	2.1%	4.7%	5.8%	5.9%	6.1%	19%

*Trailing 12 months. All data from Capital IQ as of Dec. 5, 2007.

The case of Apple appears to be a classic illustration of what a great product can do for a company. A mere four years ago, the company was languishing. We all know what has happened since then. The same can be said about the amazing turnaround at NutriSystem, led by CEO Michael Hagan, who took over the company in December 2002.

There's always a catch
Alas, the above is a backward-looking exercise, and the real key is to identify those companies with a sustainable competitive advantage before it is apparent to the vast majority of investors. Is it possible to foresee which products and concepts will dominate a particular industry?

David Gardner and his team of analysts at Motley Fool Rule Breakers would answer yes to that question. Their goal, in fact, is to spot the great businesses early on in their growth cycles and then hold those shares for the long term. This approach has already resulted in 11 multibaggers -- names such as Blue Nile and Vertex Pharmaceuticals -- since the service was launched back in October 2004.

Looking at the trend of a company's ROIC is just one approach of many one might use when panning for investment gold. Each analyst at Rule Breakers has a unique way of identifying great companies, and thus far, I'm impressed with what they've unearthed. To see all of these great companies, take a free trial today. Just click here to get started.

This article was originally published on May 30, 2007. It has been updated.

John Reeves owns shares of Vertex Pharmaceuticals. And his son is really enjoying his iPod, especially after he deleted the boring songs his dad had downloaded before giving it to him. Garmin and Netflix are Stock Advisor recommendations. The Fool has a disclosure policy.