Will You Recognize the Next Apple?

How did Apple do it? My son asked me for an iPod for his birthday. I figured he meant 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 viselike grip on the MP3 industry. It simply has to be an iPod.

But is the iPod really a superior product? Or is its popularity a result of great marketing and first-class product design? Perhaps a combination of those factors elicited my son's response. Whatever the case, Apple has managed to build a sustainable competitive advantage for its iPod, which has played a huge role in delivering 85% annual returns for Apple 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 whether a company has a sustainable competitive advantage over its competitors is to measure the trend of its return on capital (ROC) over several years. Growing ROC might indicate that the company has a superior product or service that has temporarily insulated it from competition. Such an advantage could result in outsized returns.

The following table looks at ROC 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 ROC 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

FY
2007

5-Year
Annualized
Return

Apple

0.3%

4.4%

16.4%

17.6%

22.5%

85%

Deckers Outdoor

11.5%

21.8%

20.6%

21.7%

25.9%

82%

Coach

38.2%

38.5%

35.1%

39.4%

40.0%

22%

Netflix (Nasdaq: NFLX  )

2.7%

9.0%

3.6%

12.6%

12.5%

22%

Garmin (Nasdaq: GRMN  )

20.7%

20.1%

20.2%

25.5%

29.0%

15%

NutriSystem (Nasdaq: NTRI  )

(17.6%)

8.7%

46.9%

74.1%

71.0%

94%

Nokia

21.8%

17.7%

20.7%

26.5%

28.6%

10%

Polycom (Nasdaq: PLCM  )

2.1%

4.7%

5.8%

5.9%

6.2%

15%

Data from Capital IQ and Morningstar as of June 10.

Apple appears to be a classic illustration of what a first-rate product can do for a business. A mere five years ago, the company was languishing. We all know what's happened since then.

There's always a catch
Alas, the above is a backward-looking exercise. The real key is to identify companies with a sustainable competitive advantage before that strength becomes 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 at Motley Fool Rule Breakers would say so. They aim to spot exceptional businesses early in their growth cycles, and then hold those companies' shares for the long term. This approach has already resulted in 10 stocks that have more than doubled since the service began in late 2004.

Looking at the trend of a company's ROC is just one approach you might use when panning for investment gold. Each analyst at Rule Breakers has a unique way of identifying great companies, and so far, I'm impressed with what they've unearthed. You can see all of these recommendations with a free trial subscription to the newsletter. Just click here to get started.

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

John Reeves does not own shares of any company mentioned. His son loves the iPod, especially after he deleted the boring songs his dad had downloaded into it. Apple, Netflix, and Garmin are Motley Fool Stock Advisor recommendations. Garmin is also a Global Gains selection. Polycom is a Rule Breakers pick. The Fool has a disclosure policy you can dance to.


Read/Post Comments (0) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 662858, ~/Articles/ArticleHandler.aspx, 9/16/2014 1:56:37 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement