There are really only two types of companies out there: the disrupters and the disrupted.
What's in your portfolio?
It's not an easy question to answer. Everyone likes to think that their stocks are the lions feasting on the gazelles. They can't even begin to fathom that the speedy gazelles may be the ones turning the tables and gnawing on the overly confident lions. It can be a costly mistake because knowing the difference separates the market beaters from the blindsided and vanquished.
Thankfully, there's an easy exercise that will help you determine if you're holding the prey or the hunter. I call it the three-year test.
How relevant will the companies in which you invest be in three years? If you can drum up an unbiased response, you'll be able to sidestep losers today and load up on winners.
Take three steps back before going three years forward
The hardest step in this exercise is actually approaching your own stocks objectively. Investors are primarily optimists, so the art of detachment and pondering the worst-case scenario are not entirely natural instincts.
Do it, though. You want to make money -- perhaps a whole lot of money -- in this market, don't you?
Let me cut to the chase. You may very well own Warner Music Group (NYSE: WMG ) . The record label has a great roster of artists like Green Day, Seal, and Nickelback. The stock is trading for a little more than a third of its IPO price four years ago. Labels are winning big legal judgments against folks who make illegal downloads possible. Now, can you honestly explain to me how the prerecorded music giant will be as relevant in 2012 as it is in 2009?
Piracy isn't the industry's killer. The real body blow to the labels is the leveling of the playing field. You no longer need to get "signed by a major" to get noticed. Every new Apple (Nasdaq: AAPL ) computer comes with GarageBand, a free home recording program. Is the end result worthy of laying down on a CD? No, but who needs a CD anyway? It's good enough to upload to your free MySpace page as a global demo to draw new fans and sell tickets to an upcoming show.
Bands used to need terrestrial radio, but now you have satellite radio and music discovery sites. More singers have probably emerged as contestants on American Idol than through major label signings. As music choices expand, Warner's market share will contract.
So, how confident should you be buying into a company with an awesome past, a decent present, but a cloudy future? If I were you, I would seek out the companies that will be more relevant in the future.
Dig for disruptors
Every company believes that no one else can build a better mouse trap. Shareholders know better. Disruptors always come along. Heck, even disruptors get disrupted. Remember when AOL owned online connectivity, and Dish Network (Nasdaq: DISH ) was the fast-growing player of affordable satellite television? Speedier AOL alternatives and a migration away from "me too" television subscription services turned the hunters into the hunted.
If you want to beat the market, the first step is to stay ahead of the market. Where are the disruptors today? They're everywhere, if you know where to look. Here are four I'm eyeing:
- Baidu is China's leading search engine. No one has come even close to challenging the company's market dominance in the world's most populous nation. Internet usage continues to climb. The improving economy finds advertisers willing to spend more to reach quality leads. You have to like Baidu's prospects in that scenario.
- IMAX (Nasdaq: IMAX ) is expanding its empire of proprietary mammoth-sized screens. It's the perfect network effect, as exhibitors worldwide are ramping up their orders for digital systems, just as more movie studios are releasing enhanced IMAX versions of their movies. With the latest installments of Transformers, Harry Potter, and Night at the Museum in its summer pocket, IMAX is definitely popcorn-worthy. As home theaters improve, moviegoers are seeking out the IMAX experience that they can't re-create in their living rooms.
- E*TRADE (Nasdaq: ETFC ) has been neglected in this market rally. Investors prefer its profitable peers, but the discount broker has made inroads in repairing its troubled balance sheet. The E*TRADE Baby is also one of the best discount broker campaigns in years.
- Home Inns & Hotels (Nasdaq: HMIN ) is a fast-growing chain of value-priced lodging in China. The stock has nearly doubled over the past four months, but what will a nation of 1.3 billion people do as discretionary income grows? Travel is going to be a major growth industry, and Home Inns is ramping up its capacity.
How did I come across these disruptors? Well, I'm one of the analysts on the Motley Fool Rule Breakers newsletter team. Two of these stocks -- Baidu and IMAX -- are active recommendations. Subscribers can also unearth superior growth stock ideas on the lively discussion boards, where members pick apart potential winners.
These are companies that I can see mattering a lot more in the future. They specialize in niche industries that can take down -- or revolutionize -- larger sectors. They pass my three-year test.
Sorry, Warner Music Group. You flunked with fading colors.
Join me and my fellow subscribers in sniffing out the next wave of market-thumping disruptors: I invite you to check out Motley Fool Rule Breakers free for the next 30 days. That's less than three years, but it's a great start!
This article was first published March 3, 2009. It has been updated.
Longtime Fool contributor Rick Munarriz is a fan of disruptive growth stocks and has been part of the Rule Breakers analyst team since its inception nearly five years ago. He does not own shares in any of the stocks in this story. Baidu and IMAX are Motley Fool Rule Breakers selections. Apple is a Motley Fool Stock Advisor pick. The Fool has a disclosure policy.