"I know no way of judging of the future but by the past."
-- Edward Gibbon

It earned the name "category killer," a term used for large companies that put less efficient merchants out of business. When this retailer went public in 1978, it soon became No. 1 in the market, as independent shops closed their doors, unable to compete with the growing colossus.

The future looked bright for the new industry leader in the 1980s and 1990s. The absence of competition and increased demand led to revenues of more than $10 billion per year by the late '90s. Alas, it never saw the competitor in the rearview mirror. In March 2005, the company bowed to the inevitable and accepted a $6.6 billion buyout offer from a consortium of investment firms. The deal was completed later that summer.

Why did Toys "R" Us fail to see the gathering threat posed by Wal-Mart? Perhaps it was unable to adequately predict future trends in its market. An ability to anticipate the future is perhaps the most important skill a manager or an investor can possess (which is kinda like saying "an ability to know the final score" is the most important skill required of a gambler). So where do you go to learn about the future?

In the days of old, you might have visited a fortune teller and, for a princely sum, learned that something bad is going to happen to someone you know somewhere down the line. These days, you go to Harvard Business School when you want to see what the future has in store. With this in mind, Fool co-founder David Gardner sat down with Harvard's Clayton Christensen, a professor and consultant who uses innovation to predict business growth and industry change.

When being disruptive is a good thing ...
Christensen has identified the concept of innovation -- either sustaining innovation or disruptive innovation -- as crucial to determining the direction of a particular company or industry.

Sustaining innovation is when, say, a computer company introduces a faster chip in its product. As a result of the improved product, margins should increase, thereby strengthening the company. Disruptive innovation takes root at the low end of the market. According to Christensen, disruptive innovation is the mechanism by which industries are transformed and prior market leaders (such as Toys "R" Us) are toppled. Christensen described disruptive innovation to David as follows:

A disruptive innovation is a new product or service or a new business model that doesn't attack the core market by bringing a better product to established users in direct competition with the leaders in an industry, but rather it comes into the low end of the market, either through a business model that can compete at much lower costs, can compete profitably at lower costs, or brings to the market a product or service that is so much more convenient and simple to use and affordable that a whole new population of people who previously couldn't afford or didn't have the skill to own and use a product can now own one.

There are countless examples of this business principle. Recently, my Foolish colleague Rick Munarriz wrote on how new ways of obtaining music, whether it be from satellite radio providers XM (NASDAQ:XMSR) or Sirius (NASDAQ:SIRI), or digital music downloading services like Apple's iTunes or RealNetworks' (NASDAQ:RNWK) Rhapsody, have bedeviled brick-and-mortar music stores like Tower Records. In fact, in their most recent 10-Ks, both Best Buy (NYSE:BBY) and Circuit City (NYSE:CC) mentioned that digital music downloading has hurt their CD sales.

Christensen illustrates this principle in some depth by examining the case of Charles Schwab. Below I've included a table that depicts a typical life cycle for a disruptive firm.

The Life Cycle of a Disruptive Firm

Early Life Cycle

Mid-Life Cycle

Late Life Cycle

Disruptive company enters the market via the low end.

Company meets with success and gains market share.

Company moves upmarket in search of higher margins.

Schwab was a discount broker that, much like E*Trade (NYSE:ET), utilized the Internet in a disruptive way relative to industry leaders such as Morgan Stanley (NYSE:MS). As Schwab gained market share, it was faced with a dilemma: Go upmarket in search of higher margins or remain downmarket, slugging it out against low-cost competitors in a commodity market? At the moment, the jury is still out on where Schwab is going.

The price of experience
By studying disruptive innovation, Christensen has learned to recognize certain patterns that help him to determine the future course of a company or industry. The title of his most recent tome, Seeing What's Next: Using Theories of Innovation to Predict Industry Change, provides a useful shorthand for his work. Apparently, corporate America sees a lot of value in Christensen's ideas. The demand for his insights was so strong that he started Innosight, his own consultancy. For $40,000, Innosight will visit your firm and put on a two-day innovation-themed workshop. For about $400,000, it might perform a highly detailed analysis to determine whether your firm possesses a potentially disruptive product.

In the interview, David asked Christensen about topics such as biotechnology and the future of the health-care industry -- topics addressed every month in David's Motley Fool Rule Breakers newsletter advisory service.

Seeing what's next
Christensen considers biotechnology to be disruptive relative to big pharma, and he sees the future of the entire pharmaceutical industry being turned upside down. Companies that tap into the fundamental changes affecting the industry will win out.

In the area of nanotechnology, Christensen advises investors to go slow. He explains how understanding the dynamics of the value chain will allow investors to identify the companies more likely to be successful.

One of the more tantalizing parts of the interview is when Christensen discusses the future of the health-care industry. Unlike most experts, he sees significant potential for innovation in this field. The Minute Clinic in Minneapolis, for example, represents the type of model that might transform the entire industry. This innovative company uses nurse practitioners, located within Target stores and Cub supermarkets, to treat illnesses such as strep throat, sinus infections, and earaches. Apparently, 80% of all health-care events in a family's life consist of 14 very common ailments. Patients can visit the clinics and receive immediate treatment for a modest fee (about $45). Needless to say, business is booming. As David Gardner remarked, "When you combine lower cost with more convenience, you have a killer app in the business world."

The hunt for innovators
As someone who once thought the whole personal computer thing was a fad, I should be listening to Professor Christensen, especially because he thinks disruptive technology will be playing an even larger role in the next 10 years. By my reckoning, quite a few of our current Rule Breakers stock picks are disruptive innovators. One of our more disruptive selections, Intuitive Surgical, a maker of surgical robots, is up more than 145% since we recommended it in March 2005.

Want to join us in our search for disruptive companies? David Gardner is offering a free 30-day trial to the service -- full privileges included. Your trial gives you access to the two growth stocks we like best right now and all back issues, buy reports, and interviews. If you don't like the service, just cancel. No questions asked. To have a peek at the future, just click here.

This article was originally published on Feb. 23, 2005. It has been updated.

John Reeves does not own shares of any company mentioned in this article. Best Buy and Schwab are Stock Advisor recommendations. XM Satellite Radio is a Rule Breakers pick. Wal-Mart is an Inside Value recommendation. The Motley Fool has adisclosure policy.