How did Apple do it?

My son 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 whether 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 that superior as a product? Or is this more 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 up a sustainable competitive advantage for its iPod, which has played a huge role in delivering 76% 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 invested capital (ROIC) over several years. Growing ROIC might indicate that the company has a superior product or service that has temporarily insulated it from competition. 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 case of Apple, increasing ROIC resulted in blockbuster annual returns over the same period. Superior products can indeed result in great returns:

Company

FY 2004

FY 2005

FY 2006

FY 2007

5-Year Annualized Return

Apple

4.4%

16.4%

17.6%

22.5%

75.9%

Aflac (NYSE: AFL)

13.1%

15.3%

14.9%

15.8%

15.7%

Cemex (NYSE: CX)

8.8%

9.5%

8.4%

6.4%

29.7%

Diamond Hill (Nasdaq: DHIL)

(12.3%)

12.1%

39%

32.4

80.2%

Terex (NYSE: TEX)

6.3%

10.1%

18.5%

19.4%

61.1%

Joy Global (Nasdaq: JOYG)

11%

25.2%

32.7%

27.6%

72.4%

Data from Capital IQ and Morningstar as of March 9, 2008.

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

There's always a catch
Alas, the above is a backward-looking exercise. the real key is to identify those companies with a sustainable competitive advantage before they become 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.

Looking at the trend of a company's ROIC 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 thus far, I'm impressed with what they've unearthed. You can see all of these great companies with a free trial. Just click here to get started.

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

John Reeves does not own shares of any company mentioned. And his son is really enjoying his iPod, especially after he deleted the boring songs his dad had downloaded before giving it to him. Apple and Aflac are Stock Advisor recommendations. Cemex is a Global Gains recommendation. The Motley Fool owns shares of Cemex. The Fool has a disclosure policy you can dance to.