How did Apple do it?

My son asked me for an iPod for his birthday. I figured he really meant that he wanted an MP3 player of any type, and I asked him if he wanted to try the simple, utilitarian MP3 players from Philips Electronics (NYSE: PHG). "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 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 82% 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 five companies, each with varying degrees of success relative to its rivals. In Apple's case, increasing ROC resulted in blockbuster annual results over the same period. Superior products can indeed produce great returns:


FY 2004

FY 2005

FY 2006

FY 2007

5-Year Annual Return







Dun & Bradstreet (NYSE: DNB)






McGraw-Hill (NYSE: MHP)






Alcon (NYSE: ACL)






Marvel Entertainment (NYSE: MVL)






Data from Capital IQ and Morningstar as of May 11, 2008.

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 11 multibaggers 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 thus 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. 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 Marvel are Stock Advisor recommendations. McGraw-Hill is an Inside Value recommendation. The Fool has a disclosure policy you can dance to.