How to Catch the Big One

Have you ever heard the phrase "disruptive innovation"? If not, too bad, because if you spot a disruptive innovation early enough, it can make you a fortune.

The wise man
Clayton Christensen, author of The Investor's Dilemma and The Innovator's Solution, coined the phrase "new market disruption." It occurs when a newcomer circumvents an established business model or technology to serve an overlooked market. The end result is a new and improved way to meet a customer need -- and big profits for investors.

Out with the old, in with the new
Ten years ago, Blockbuster, Hollywood Video, and Movie Gallery ruled the movie-rental market. Then Netflix (NASDAQ:NFLX) burst on the scene, and everything changed. At the time, its business model of mailing videos to subscribers was so radical, the big boys doubted that it could ever work. But the superiority of a centralized distribution system over the old capital- and labor-intensive model has since forced two of those businesses into bankruptcy, and Blockbuster is still struggling.

Meanwhile, early Netflix shareholders have made many times their initial investment.

Other examples of disruptive innovations include Microsoft (NASDAQ:MSFT), reinventing the word processor, and eBay (NASDAQ:EBAY), using the Internet to bring buyers and sellers together. eBay stock has risen 700% since its public debut, and Microsoft investors have enjoyed a 70-bagger since the company released its first Office Suite in 1989.

Investing in such innovators early enough can change your financial picture and quite possibly your life. Unfortunately, these businesses aren't easy to find.

The risks
There are a lot of pretenders out there. If you lost money during the dot-com craze, you may remember Webvan. The online credit and delivery business promised to get customers their groceries within a 30-minute window. But despite investments from giants such as Goldman Sachs, Yahoo!, and a lot of individual investors, the company went bankrupt. Picking the wrong type of business can be a high-risk, extremely costly proposition.

How to catch the big one
Fool co-founder David Gardner has been identifying successful innovators for more than 15 years. It's not easy to look around corners, to essentially see what others don't see, so he and his team of Rule Breakers analysts have developed a process for separating the true innovators from the pretenders.

Here it is:

• Identify potentially huge growth markets and learn about the players.
• Find out whether there's a company with a newer, better way to provide a good or service.
• Look at a company from every angle to understand its risks and determine possible rewards.
• Decide whether management has what it takes to guide its company to outsized performance.
• Identify the levers that drive the business and develop an investing thesis.

The work, however, doesn't stop there. You'll also need to constantly monitor the performance of the company and any relevant developments, and know when to listen and when to tune out the noise of the market.

Fat rewards
Sound tough? It is, but consider the rewards. If you were able to find disruptive innovators such as Wal-Mart (NYSE:WMT), Amazon.com (NASDAQ:AMZN), or Google (NASDAQ:GOOG) early on in their growth cycle, you would have returns many times your initial investment. In this case, a table is worth a thousand words:

Data from Yahoo! Finance as of Oct. 22.

You may have noticed that despite its impressive returns, one is not yet as widely recognized as the rest, and it still has room to run. David Gardner first recommended Intuitive Surgical to Rule Breakers members more than three years ago. At the time, this young upstart was doing just $139 million in sales. Since then, this disruptive innovator has blossomed into a business generating $833 million in sales, and it shows no signs of slowing down.

Why won't it slow down? Because it has a monopoly on a robotic device used to make small incisions during minimally invasive surgeries that are becoming increasingly popular among hospitals as more baby boomers retire. Its technology allows doctors to perform precise micro-movements that are otherwise difficult to duplicate. The kicker is that the company also receives recurring sales from making instruments and accessories that work with these devices.

Back in 2005, David summed it up this way: "We are in the early stages of a new surgical revolution, being brought to us by Intuitive Surgical and its da Vinci robots. These four-armed machines are, as the company puts it, 'taking surgery beyond the limits of the human hand.'"

Excited?
You can profit by learning about Intuitive Surgical and other disruptive businesses poised for greatness. If you'd like some more ideas, the members of our Rule Breakers team just returned from an "Innovation Tour" around Silicon Valley, where they met with and interviewed management teams from both public and private companies, as well as venture capitalists. To get their dispatch reports, just click here and enter your email address.

Wade Michels makes sure he can't be bumped by the new guy by disclosing that he doesn't own any stocks mentioned in this article. Intuitive Surgical and Google are Rule Breakers selections. Amazon, eBay, and Netflix are Stock Advisor picks. Wal-Mart and Microsoft are Inside Value recommendations. The Fool's disclosure policy is as cool as the other side of the pillow.