Will You Recognize the Next Apple?

How did Apple do it? My son asked me for an iPod for his birthday. I figured he meant he wanted an MP3 player of any type, and I asked him if 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 a superior product? Or is its popularity 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 a sustainable competitive advantage for its iPod, which has played a huge role in delivering 77% 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 six companies, each with varying degrees of success in relation to its rivals. In the cases of Apple and NVIDIA (Nasdaq: NVDA), increasing ROC resulted in blockbuster annual returns over the same period. Great products can indeed result in great returns:

Company	FY 2004	FY 2005	FY 2006	FY 2007	LTM*	5-Year Annualized Return
Apple	4.4%	16.4%	17.6%	22.5%	22.9%	77.3%
Best Buy (NYSE: BBY)	21.0%	19.3%	18.7%	19.6%	21.4%	6.6%
NVIDIA	2.9%	5.2%	16.1%	16.2%	23.2%	7.0%
Sotheby's (NYSE: BID)	16.9%	16.4%	24.4%	24.6%	19.3%	24.9%
Logitech (Nasdaq: LOGI)	16.3%	16.6%	18.0%	18.6%	19.7%	26.1%
Genentech (NYSE: DNA)	11.7%	15.7%	19.5%	20.6%	19.9%	15.1%

*Trailing 12 months. Data from Capital IQ & Morningstar as of July 9, 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. It's much trickier 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 10 stocks that have more than doubled 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 so 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.

Copyright © 2008 Universal Press Syndicate.