Investing: Finding the Next iPod

Investing pros explain why exploiting hit products is so difficult—and how to spot a company that does it right

The new iPad tablet device from Apple Inc. (AAPL), introduced by the company's CEO Steve Jobs on Jan. 27, has Wall Street speculating what the new offering means for the company's bottom line and how competitors will respond.

Investors are right to pay attention: Nothing moves a stock like the excitement surrounding a new product. (Apple's shares, which advanced 134% since Mar. 9, 2009, closed 1.4% higher on Jan. 27—the day the iPad was unveiled—but fell 4.1% on Jan. 28.)

But this can be a dangerous game for investors. The stock market's enthusiasm rarely lasts long. Stocks fueled by wildly popular products can rocket higher, then collapse suddenly when anything goes wrong.

Apple has held on to stock gains since its iPod was first introduced in 2001, but other companies haven't sustained Wall Street's enthusiasm. Popular products like Motorola's (MOT) RAZR phone and Nintendo's (7974:JP) Wii video game console pushed stocks higher initially, but both companies now trade below their prices when the products were unveiled.

Sometimes the market moves are especially wild. Crocs (CROX) saw its stock rise 423% in the 20 months after its 2006 initial public offering, but then the footwear company lost 90% of its value in the next nine months as the popularity of its Crocs shoes waned.

Investors have to ask: Will a new product be a Cabbage Patch Kid—the must-have doll that briefly made Coleco a Wall Street darling back in the 1980s, before a foray into computers helped send the stock into oblivion—or a long-term franchise like 3M Corp.'s (MMM) Post-it Notes?

Prediction Game

The first task, investing experts say, is predicting which new products will be successful.

"Get out and talk to people who are using the product and see what they like about it," advises Richard Parower, manager of Seligman Investments' Global Technology Fund (SHGTX). For products aimed at businesses, you'll need more technical expertise, he says: The opinion of the man on the street won't matter for enterprise software, for example.

Wall Street has a long history of regrets about companies and products that looked promising but flopped, warns Brett D'Arcy, chief investment officer at CBIZ Wealth Management (CBZ). In advance, "it's very difficult to tell," he says.

Investors need to put themselves in the shoes of the customers of the future. If everyone already agrees a product is groundbreaking and innovative, it's too late for investors, says Paul Sutherland, president and chief investment officer of Financial & Investment Management Group. "You don't want to own what looks good now," he says. You want to own what will be hot "five years from now."

Even the most innovative product doesn't guarantee profits for investors, especially because creative, visionary executives are rarely equipped to handle the problems that rapid growth can cause. Coming up with a hit product is one thing. Profitably manufacturing, marketing, and distributing it is another.

"Young and inexperienced management teams might not see the brick wall coming toward them," Parower says.

Competition Follows

One obstacle companies must maneuver around is the competition. And, if your product is catching on, it will almost certainly attract rivals. "Competition goes where there is profit to be made," Sutherland says.

Netscape's Navigator browser reigned supreme for the early years of the World Wide Web, but later lost ground to Microsoft's (MSFT) Internet Explorer and other browsers. Research In Motion (RIMM) must continually introduce new versions of its BlackBerry to fight off rival smartphones.

Some companies, like pharmaceutical manufacturers, can rely on patents to protect profits. But, in the fast-moving world of product innovation, such examples are rare. "It's very difficult to have a moat in place to keep that innovation only to yourself," says Michael Yoshikami, president and chief investment strategist at YCMNET Advisors.

Pfizer (PFE) shares rose 38% in the year after Viagra, its erectile dysfunction drug, won approval in 1998. But those gains fizzled by 2004, as competing drugs were developed for the same condition and Pfizer failed to come up with other blockbuster compounds to replace those facing the loss of patent protection.

The only option for most companies is to keep innovating, trying to stay one step ahead of competitors. Companies that can achieve that goal, like Apple, are rare, analysts note.

"It's very difficult to sustain innovation," says Wyatt Crumpler, who oversees portfolio managers at American Beacon Advisors. "Most companies will flame out over time."

Innovative and Deep-Pocketed

Yoshikami advises investors to look for innovative companies with strong finances—or that are backed by investors with deep pockets. "That gives you the staying power and helps you continue to innovate," he says. One example, he says, is BYD Co., a Chinese battery maker partly owned by Berkshire Hathaway (BRK/A), which is led by billionaire investor Warren Buffett.

Big companies are often much better at making many small improvements than coming up with one big blockbuster innovation, Crumpler notes, citing the philosophy of kaizen, or "continuous improvement," pioneered by many Japanese companies.

In theory, stock prices reflect a company's long-term prospects. And when innovation is happening rapidly, the future is often very difficult to predict.

It's important to keep a close eye on a company's product pipeline, Crumpler says. If a company shows any signs of slowing down its pace of innovation, it's a good idea to sell. "You really need to stay on top of it [and] get out before it's too late," he says.

Many find new products far too risky and uncertain to justify betting on specific companies. One alternate strategy pursued by CBIZ's D'Arcy is to invest in a broad array of stocks that are benefiting from innovation. Though it's hard to predict which tech company will win or lose out in the end, he says, "I don't think the technology revolution is over." So, he invests in the iShares S&P North American Technology Sector Index Fund (IGM).

Still, it's hard for investors to ignore innovation when picking stocks. Every company—even in relatively stable, boring industries—won't survive without coming up with new products and services. "Or they're going to lose market share," Sutherland says. "Nobody in business can relax."

Steverman is a reporter for Bloomberg BusinessWeek's Finance channel.