Innovation Nation: Finding Stock Market Winners

Sept. 5, 2012— -- At the end of the '90s, Apple's prospects were looking dim – and investors knew it. When Steve Jobs returned to the company in 1997, it was on the brink of bankruptcy after suffering annual losses of more than a billion dollars.

Apple had a paltry 5 percent share of the personal computer market, and the stock had cratered. Michael Dell famously said at the time that if he were running Apple, he'd "shut it down and give the money back to shareholders."

Then, in 2001, the iPod debuted to rave reviews. The company had revisited the shopworn Walkman concept and taken it digital, producing headphone sound that rivaled a concert hall. Apple went on to reinvent the recorded music business.

The iPod and the stream of products that followed – increasingly advanced generations of iPods and iPhone and the iPad — came not just from the late Steve Jobs' genius, but from his company's dogged dedication to innovation.

These innovations have made Apple the biggest company in the world. Apple sales in the last quarter topped $35 billion – 43 percent of it from iPhones. About 75 percent of Apple's revenue is from products that didn't exist 11 years ago.

Innovation is one of the few economic factors that is extremely hard to measure. It is often ignored by investors and missed by Wall Street analysts. But it's always there at the core of high-performing companies, like the gleam in the eye of a progenitor.

How long an innovation lasts as a competitive advantage is anybody's guess. Yet one thing is certain: Without innovation, most companies cannot succeed initially or remain successful. Michael Porter, a global authority on competitive strategy and a Harvard Business School professor, has said: "The only way to have an advantage is through innovation."

Typically, innovative products and services embody new technology. Virtually every industrial revolution in the world's history has been spurred, at least in part, by technological advances stemming from innovation.

Amazon saw the Internet as the wave of the future for shopping. As ordering books online rose, old-style book stores like Barnes & Noble and Borders fell. Amazon's business model wasn't limited to books, of course, and now the company may be eating Best Buy's lunch and has emerged as the champion of e-commerce.

The company's most recent innovations include venturing into web services and the Kindle. Amazon is expected to announce a new Kindle generation early this week.) The rise of Amazon and Apple are common parables of contemporary business because they are examples of a new model that is changing the way we do business.

In Creative Destruction: Why Companies That Are Built to Last Underperform the Market--And How to Successfully Transform Them, authors Richard Foster and Sarah Kaplan show how innovation has transformed the global business landscape over the past 100 years. This new guard has succeeded by attacking the old guard -- mature companies that have failed to innovate and thus are vulnerable.

Apple is in a class by itself because it's a company that continues to innovate by jumping back on what Paul Nunes, executive director of research at the Institute of High Performance at Accenture, and Tim Breene, the CEO of Accenture Interactive, call the S-curve in their book, Jumping the S-Curve: How to Beat the Growth Cycle, Get on Top, and Stay There.

The authors explain that it's essential to beat the competition while a new industry is still evolving. Successful companies ride the S curve to success via innovation and then jump to the next curve with new innovation – repeatedly. After initially succeeding through innovation, most companies plateau because they don't reinvent their mentalities, cultures or products. The book explores how industry leaders were caught off guard as Apple reinvented the recorded music business and then the mobile device business.

All-Star investor and founder of Investor's Business Daily William J. O'Neil studied the best-performing stocks for the last 100 years and found seven common characteristics. These traits are factors in O'Neil's highly regarded CAN SLIM Investing System. The "N" in CAN SLIM® stands for "new," assigned high-performing companies that have advanced through a new product or service that has changed our lives or the way we do business.

How can investors identify the next big thing and the companies that will exploit it most profitably?

Here are some things to look for:

• Extremely rapid growth. When a company's growth is meteoric, it's usually because of innovation. Increasing growth in annual and quarterly earnings of about 25 percent or more is usually a good indicator of fruitful innovation when combined with accelerating sales. Examples are cloud computing companies VMware and Rackspace. Of course, some would say that this rapid growth is pricing up such stocks to the point where they're not a great investment. Yet companies that are truly innovative can jump onto the next S-curve, spurring acceleration of earnings and an upward revision in estimates by Wall Street analysts. Will a rumored Apple television device be the company's next S-curve?

• A strong commitment to research and development (R&D). Merely throwing money at R&D doesn't guarantee that companies will make money from what they develop. But without a commitment to R&D spending, no successful innovation will occur. Look for management who have a zeal for innovation, as opposed to a caretaker mentality. For example, in an interview in Bloomberg Businessweek Amazon CEO Jeff Bezos stated that there is no bad time to innovate: "You should be doing it when times are good and when times are tough."

• The presences of numerous new players in a given industry. New entrants are attracted by areas of opportunity, which hold potential for strong returns. Not every new entrant will succeed, but the more entrants there are, the greater likelihood of successful new business models that generate much high returns for shareholders.

By assessing these factors, investors can begin to get a better idea of who is innovating and who isn't. Of course, all innovations don't result in dramatic growth. However, a discernible lack of innovation is usually a clear sign of a company that won't ultimately become a high performer, consistently surpassing its peers in revenue growth, profitability and total return to shareholders.

Craig J. Coletta has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst charterholder, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.