How to Find The Next Apple

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Today, I want to answer the following letter from a reader:

“I’m not content with ordinary gains. I haven’t saved enough for retirement and it’s causing me anxiety. I’m looking for stocks that can generate exponential gains. What criteria do you use, for finding such stocks?” — Jerry B.

Jerry, we’ve all heard the lament: If only I had the foresight to buy certain stocks in their infancy, I’d be living on a private island in the Caribbean.

But reliance on technology only partly explains the explosive gains of, say, legendary behemoth Apple (NSDQ: AAPL). Thousands of other companies in the tech sector have not performed nearly as well.

From my perspective, there are four traits that explain a stock’s extreme outperformance. The company must be:

• A “disruptor” in a large market with an established incumbent that is vulnerable to attack.
• Nimble enough to capitalize on the opportunity, with the financial flexibility to access the capital markets while investing for growth.
• “Flying below the radar” of the mainstream financial media, so it can establish a position in its market before the investment herd catches on.
• Inexpensively valued compared to the size of its future market opportunity.

Let’s take a closer look at each one of those characteristics and why they are critical to success.

Market Disruptor

The companies that are tapped into constant change prove the most profitable, especially in these tumultuous times. Apple is an instructive case study.

Until Apple came along, the Sony (NYSE: SONY) Walkman was considered a revolutionary breakthrough in portable music. Remember the Walkman?

Apple’s iPod was gaining market share as a portable music device, but once Steve Jobs realized that he could add music as an app to a smartphone, the days of the Sony Walkman were numbered.

Not only was Sony unaware of Apple’s decision to emphasize apps for its iPhone, but the makers of the BlackBerry (NYSE: BB) cell phone felt equally untouchable…until it was too late.

What both of those sector giants failed to realize was that they were vulnerable to attack from below, in this case by Apple’s decision to convert the cell phone into a pocket computer.

Financial Agility

Recognizing that a window of opportunity has opened is only valuable if a company is able to act on it quickly. That requires sufficient financial and operational flexibility to implement a comprehensive strategy to capitalize on the opportunity, without blowing up the balance sheet by taking on too much debt or issuing too much stock.

One of the biggest challenges for a small company is acquiring capital at a sustainable cost. If the fledgling firm borrows too much money, the cost of servicing that debt can eventually lead to bankruptcy. But if it issues too much equity, it risks diluting its earnings to the point that its shareholders dump the stock in favor of more attractive opportunities.

Low Profile

Perhaps the most surprising aspect of Apple’s assault on Sony and BlackBerry is that it was able to develop its smartphone to very little fanfare.

If something as ubiquitous as the smartphone could go unnoticed during its creation 10 years ago, then tomorrow’s breakthrough product or service could be sitting right under our noses today.

I subscribe to the contrarian school of investing. If a “story stock” is being hyped on financial television, I get suspicious. I prefer to roll-up my sleeves and unearth hidden gems that the lemming-like investing crowd is overlooking.

Mispriced Opportunity

The final condition that must be present for a small company to explode in value is a current share price that’s grossly mispriced compared to the size of the market opportunity.

Focusing on valuation seems like a no-brainer, right? Well, this rule is often ignored. Investors can get excited about a stock that seems too compelling to avoid, even if it’s absurdly overvalued.

This truism bears repeating: If a stock is considerably more expensive than its industry or direct peers, or its estimated growth is greatly out of whack with its valuation, stay away.

Editor’s Note: I’ve just explained the criteria by which you can find the “next big thing.” One industry that’s rife with promising disruptors is marijuana.

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John Persinos is the editorial director of Investing Daily.

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