Investing: Finding the Next iPod

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"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.

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