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Stock Strategist

Long-Term Investing vs. the Hot Product

Temper your excitement with real-world expectations.

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We analyze all kinds of companies to find opportunities for the long-term investor. One category that can be a challenge sometimes is the firm with a hot product on its hands. The product is usually something new that is generating a lot of hype and excitement. Soon enough all the "cool" people have the item and the sky's the limit on the new opportunity.

With excitement comes risk, however, as stock prices shoot up and attract investors at the peak of expectations. Then the realities of the marketplace hit. Some investors get caught at the top, unaware of the white-knuckle ride back down that will soon commence.

There are many reasons why this pattern occurs, most beyond the scope of this article. One concept we want to highlight centers around how a group adopts a new technology, such as a microwave or an MP3 player, and--of equal importance--who ends up selling it to them.

Assuming that there is a normal distribution of people who all want a certain technology, we will find some gadget freaks at one end of the curve and some technophobes at the other end (which combined account for about one third of a typical group). In between are a lot of regular folks (the remaining two thirds of the group).

With a hot product, adoption is rapid. Unit sales can post triple-digit growth rates, company profits expand faster than expected, and the media is breathless about the revolutionary nature of the "new" item.

Mr. Market, not to be outdone, declares that it will be different this time and promptly applies a generous multiple to a peak earnings number. The stock shoots up as greed joins hands with the fear of missing the next big thing, and investors pile on.

Then reality sets in. The early-adopter gadget freaks get their fill, and growth rates start to slow as other folks take their time evaluating and purchasing. Well-financed competitors see the money the lucky firm is raking in and redouble efforts to grab a piece of the pie. Soon the bloom comes off the quarterly numbers, and valuations adjust to more prudent levels. People quickly figure out that the portion of the bigger "E" in P/E that came from the new product doesn't really deserve the large multiple that was hastily applied on the stock's ascent. (An ironic side note is this process can also get taken too far to the downside and some early leaders resurface as good buys again, as in the case of  Yahoo (YHOO) in 2001.)

We think this happens in part because the company delivering the new technology to the front half of the curve enjoys a couple of benefits. Some of these benefits include serving a relatively high-margin product to eager consumers who may overlook the fact that battery life is short, the device is a bit clunky, or that customer support is on the thin side. The back half of the population set, on the other hand, can be more discriminating. These consumers sometimes require lower prices, higher quality, more selection, or better service. It can sometimes be easier for competitors to take an existing product and make it better rather than start from scratch. These factors--demanding customers and cutthroat competitors--can really cut into the first company's profits rather quickly.

The approach can cause us to be overly conservative, at least in retrospect. An example is in our coverage of  Apple Computer (AAPL). Though not perfect every step of the way, we applied this logic of a dispersion of technology into a population in modeling Apple's iPod and Macintosh opportunity. As can be seen in the price/fair-value chart for Apple on our site, including this eventual slowdown phase for Apple in our model kept our fair value estimate a step behind the stock price as new information about product sales and profitability streamed in each quarter. We stuck to our approach, though, and modeled a best-case sales and profitability scenario that suggested a valuation peak near $60 late last year. The stock continued to rise to an uncomfortably high $86 before working its way back to a level that we think is more reasonable.

We see similar scenarios elsewhere. Mobile GPS devices, such as the ones made by  Garmin (GRMN), spring to mind. The GPS marketplace offered strong opportunity initially but eventually faded as others found ways to serve the more fastidious customers who remained. Unloved  Sony (SNE), with its digital cameras, LCD flat-panel TVs, and PlayStation3 game console, is another firm that is well-positioned for a big wave of technology adoption. Both stocks have 3-star Morningstar Ratings for stocks today; a hiccup in the markets, however, could serve up a buying opportunity.

Investors aren't limited to tech stocks either. Another stock with a hot product on its hands,  Hansen Natural (HANS), is on the cusp of a 5-star rating. This firm makes the Monster brand energy drink that's closing in fast on the popular Red Bull.

Our advice, however, is this: Find a smart point at which to build a position early, or wait on the sidelines for another opportunity. Chasing stocks when the excitement is at a fever-pitch is a tough way to get ahead, because that's when things usually start to slow down.

Rod Bare does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.