‘Hot’ stocks could prove risky in the long run

Google and Apple are two of the hippest companies around. Both have been successful in uprooting the old establishment and creating innovative products and services that consumers have embraced with open arms – Google with its search engine and Apple with the iPod.

Both companies have successfully monetized their products into cash cows. Their profits have soared. Google’s net income increased from a little over $399 million in 2004 to over $3 billion in 2006. That’s a 651 percent increase in two years. Apple’s net income increased from $276 million in 2004 to $1.99 billion in 2006.

Clearly, investors who held Google or Apple stock from 2004 to 2006 were handsomely rewarded, as the explosion in the companies’ stock prices is as amazing as the explosion in profits. Google’s stock increased from its initial public offering of $100 in August 2004 to around $440 today, while Apple, trading in the mid $20s during most of 2004, nearly tripled by January 2005, before a 2-for-1 split in February 2005. It has doubled from that point to around $90 today.

The coolness factor and phenomenal growth rates of both companies have made them popular investments. However, I think there’s a risk in this popularity for new investors. New investors invariably seem to think that good companies always make good investments. And because Google and Apple’s success is so well known, I am afraid that many new investors may be investing in the companies strictly based on these factors.

Remember, a stock’s fundamentals and long term prospects are what’s important. I think the fundamentals of both companies are sound. Both have hoards of cash, are growing at feverish paces and trading at valuations that I feel fairly encapsulate their near term growth prospects.

What troubles me is the long term prospects of each company. I do not think either company can sustain the growth they have had in the long term. I believe that potential fundamental and business-specific problems could threaten each company’s current competitive advantage and success in the future.

Both companies face an environment of technological change and continual innovation by competitors, which seems to be the nature of the technology industry. These two factors could conceivably provide challenges to Google and Apple in the future.

Google has had great success with its search engine. Google created a search engine that was perceived to be better than all the others and it has been able to maintain this advantage. Google has monetized its search engine by selling click-through advertising.

Google makes money every time someone clicks on an advertising link displayed by the search engine, based upon key words or phrases of the search query. Google has also leveraged its brand awareness and market share into other arenas, such as Google Earth, Google Checkout and Google Finance.

However, I think Google’s prospects are not as rosy as most people think. According to morningstar.com, Google continues to make almost all of its income from the advertising on its search engine. While its other portfolio of products are certainly neat, they have not produced a significant revenue stream. A company without a diversified stream of revenue from several products is always at risk.

There are three potential threats Google could face in the future.

First, Google’s search engine may face obsol-escence, if online technol-ogies and applications continue to advance at record paces.

Second, Google has fierce search competitors in Microsoft, Yahoo and IAC. All already have competitive search engines, and they have the capital and talent to continue to upgrade them. If Google and these other firms continue to produce superior search engines, the technology will probably progress to a point of diminishing returns – where every search engine provides the same results.

This produces an environment where Google would become a commodity. Its main revenue stream, click-through advertising, would be significantly less valuable.

Third is that another competitor designs a superior search engine. Do you remember Ask Jeeves and AltaVista? They were marginalized by companies like Google.

Apple also has potential threats to its iPod.

The iPod is a wonderful device. Right now, Apple has an advantage over its competitors. It offers a highly regarded product everyone knows and its applications and storage capacity seem to offer a better value over its competitors.

However, Apple also has worthy competitors who certainly have an incentive to dethrone Apple. Companies like SanDisk, with their Sansa, and Microsoft, with the Zune, have created products that have many of the advantages of the iPod. The gap between the competitors and Apple will only get smaller.

I also think Apple could have problems with its iPhone. I believe the iPhone’s $500 price tag and exclusive contract with Cingular Wireless will hinder its adoption by iPod users.

Apple appears to be safe for now. It still has a significant share of the MP3 and hard drive market. I believe part of this is due to Apple’s iTunes, which has provided iPod users with an excellent music and media service for all their iPod needs.

However, in my opinion, the changing technology environment or competitors could eventually prevail over Apple. I don’t think Google and Apple’s businesses will be threatened in the near future. Regardless, I think it’s too early to determine if their products will be around for decades to come. It’s very possible that the scenarios I have laid out about each company will never come to fruition.

But there’s also the possibility I may be right. Google and Apple must prove they can continue to innovate and meet the needs of consumers by providing superior products. This prospect will take time to determine and until they do I recommend that when investing, you stick with established companies, which have already proven their competitive advantage and success over time.