How to Spot Innovative Companies

By Markets Fool.com

Many of the companies that keep showing up as recommendations in The Motley Fool's stock-picking services are disruptive -- companies that totally change the status quo of their industries, that meet needs their markets hadn't even known they desperately wanted.

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In this week's Industry Focus: Tech, host Dylan Lewis talks with Million Dollar Portfolio analyst Simon Erickson about five principles that investors can use as guidelines to identify disruptive companies, based on Clayton Christensen's book The Innovator's Dilemma. Also, they explain why once-disruptive companies often lose their game-changing luster with time, why it's so hard to predict future markets, what Facebook (NASDAQ: FB) and Netflix (NASDAQ: NFLX) did so right, and more.

A full transcript follows the video.

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This podcast was recorded on Sept. 2, 2016.

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Dylan Lewis: Welcome to Industry Focus, thepodcast that dives into a different sector of the stock market every day. It's Friday, Sept. 2,and we're talking innovation and disruption.I'm your host, Dylan Lewis, andI'm joined in the studio by Fool premium analyst Simon Erickson.Simon, how's it going?

Simon Erickson: Great,Dylan. Two of the finestwords in investing right there: innovation and disruption.I love it already.

Lewis: Have you tried toreach out to people at dictionary.comand get your facedirectly next to thosedefinitions?

Erickson: I really need to. That's a great idea.

Lewis: Yeah,one of these days. This should be a really fun show. We're basically going to go through the Fool'sintroduction to disruption, like Disruption 101 class. Thankfully,I have Professor Simon Erickson to help me out.Simon, when I say this is a class, I'm not kidding. This is something we've institutionalized a little bit.

Erickson: That's true.

Lewis: You gave a presentation a couple months ago to Fools,whoever wanted to show up and hang out and listen,check it out. This discussion we're going to haveis also a part of what the analyst development programon the investing team side,what those people go through as cohortwhen they come in and learn how we invest,and become part of our program. So,this is kind of a look behind how our investing teamthinks about some of the stuff, and,I think, a cool thing tobe able to share with listeners.

Erickson: Yeah,and it's really a neat field. It's all based on a book called The Innovator's Dilemma written by Clayton Christensenback in 1997. We incorporate it into ourinvesting process. You see it a lot in our Rule Breakers service, our Supernovapremium service. It's basically anunderstanding of, why do these huge companies, like theIBMs and the Ciscos ofthe world not just keep getting bigger and bigger and more efficient and taking over the world eventually? There'ssomething that changes along the way, and disruption,to a very large extent, explains what's happening.

Lewis: Yeah,and it's something that's near and dear to the Fool's heart. Like you said,a lot of the very successful stock picks from our newsletters have been highly disruptive companies. We've beenable to benefit from having folksidentify thesehot spaces and the companiesoperating in them fairly early on, andhopefully helped outinvestors along the way. Listeners, the idea with this show is,we're going to outline, basically, what it truly means to be disruptive. There may be a little bit of a misconception out there. Also, why investors should care, and some of the principles that Fools use to identify disruption andsome of the companies that are leading the charge in some of these spaces.Simon, to kick it off,what is disruption as you define it here, and as Christensen defines it?

Erickson: Disruption is based, first, off oftechnology itself. Technology, the definition of that is really just aprocess that changes labor,money, materials from something of a lower value to a higher value. You see examples of this all the time.Appletakes radios andprocessors and compiles them all into an iPhone, which is ofmuch higher value for somebody than all those pieces together.Wal-Martdoes the same thing. They take aworld-class inventory management systemand can work with vendors all over the globe to put those products into a discount retailer. Technology ishow you bring something from a lower valueto a higher value.

Theinteresting part is thattechnology changes over time. We call that innovation. There's really two types of change intechnology. One is sustaining innovation. That's basically, we'redoing something kind of similar to what we did before,but it's a little bit better and a little bit higher tech. So,when Apple comes out with the iPhone 7,probably in September --

Lewis: Hopefully, fingers crossed.

Erickson: -- it'sprobably going to look a lot like the iPhone 6. It's going to have, probably, a better camera, better processors,stuff like that, but still based off the wayApple packages products.

Lewis: And that type ofinnovation, to me, sounds much more iterative. The idea of being like, "OK,we can kind of project where this is going." It's easy to see what the next phase of this might look like.

Erickson: Exactly. Andthe other side of that, to answer your questionin the most long-winded way I possibly could, is sometimes,we have disruptive innovation, where youdo not base it off of an established product or process. It'scompletely doing something differently. It brings new value to customers through a new technology or a new business model. We cango more into that a little bit later in the show.

Lewis: Yeah, we'll dive deep into that. But, something tokeep in mind as you see outlets orpodcasts or anyone talking aboutsomething that is disruptive, think about whether it's something that slightly changes what we already know, or is truly coming out of a new space. Looking at why investors should care about disruption -- we touched on some of the great Rule Breakers picks, some of the great picks from the Fool universe have been highly disruptive companies. Any color you want to add there, Simon?

Erickson: It's interesting. Thesustaining innovations, the improvementsthat are complimenting existing technologies out there, reallybenefit the larger firms. They already have, maybe, a plant built out.Maybe they have a huge process thatmakes them a lot more efficient than smaller companies can be. So,typically, they'll shy away from disruption,which is what makes it so interesting -- disruptive innovation favors the newcomers thathave a different set of glasses on, are able to see things differently,bring a new business model out there.

I think the reason why you should care,if you're a big company, about disruption is ... Let's not forget that Cisco, for many years, wasthe largest company on the stock market. I believe it had a $500 billion market cap, at some point. And now,it's definitely a shade of that,because the business world changes,and you have to keep pace with those changes, and sometimes disrupt yourself, if you're a big company. So, for big companies, small companies, investors,it's definitely something that we should all be paying attention to.

Lewis: And your point about Cisco --even if you're not someone who is a highly growth-oriented investor,and you don't like the idea of playing and more nascent spaces,you want to see that some of these stalwart companies thatyou're invested in are at least considering this kind of stuff. Whether it's a smalldepartment that's working on projectslike this, or through acquisitions, just, thatthey aren't going to be passed byby technological change.

Erickson: Exactly. Thereally interesting part, Dylan, is that thesecompanies aren't doing anything wrong. It'shard to call the managers of thesemultibillion-dollar segmentsof these companies --they're not idiots. They'resmart guys that are making great rational business decisions. It's just, disruption looks at,why does that not always work? What is it thatthey didn't see coming that changes the business out there?

Lewis: Andin some cases, there are characteristics of the business thatmake it tough to really engagein some of these markets. With that said,why don't we look at a couple of the principlesthat you and some of the investing folks useto identify spaces that are, maybe, ripe for disruption, orcompanies that are ready to turn the world on its head.

Erickson: Like you said, there'sfive principles you could look for to predict when disruption is going to hit an industry or a certain company. We can walk through those, for this podcast, one at a time. The first is what Christensen calls the theory of resource dependence. He really says thatit's not companies, but it's their customers and their investors thatdictate how they're spending their money. Which is crazy, right?

You think about it,companies are always allocating capital, "We're going to do this and that." A lot of times, it's the investors saying, "We want you tomake this acquisition to juice your return on equity." Or,your customers might be saying,"We want aslightly better product, that we'll pay a little bit more for it," and that guides yourallocation decisions. But the concept is, a disruptivecompany will look at where the market is headed, and is not as subject to their owncustomers or their existing investors telling them how to spend that money.

I have an example for it. Is it OK if I throw in an example?

Lewis: Drop an example, absolutely!

Erickson: One of the great examples -- we havea lot of these on our scorecardsfrom The Motley Fool -- it's Netflix. Netflix, as you and Idiscussed before the show, had a very profitableDVD-by-mail business.Reed Hastings, of course, went out and said, "Guys,I think the future is in online streaming. I'm going to get a lot more data aboutwhat shows people are watching and build this recommendation engine." Anda lot of people thought he was crazy for spending moneyon a market that really didn't exist yet. But he, in essence, disrupted his own business, and it's provedvery profitable in the long run for Netflix.

Lewis: Yeah,and you hear a lot of businesses talk abouthow you want to cater to the customer, and deliver what the customer wants. There are a lot of instances where the customer doesn't know that they want somethinguntil it's available. Then, it's "How do I live without this? What am I going to watch onSaturday night if I can't stream Netflix?" Andthat's something that wouldn't have even been a thought 10 years ago. Sometimes,companies have to be willing to anticipate what people want rather than respond directly to it.

Erickson: Very true, both of those. On top of that, what isavailable in the market at the time? Until people really had high-speed broadband internet, streaming movies over the internet was almost impossible. When that enabled digital streaming, Netflix really took off. It was in the right place at the right time.

Lewis: I see No. 2: Small markets don't solve growth needs. Youwant to elaborate on that a little bit?

Erickson: Say thatyou'reBerkshire Hathaway, you'reWarren Buffett.Buffett has famously said thathe can't go after small fish anymore. He can't go after small-cap companiesas investments because they're just not going to move the needle forBerkshire Hathaway. He has multiple hundreds of billions of dollarsin divested capitalthat he has to go after theCoca-Colasand the IBMs as investments. It'sthe same thing with businesses. If you're wildly successful, doing $100 billion a year,you have to find a market that's existing today that's a $10 billion market for you to grow 10%. A $100 million company just has to have $10 million to do the same thing.

Disruptive companies, a lot of times, willlook at markets that big companies are not looking at. The example for this one is a Rule Breakers' recommendation,Ubiquiti Networks (NASDAQ: UBNT), that'ssetting up wireless access points toget onto the internet. When you think about the internet service providers we've typically had, they lay a lot of cable, they go and want to dominate a market. Maybeif you have an apartment complex in the D.C. area, you'relocked into one certainprovider.

Lewis: I know that game very well.

Erickson: Huge costs, huge sales forces like to go in and dominate areas. Ubiquiti has no direct sales force, and very little marketing costs. They basically have customers come to them and say, "Hey,I would really like this kind of product spec. Can you build it for me andtell us how much we'll pay for it?!" It's been really successful inuniversities and sports stadiums and emerging markets. A very, very profitable business.

Lewis: Yeah. Very interesting. No. 3, moving along: Markets thatdon't exist can't be analyzed. I think this might beone of the most interesting points that we'll raise during this show.

Erickson: It'smy favorite of the five, actually. Can I ask you,how did he come up with the name The Innovator's Dilemma? Do you knowwhat that actually refers to?

Lewis: I don't.

Erickson: It's aninteresting thing. The Innovator's Dilemma is,if you want to get into something new,you don't have the data to support that decision,necessarily, because it's new. You don't know if it's going to work or not.

Lewis:So,the idea is, you're working on a hunch and not much more, in some cases.

Erickson: Yeah. It would be a no-brainer if all the data told you, "Hey, this new market that nobody's going into is going to be wildly successful." You don't get that. You have to jump out there ahead of the pack.

Lewis: And, in fairness, if the data suggested it,everyone would be doing it.

Erickson: Exactly. So, that's the beauty of The Innovator's Dilemma. It's always forward-looking, it's not looking at financial ratios. A lot of what Wall Street lives and dies by is things likemargins, return on equity, return on invested capital. This is always a framework looking forward.

Lewis: Evensomething like addressable market, which issomething that we like to look at when we can,but if you don't even know what a market is going to look like,or what the scale of a technology might be,it's kind of a Fool's errand toeven put a number on it.

Erickson: Exactly. And let's go back in time to 2004, 2002 -- social media, social networks, Facebook is theexample for this one. This wassomething that most people didn't understand. You hadMySpaceand a couple otherstrying to figure this out out there. But Facebook was so far aheadof the game of the larger competitorsin the traditional space thatthey learned a lot more about what people wanted to doon social networks, then they collected that data and didtargeted advertising. Of course, now, it's a more than $300 billion market cap company.

Lewis: I will say, I saw aninterview that Zuckerberg did recentlywith the founder ofY Combinator. He asked him, "What wasone of the tougher things you experienced as CEO andin the development of Facebook?" And he said "People not seeing the vision that I see." These weren't external folks. These werepeople that were internal employees,members of the management team,that were disappointed when Facebook decided to shunearly buyout offers.

He saw this hugepotential to get beyond colleges, to become this huge platform that connects everybody, andthey didn't. And a lot of them actually leftwhen they decided to reject that buyout offer. So, this is not something that's limited to your average investor or mom and pop at home. This is something that even people in the space might not be 100% capable of grasping market size.

Erickson: Andjust like you said, it has to be the right person. You have to have the right vision,and not somebody that's leading youin the completely wrong path thatmaybe they think is the future of the business that really isn't. Good point on that.

Lewis: And even beyond the platform itself, we can look at the idea of,markets that don't exist can't be analyzed, orcan't be totally grasped -- withFacebook, in the context of its pivot to mobile. A lot ofpeople were pretty skepticalof Facebook's ability to monetize mobile audienceswhen they saw thatthat's where the majority of web traffic was going. Clearly, it'sworked out for Facebook. They, basically,quintupled in value as they've reallysuccessfully pivoted to mobile. Now, mobile makes up, I think 84% to 85% of their total revenue take. So, this is not evennecessarily something that is limited towhen a company is first starting out. It can be something that,similar to the idea of streaming video with Netflix, happens as a company sees opportunities, and maybe leaves some of the market behind because they don't.

Erickson: Yeah. It turns out,interesting as this might be, that predicting the future is actually pretty hard. It's not so easy to have a crystal ball and say, "We're going to put billions of dollars behind this new market that doesn't exist yet." A storyI love to tell when talking about this is back in the year 1980,AT&ThiredMcKinsey to do a study of how many U.S.-based cellphonesubscribers they thought there would be by the year 2000. 20 years in the future. Put yourself back in 1980, say, "There's this new thing called a cellular phone. How many subscribers do you think it could possibly reach by the year 2000?" Any shot on what the estimate was?

Lewis: Do you haveany idea what the population was back then,so I can kind of anchor to it? You know,I'm going to say 40 million.

Erickson: Good guess. The actual estimate that McKinsey -- one of the bestconsultants in the world at the time, keep in mind -- they said it would be about 900,000 people.

Lewis: Wow!

Erickson: The actual number by the year 2000 was 109 million, just in the United States. It just shows how hard it is to lookeven five years in the future, and predict where the market is going to head. But you do have to look, at some point, at smaller companies that are going in a path that everyone else is not going in.

Lewis: I think that segues very nicely into No. 4 on our five-point principle list here. Capabilities define disabilities. I think this plays into the idea ofsmaller companies maybe being ableto be a little bit more nimble, andthere being a certain stodginess with being a larger company, and being a little bit more fully formed.

Erickson: Yeah, that's right. It'skind of an interesting way,how you can define culturein a bunch of different ways. But one way topossibly define culture is howdecisions get made at a company. There'stypically certain metrics that in the boardroom of a business, managers and bigwigs of the companies, are using to base whether a decision is good or bad. Does this bring in a certain amount of cash flow? Is this a good return on our investment today? Do we havecustomers lined up that are ready to do this kind of stuff?

That's interesting because those capabilities, how a business is making decisions, its culture, and how it's deciding on things, can actually handicap it inlooking at all of the stuff we're talking about today. Anexample of this isthe large regulated utilities. When utilities spend billions of dollars to build a new power plant, they mandate a certain return on equity and a return for their investors that they can pass along to shareholders. It's heavily regulated by the states. That's how business is done. These are huge decisions.

Then, you have this small, scrappy company calledSolarCity.

Lewis: Oh,I think I've heard of them.

Erickson: Maybe a time or two before. One ofmy favorite companies -- apparently Tesla also like them, they're trying to acquire them right now.

Lewis: Yeah, Elon Musk seems to really like them.

Erickson: That's right. They said, "Itdoesn't have to be this way. If you can figure outhow much electricity one house needs, you can size a solar panel on the rooftop and have that produce all of theelectricity you need for that one house. You can size those accordingly." And if people payon a monthly basis for that power, you don't have to put up the $20,000 to $30.000 to build it yourself. Totally disruptive idea. Didn't have the same metrics they were using to make decisions,because they weren't building thesegiant power plants. Avery disruptive company to the energy industry.

Lewis: Yeah, and that is a little bit of an inside example, one that maybe needed to know the industry a bit better,understand how it works, to fully grasp. I think,to go back to Netflix, they'reanother example of a company that,even by name, shows thatthey weren't limited to the business structure that they hadwhen they first started.

I've heard David Gardner make this point before,and it's a very bright one -- they're called Netflix. They were not called MoviesByMailFlix. That would have been redundant. But, they weren't tethered to this idea of being a by-mail company. They were a digital company that pivoted when they saw the opportunity. And their name suggested that. So, that's tougher to recognize,but something to keep in mind. I don't know how many exampleswill show themselves like that. There are different waysthat businesses indicate, I think, their flexibility and how nimble they are. Any indicator you can find there can behelpful in looking for some of these more disruptive companies.

Erickson: And David has many times calledReed Hastings the smartest guy in any roomthat he's in, which isa telling sign of exactly what you said,that he saw changes in the industry to take advantage of.

Lewis: Yeah,I certainly wouldn't fight that. Ourlast one here, No. 5: Technology supplyversus market demand. Youwant to dive into that one?

Erickson: Yeah. Alot of times, companies get really excitedabout their technology,and try to push it to the limit. They say, "We havethe greatest-in-the-industry widget that'sgoing to do something 10 times betterthan you even need it to do in the first place," whichsounds great, but it's actuallycompletely inefficient. You want atechnology to meet the market'sdemand, and do exactly what the market isasking you to do. Otherwise,you're probably spendingway too much money of your [research and development]efforts ondeveloping something that isn't even needed in the first place.

The trick is to see,what is it that your market wants your industry to do? What is thevalue that you're bringing to your customers? What are they asking you for,and how can you hit that right in the sweet spot so you're not overspending or underinvesting, butgoing right after what they're asking you to do?

Lewis: I'm curious what you think aboutapplying that type of approach to Tesla. Theystarted with a very elite, luxury product. The difference is, they went small market first and created anexcellent product, reached the high-value markets, then slowly havedecided to make it more accessible,build out their scale. Would you saythat might be an example of a companybeing limited in the scope of technology,and maybe not spending as much in R&D as they would have, had they been more ambitious, but doing it in a smart way?

Erickson: Interesting example. Actually,electric vehicles were talked about in Christensen's original book in '97.

Lewis: That's early on.

Erickson: Exactly, right? I think Tesla, early on, wasmore about the brand than the car and its performance. They really went after the highest end so they could start at the top of the market, and geteverybody to want a Tesla,that all the movie stars like Leo DiCaprio had. And if you had a Tesla at the mid-market, or the lower end, one that was affordable, you were buying into a luxury vehicle. I mean, it's a Tesla, this thing is awesome. Even thoughit might have cost, I think the next one is supposed to be $35,000, the Model 3.

The one I like, Dylan, isactually a company calledSplunk (NASDAQ: SPLK),that can just look at a ton of data out there and distill it down into a very simple dashboard for their customers to understand. Examples ofwho they're working with -- theSan Francisco 49ers --

Lewis: Oh! I was not expecting a sports example!

Erickson: Yeah! What Cokes and what hot dogs people are buying indifferent sections, maybe they can market to them.Domino's Pizzauses Splunk to know what, regionally, is selling better. If thejalapeno pineapple pizzais only selling in Cleveland, Ohio,then maybe you go after more marketing there.

Lewis: I have a feeling it's not Cleveland, Ohio, for jalapeno pizza. I know Sean O'Reilly,host of the Energy Industry Focus show, has one of the blandest palates I've come across at The Fool,and he's from Ohio.

Erickson: Youmight have to ask him if he would eat it,pineapple jalapeno pizza.

Lewis: I'll follow up with him after the show.

Erickson: OK. Probablynot the best example on my part, then.

Lewis: But,the idea being, they'reteasing out insights from data, andhelping businesses make smarter decisions.

Erickson: Yeah. And if you're in a board room, maybe you're a CEO, you're a decision-making manager,you don't want a whole lot of data that doesn't mean anything to you. Youwant to say, "OK,what is this going to matter to me?" And Splunk does a great job ofdistilling all of that down, and saying, "What are you trying to accomplish? Let'slook at what the data is telling us,and let's move forward from that." Again, hitting the sweet spot. What is the market demanding? What do they want your product to do? Companies going out with thetechnology to achieve that.

Lewis: Yeah,I think sometimesyou can overdeliveron the tech side or the capability side,and it's just extra. Or,your customers aren't seeing the value, and you've spent all this time and ramp up getting it there andit might not even be a very useful feature or add-on. So,definitely something to keep in mind.

Erickson: Absolutely.

Lewis: So,those are our five points. Anything else on the topic ofinnovation or disruptionthat you want to give for listeners here, Simon?

Erickson: I guess, to wrap it all together, Dylan, there's only three points that I try to have as my key takeaways when we'relooking at disruption.

The first is, how doesthe industry define value? What is it important thatyour company needs to achieve that is valued by your customers? That's a really hard question to answer, especially for markets that don't exist. That's one of the keys of whether yourcompany is successful or unsuccessful --are you correctly going after the thingsyour customers want you to be going after? Ifyou're achieving them,there's a high likelihood thatyou will be a disruptive, successful company.

Thesecond one is, what is the positionof the incumbents? What isgoing to be their reactionto what you are doing? Arethey going to come in and just crush you anddo it better, because they already have anestablished process? Or,is there truly something that's keeping them from pivoting towhat you're trying to do?

And then, the third one, I always say is, who's in the captain's chair? Who's the leader? You were talking about MarkZuckerberg, or Reed Hastings. Who's making these decisions, and are they valuing the future of the company? Or are they just lookingbackwards? And that plays a huge role in whether it's successful or not.

So, those are my three key takeaways for disruption.

Lewis: Yeah. Thesedifferent principles we outlined are great, but they're only as good as they'reeventually being an end customer, or not being an "a-ha" moment from a big company, and then justcoming in and squashing them.I think those are good things to keep in mind, and nice caveats to have. Simon, you'veobviously drawn quite a bit of inspirationfrom Clayton Christensen.I understand that you're going to beinterviewing him.

Erickson: Yes.

Lewis: Later this month?

Erickson: Next month, October.

Lewis: OK. I know he's written some other books. He hasanother book coming out. Do you want to talk about thata little bit?

Erickson: He does,he has another book coming out right now. I don't believe it's been published yet,so I don't want to talk too much about it. But keep in mind,he has influenced all of this thinking. I think he's just a real visionary guy, very forward-looking guy, an author,started as a Harvard Business School professor,still teaching there today in addition to writing books andinfluencing business leaders.

We'rereally looking forward -- I can't tell you how excited I am about this interview. We're going to be posting itall over our sites. It's definitely going to be influencing our Rule Breakers service and our Supernova services. But really,for anybody that's a growth-minded investor, I think this is something youat least have to keep an eye on and be aware of.

Lewis: So, folks who are looking for some moreinformation on this, stay tuned.I will probably steal Simon againand have him talk aboutthe interview that he did with Clayton Christensen, as a little follow-up, in a month and a half or so. But,if you're interested in learning more, I would certainly read The Innovator's Dilemma,and I would check out his other books. That'sanother great placeto jump off and dive into this topic a little bit more. Otherwise,I think that does it for this episode of Industry Focus. Yeah?

Erickson: Hey,I'm glad to be here. Thanks forinviting me for the show,this was a really fun for me.

Lewis: Yeah, this is like yourChristmas morning.

Erickson: That's right.

Lewis: Well,listeners, that does it for this episode of Industry Focus. Ifyou have any questions or just wantto reach out and say, "Hey," you can shoot us an email at industryfocus@fool.com. You can always tweet us @MFIndustryFocus. Ifyou're looking for more stuff, you can subscribe on iTunes, or check out The Fool's family of shows at fool.com/podcasts.

As always,people on the program may own companies discussed on the show,and The Motley Fool may have formal recommendationsfor or against stocks mentioned,so don't buy or sell anything based solely on what you hear. For Simon Erickson,I'm Dylan Lewis, thanks for listening and Fool on!

Dylan Lewis owns shares of Apple and Tesla Motors. Simon Erickson owns shares of Apple, Berkshire Hathaway (B shares), Facebook, Netflix, SolarCity, Splunk, and Tesla Motors. Simon Erickson has the following options: long January 2017 $50 calls on SolarCity, short January 2017 $50 puts on SolarCity, and short January 2017 $40 puts on SolarCity. The Motley Fool owns shares of and recommends Apple, Berkshire Hathaway (B shares), Facebook, Netflix, SolarCity, Splunk, and Tesla Motors. The Motley Fool is short Domino's Pizza and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Cisco Systems and Ubiquiti Networks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.