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By Joseph Beaulieu

Americans love rooting for the underdog, and the press and other technology mavens love upstart companies. But investors would be well served to face up to reality: in the handset industry, scale, features, and reputation are everything. For that reason, we think investors looking to invest in the growth of the smartphone market should narrow their focus to Apple (NASDAQ:AAPL) and Research in Motion (RIMM).

Three Features of a Winning Smartphone Company
We've settled on these firms because they (and their platforms) meet what we view as three key criteria for long-term success in the smartphone market. The first criterion is that the company controls both the hardware and the operating system. We think firms that control both aspects are able to provide a more controlled, consistent user experience and allow them to drive customer loyalty.

The second criterion is that the firm has sufficient scale for marketing and distribution, and for the wireless carriers to devote their own marketing and support dollars to the platform. Getting the phones onto the carrier's web page or store selves isn't enough--the carriers must actually have the incentive to steer customers to the phones and understand them well enough to sell and support them.

The third criterion is that they must be true "smartphones," rather than "feature phones" (i.e. phones with some enhanced features). Support for first and third-party applications, web browsing, and full-featured email are minimum requirements to be considered a true smartphone, in our view. Touch-screens, media (music and video) support, QWERTY keyboards (physical or virtual) and Wi-Fi connectivity are requirements at the higher end of the smartphone spectrum.

Who Doesn't Meet These Criteria?
We excluded Motorola (MOT), because while the company's Droid is a top-of-the-line smartphone, and Motorola has substantial scale and relationships with the wireless service providers, the company is essentially a commodity hardware provider offering phones for the Android platform. Even though Motorola is trying to build in functionality that ties the user to Motorola rather than just the Android platform, we are uncomfortable with the fact that Motorola does not control its own destiny. If a user likes their Motorola Android phone, there is little to prevent them from jumping to an Android phone from HTC, Google (NASDAQ:GOOG), or Samsung the next time around. As the PC manufacturers learned in the early 1990s, putting a proprietary "shell" around the Windows operating system wasn't enough to differentiate one from another, and we believe this is true with the different look-and-feel that some Android handset makers are using to attempt to differentiate themselves. It is important to note that this is not a knock against Android--we just think that it is unlikely that any handset manufacturer will be able to differentiate itself from the competition using Android.

Palm's (PALM) situation has clearly deteriorated over the past month since it released weak third-quarter results and disappointing fourth-quarter projections, but even prior to that it would have not made our list. Although the company is now a soup-to-nuts smartphone company (owning both the hardware and the software), and even though the Palm Pre is truly a full-featured smartphone, the firm did not have the scale or relationships necessary to get its phones onto AT&T (NYSE:T) or Verizon (NYSE:VZ), leaving it with Sprint (NYSE:S) as its only carrier at launch. By the time it lined up Verizon as a carrier, the hype around the Pre launch had dissipated (and the hype around the Droid was still going strong), and as the sell-through numbers for the third-quarter showed, Verizon was unwilling or unable to move the Pre at the retail level.

On the Borderline
Nokia (NYSE:NOK) is a borderline case, in our view. The company is a hybrid in that its own Symbian operating system is now open source, but it retained ownership of the higher-end Maemo system that runs its highest-end phones. Nokia's smartphones (some of which are certainly high-end) fall into a much larger category it terms "converged devices," which also contains handsets we would consider to be "feature phones" rather than full-featured smartphones. As the largest handset maker in the world, Nokia has scale and clout with carriers. So while in some ways we see Nokia as a peer to both Apple and Research in Motion, just a small part of Nokia' revenue comes from the category we consider true "smartphones." Someone looking for exposure to the broad handset market would be well served by taking a closer look at Nokia.

Our Favorites
Apple, with its iconic iPhone, remains our top pick. The litany of complaints nay-sayers have leveled against the iPhone is long: it is a closed, locked system; AT&T's coverage is terrible; iTunes is proprietary; the phone is expensive and the data plan is even more expensive; you can't "tether" it to a computer; multiple applications cannot run simultaneously etc. All of these complaints have some truth to them, but if iPhone sales and usage are any indication (and we are pretty sure that they are), actual iPhone users do not care. Satisfaction metrics for the iPhone remain tremendously high, and a majority of iPhone users would recommend the iPhone to a friend. In order to be unseated, we believe that Apple would have to make some serious unforced errors.

While Research in Motion's BlackBerry has been overtaken by the iPhone in popularity, and while it is showing its age, the BlackBerry remains an extremely compelling smartphone platform. It earned its reputation as the communication device to own when reliability, timeliness, and security are critical. (We think that the BlackBerry is arguably a better communication device than the iPhone, while the iPhone bests the BlackBerry on features like applications and web browsing). During the past few years, the BlackBerry has shifted from deriving the vast majority of its revenue base from the corporate market, to generating a bit over half of its revenue from the consumer market, with about 80% of new users added every quarter being consumers. In order to retain its new consumer customer base, while still retaining its corporate customers, Research in Motion is going to need to catch up with the iPhone on the multimedia/entertainment front, while not skimping on the features that appeal to the enterprise.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: With Smartphones, Investors Should Stick With What They Know