Stocks With Room to Run

The "Rule of 72" is a great way to calculate compounding interest in your head. The rule states that to find the number of years it would take a figure to double, simply divide the number 72 by the assumed growth rate. For example, if you think your stock will grow at a rate of 7.2% per year, it will take roughly 10 years for it to double (72/7.2 = 10).

A 7.2% annualized return doesn't sound like a great 10-year return for stocks -- and it's not. Consider that the Vanguard Total Bond Market Index (VBMFX) returned about 5.8% per year on average over the past 10 years. A 1% risk premium for investing in stocks instead of bonds is simply not a great margin.

Yet there are stocks that return just that -- or even worse.

Consider that of the 62 companies capitalized at more than $20 billion in December 1997, three-quarters (47) failed to achieve a 7.2% annualized return over the next 10 years. Some of the more disappointing investments include:

And these aren't no-name stocks, either. All three are S&P 500 components. Makes you want to take a closer look at your index fund, doesn't it?

Lean on me
The good news is that for each of the aforementioned underperforming mega caps, there have been others that have been holding down the fort over the past 10 years. Without these companies, the S&P 500 wouldn't have returned (a still disappointing) 5.8% per year during that stretch. Included in this list are:

Now we're talking. This is the kind of growth you expect to see from your stocks. This is why you take the extra risk by investing in stocks instead of bonds or CDs.

But is the best good enough?
Yet these were among the best-performing mega caps of the past 10 years, and I consider a 15% annualized return to be about the most any mega-cap investor can hope for over the long run. Why? Simply put: The Law of Diminishing Returns. As it becomes big, a company's growth begins to plateau. Microsoft, after all, was once a tremendous growth stock -- averaging greater than 50% annual returns from 1986 to 2000 -- before it got so big that it became difficult for its growth efforts to drive the bottom line.

Furthermore, according to Professor Jeremy Siegel's research, only 11 S&P stocks were able to sustain more than 14.7% annual returns from 1957 to 2003, even after we include dividend reinvestment! As companies mature, your returns diminish.

You can do better
Small-cap stocks, on the other hand, have much more room to grow than their larger counterparts. Indeed, all of the market's 10 best stocks of the past 10 years were small caps. Of this group, Hansen Natural returned 25,538% and Chico's FAS yielded 8,773%.

This isn't to say you should scrap your large caps -- diversification is important -- but if you're looking for a few great growth stocks to add to your portfolio, you might want to consider a small company instead of an S&P giant.

Fool's final word
Fool co-founder Tom Gardner and the Motley Fool Hidden Gems team are always on the lookout for the kind of small-cap stocks that are worthy of your investing dollars. Their methodology looks at several factors, including a strong balance sheet, a wide market opportunity, and solid leadership, to identify promising small companies. And, to date, they're succeeding -- their picks have returned nearly 42% on average, compared with 17% for the S&P 500.

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This article was originally published on Oct. 20, 2006. It has been updated.

At time of publication, Fool contributor Todd Wenning did not own shares of any company mentioned in this article. Intel and Microsoft are Motley Fool Inside Value picks. Eli Lilly is an Income Investor pick. The Fool is investors writing for investors.