Stocks With Room to Run

The "Rule of 72" is a great way to calculate compounding interest in your head. 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).

If that 7.2% long-term equity growth rate seems too slow, consider that the Vanguard Total Bond Market Index (VBMFX) returned about 6% per year on average over the past 10 years, while the S&P 500 was flat over that same time period.

It's been a disappointing decade, to be sure, and many notable companies not only underperformed the bond market but also posted negative 10-year returns.

Of the 500 companies currently in the S&P 500, 113 have failed to break even since October 1999, including dividends. Some of those dreary investments include:

Company

Trailing-10-Year Annualized Return

Citigroup (NYSE: C  )

(15%)

Southwest Airlines (NYSE: LUV  )

(1.5%)

AT&T (NYSE: T  )

(4.3%)

Merck (NYSE: MRK  )

(4.1%)

Data from Capital IQ, a division of Standard & Poor's.

Makes you want to take a closer look at your index fund, doesn't it?

Lean on me
The good news? For each of the aforementioned underperforming large caps, 187 current S&P 500 members more than doubled and held the fort over the past decade. Without these companies, the index may have fared even worse than it did. This list includes:

Company

Trailing-10-Year Annualized Return

Freeport-McMoRan (NYSE: FCX  )

18.4%

UnitedHealth (NYSE: UNH  )

16.5%

Tesoro (NYSE: TSO  )

8.6%

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 Treasuries or CDs.

But is the best good enough?
Yet these were among the best-performing megacaps of the past 10 years, and I consider a 15% annualized return to be about the most any megacap 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 90% 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. For instance, Hansen Natural has gained more than 7,000% since March 1999, when it was just a $36 million company. Indeed, all of the market's 10 best stocks of the past 10 years were small caps.

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.

The Motley Fool Hidden Gems team is always on the lookout for small-cap stocks that deserve 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.

If you'd like to put some potential-laden stocks to work in your portfolio and view all of the team's picks, click here to join Hidden Gems free for 30 days.

Already subscribed to Hidden Gems? Log in at the top of this page.

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

At the time of publication, Fool analyst Todd Wenning did not own shares of any company mentioned. Microsoft and UnitedHealth are Motley Fool Inside Value recommendations. Hansen Natural is a Rule Breakers pick. UnitedHealth Group is a Motley Fool Stock Advisor recommendation. The Fool owns shares of UnitedHealth Group. The Fool is investors writing for investors.


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