Discovering the Next Starbucks

Let's face it. We'd all like to find the next Starbucks.

Unfortunately, for every superstar stock out there, there are dozens of clunkers guaranteed to become a drag on your portfolio. When it comes to finding great companies, how do we separate the wheat from the chaff?

Who'd pay that much for coffee?
Starbucks in the mid-1990s offers us some valuable insights. Though it would have been considered overvalued by most traditional metrics, it was also delivering outstanding growth rates. In 1995, its earnings per share (EPS) grew by more than 100%. In 1996, its EPS grew by another 49%.

But Starbucks wasn't just about gaudy growth rates. It also had an innovative business model that changed the way coffee was sold around the globe. The company summarized its outlook in just one sentence in its 1996 10-K: "The Company believes that its customers choose among retailers primarily on the basis of quality and convenience, and, to a lesser extent, on price."

I'd say Starbucks was right about that.

Savvy investors who recognized this amazing business early on would have been well-rewarded. A $20,000 investment in February 1996 would now be worth more than $157,000 — an annualized rate of return of 20%. That's an impressive return, even factoring in our current market environment.

20/20 hindsight
A number of things jump out at us as we look at the Starbucks story. In the early and mid-1990s, the company had begun transforming an entire sector by selling a well-known commodity at premium prices to a loyal and growing customer base. As a result, it experienced rapid growth in revenue and earnings. It all seems so simple in retrospect.

Using these insights, I ran a basic screen that unearthed seven stocks. I was looking for established companies with growth rates of 20% or more per year, and I included only companies that were rated highly among the investors participating in our Motley Fool CAPS stock-rating service. Here's what I found:

Data from Yahoo! Finance, Motley Fool CAPS, and Capital IQ as of March 11, 2008.

Not all of these companies have the potential to match the superior returns that Starbucks has generated over the past decade. For example, because China Mobile is already a $295 billion company, it would have a much harder time achieving those types of returns. Hypothetically, if the company's stock kept pace with its projected growth rate of 21% per year for the next five years, it would be a $762 billion company by 2013. Possible? Yes, but rather unlikely.

So it stands to reason that we need to look for companies that are slightly smaller than China Mobile, if we expect Starbucks-like growth into the next decade. For example, in 1996, Starbucks was a relatively tiny $2 billion company, and it still had plenty of room left to grow.

The quest begins
Intuitive Surgical, the company behind the da Vinci robots used in minimally invasive surgical procedures, is a perfect example of a dynamic company that is still experiencing outstanding growth. Its five-year estimated growth rate is 36%, its CAPS rating is four stars (out of five), and it's an official recommendation in our Motley Fool Rule Breakers investing service, led by Fool co-founder David Gardner.

David and his team of analysts are always searching for the next Starbucks -- that is, great companies still at a young point in their growth cycles. Rule Breakers has already delivered outstanding returns since inception three years ago. If you'd like to see all of our picks and research, including our top five ideas for right now, click here for a no-obligation 30-day trial.

This article was originally published on Feb. 3, 2007. It has been updated.

John Reeves does not own shares in any of the companies mentioned, though he spends way too much money at Starbucks each week. Starbucks, Omniture, and Garmin are Stock Advisor selections, and Blackboard is a Hidden Gems pick. Mindray Medical and Intuitive Surgical are Rule Breakers recommendations. The Fool has a disclosure policy.