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 5.7% per year on average over the past 10 years. A 1.5% 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 96 companies capitalized at more than $20 billion in February 1998, over four-fifths of them (77) 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 part of the S&P 500. 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 megacaps, there have been others holding down the fort over the past 10 years. Without these companies, the S&P 500 wouldn't have returned (a still disappointing) 5.1% per year during that stretch. Included in this list are:

This is the closer to 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 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 a company becomes big, its 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, research from Jeremy Siegel, professor of finance at Wharton, shows that 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 large caps. Indeed, all of the market's 10 best stocks of the past 10 years were small caps. Of this group, Clean Harbors returned 3,378% and Immucor (Nasdaq: BLUD) yielded 2,941%.

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 27% on average, compared with 7% for the S&P 500.

If you'd like to put that performance to work in your portfolio and view all of Tom's picks, click here to join Hidden Gems free for 30 days.

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. Microsoft and Anheuser-Busch are Motley Fool Inside Value picks. Johnson & Johnson is an Income Investor selection. The Fool is investors writing for investors.