The Best Kind of Growth Stock

I admit it: I'm not a healthy eater.
 
Unwilling to pay the higher prices, I shun the Whole Foods and Trader Joe's of the world with their healthy, organic choices. I'm content to eat my pesticide-laced fruit and genetically enhanced chicken if it means some extra bucks in my pocket at the end of the month. And, until prices drop -- a lot -- I doubt I'll make the switch to organic anytime soon.

Even though I don't eat organic, I definitely invest organic.

Size does not matter
Perhaps the most universally accepted and timeless way to achieve outstanding returns is to identify businesses that exhibit consistent organic growth. Organic growth is simply expanding your core operations -- not acquiring a bunch of ancillary businesses. There's even a disparaging term for the latter: empire-building. These acquisition-happy companies focus on getting bigger, not better.

A glaring example of a company that has failed with its acquisition strategy is Time Warner (NYSE:TWX), formerly AOL Time Warner. In 2000, proponents of AOL's acquisition of Time Warner hailed the deal for its anticipated synergies and potential to transform the media industry. Less than a decade later, the company has sold off disparate businesses, and is on its way to undoing what was once viewed as a groundbreaking merger.

A warning sign
One of the telltale signs that a company may be destroying value through acquisitions is to examine the goodwill on the balance sheet. At the end of 2001, then-AOL Time Warner had $128 billion in goodwill and other intangible assets.

In record time, the company wrote down $91 billion of these so-called assets during the course of one fiscal year. For all of the anticipation and hoopla surrounding the acquisition, destruction of shareholder value was the end result.

In his book It's Earnings That Count, Hewitt Heiserman suggests avoiding companies with an intangible assets ratio above 20% (Intangible Assets = Goodwill + Other Intangible Assets / Total Assets). This is an excellent standard you can use when looking for organic growers.

Recipe for success
Mark Sirower, former professor of mergers and acquisitions at Wharton and author of The Synergy Trap, estimates that as many as 80% of mergers fail. Not only do acquirers pay too much, they overestimate their ability to manage newly acquired firms. The result? Wasted money, inefficiency, and, eventually, depressed shares.

The recipe for consistently producing market-beating returns must contain a few essential ingredients:

• High return on capital (ROC)
• Strong return on equity (ROE)
• Tremendous revenue growth
• Dominant positions in their markets

Metrics like ROC and ROE should be one of your key considerations, because they indicate how effectively management uses your capital. If a company isn't earning an acceptable return for you, you should take your money elsewhere. Dominant organic growers often have double-digit ROE and ROC because they outcompete their rivals and tend to be excellent operators.

Pay close attention to these metrics when hunting for companies worthy of your hard-earned dollars, because these are the kinds of companies that will earn you outsized returns. Consider the following examples:

For you health nuts out there
It's no accident that Dawson has more than doubled in less than three years. The only acquisitions Dawson makes are of new seismic crews to bring in more revenues and profits for the company.

Ctrip.com and Baidu.com, in crushing competitors eLong and Google (NASDAQ:GOOG), respectively, have translated their dominant status in the expansive Chinese economy into exceptional revenue growth. Double-digit ROE and ROC result in more of those revenues coming back to shareholders. Intuitive Surgical's technological innovation and Buffalo Wild Wings' emphasis on customer satisfaction were instrumental in those stocks' impressive three-year performances.

These are just a few excellent organically growing companies worth keeping an eye on. They have invested their handsome profits back in the business, which begets more handsome profits. Fortunately, this cycle has yet to end, and more importantly, I don't think they're likely to slow down soon. That is the best kind of growth stock.

If you are looking for more organic growers poised to beat the market, I invite you to check out our Motley Fool Hidden Gems investing service. We are currently recommending several dominant organic growers (like Dawson Geophysical, Ctrip, and Buffalo Wild Wings) that we believe are undervalued right now. Simply click here for a free 30-day guest pass to our service.

Keith Beverly owns shares of Dawson Geophysical. Buffalo Wild Wings, Ctrip, and Dawson Geophysical are Hidden Gems recommendations. Intuitive Surgical, Baidu, and Google are Rule Breakers selections. Whole Foods is a Stock Advisor pick. The Motley Fool owns shares of Buffalo Wild Wings and has a tasty disclosure policy.