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).

If that 7.2% long-term equity growth rate seems too slow, consider that the Vanguard Total Bond Market Index (VBMFX) returned about 5% per year on average over the past 10 years while the S&P 500 has only gained 3%.

Not only have many larger stocks underperformed the bond market, many have even posted negative 10-year returns.

Consider that of the 500 companies in the S&P 500, 146 of them -- about 30% -- have failed to break even since October 1998. Some of the more disappointing investments include:

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) 3% 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 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 4,000% since October 1998, when it was just a $50 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.

Fool's final word
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This article was originally published on Oct. 20, 2006. It has been updated.

At the time of publication, Todd Wenning did not own shares of any company mentioned in this article. Microsoft is a Motley Fool Inside Value pick. Johnson & Johnson is an Income Investor pick. The Fool is investors writing for investors.