Think back to 1995. Music had an aquatic theme, with Seal and Hootie & the Blowfish releasing top singles. The Internet was just becoming mainstream. Pixar (NASDAQ:PIXR) changed movies forever with Toy Story -- not just by creating the first full-length computer-animated film, but also by recognizing from the start that the story was more important than the technology. This idea led to the top movie of the year and a successful initial public offering (IPO). And, after releasing its Zip drive, Iomega (NYSE:IOM) became the top-performing stock of the year, up about 1,300%.
If, at that point, you had been designing your portfolio for the next 10 years, what would you have been buying? Iomega looked interesting, with the potential to become the next standard in floppy drives. It did well over the next year -- doubling, in fact -- but if you had held for a decade, you would have lost roughly 80% of your investment. Buying Pixar would have worked. You'd have been down almost 50% in the first year, but over 10 years, you would have made 16% annual returns.
On the other hand, you could have had similar results, with less volatility, by buying well-known, established growth companies. You could have made a 17% annual return by buying American Express (NYSE:AXP), or 16% by buying Cardinal Health (NYSE:CAH) or Wells Fargo (NYSE:WFC). Such consistent performance may not be as exciting as the unpredictable growth patterns of new tech companies, but over the long term, these consistent high-growth companies can hold their own when it comes to returns. And really, outstanding returns are what this game is all about.
Two paths to profit
So if you're looking for growth stocks that will have incredible returns over the next 10 years, I can see two different paths to profit. Down path No. 1 is buying unproven high-risk, high-return companies like Iomega and Pixar. These sorts of stocks are often in dynamic, high-growth industries like technology and biotech. Frequently, these companies are trying to establish their position and may be unprofitable. And even those with seemingly strong competitive advantages can instantly lose their edge if new technology is developed that changes the game. But when they're successful, they can post absolutely incredible returns. (Here at the Fool, we look for these companies in our Motley Fool Rule Breakers newsletter.)
Path No. 2 is buying established growth companies -- dominant, hugely profitable firms with significant competitive advantages. These businesses grow for years and are unlikely to be displaced by anyone. But they're more likely to show 10% to 25% annual growth than 50% to 100% growth. You're probably not going to get a 10-bagger in a year with one of these companies, but 100% returns are possible.
The key is to correctly identify the companies with the strongest competitive positions and then pick them up when they're trading at a significant discount to their fair value. Buying at a discount provides a margin of safety against loss of capital if the company falters, a nice profit if the stock simply returns to fair value, and huge long-term returns if the stock continues on its growth path. (Our Motley Fool Inside Value newsletter adheres to this philosophy.)
Which method's better?
There have been successful investors who use each strategy. The strategy you use should depend on two factors: your personality and your tolerance for risk.
For example, both Rule Breakers and Inside Value were formed at about the same time, a year and a half ago. Since then, Rule Breakers has identified three companies that have returned more than 100% -- including Vertex Pharmaceuticals (NASDAQ:VRTX), which has returned more than 200%. Inside Value has identified one -- pharmaceutical service company Omnicare (NYSE:OCR). On the other hand, Rule Breakers has also recommended six companies that are down by at least 25%. Inside Value has only suffered one such mistake.
So, if you can stomach volatility and are willing to face a potential loser in order to find a huge winner, a high-growth strategy could be the one for you. If, on the other hand, you prefer less volatility and want to sleep at night while maintaining a significant upside, the value strategy could make more sense.
Of course, there's no reason why you can't use a combination of both strategies.
No, really, which method's better?
I'm part of the Inside Value team, and that's because I have more confidence in that strategy than in any other -- so much confidence that 95% of the stocks in my portfolio are value stocks. The value strategy is intuitively appealing to me -- buy an asset worth $100 when it's selling for only $50, just like buying steak when it's on sale. The discount to fair value reduces the possible downside and increases the possible upside -- really tilting the odds in my favor. Plus, after living through the tech crash, I appreciate the reduced volatility, and I don't think that the reduced risk significantly decreases the returns of the overall portfolio. After all, this is the strategy that Warren Buffett used to become the second-richest person in the world -- it's hard to argue that you need better results than that.
So, if I'm putting my money on the table looking for a growth stock for the next 10 years, I'm looking for an established growth company, with a solid competitive position, trading at a discount to fair value. But that's just me. David Gardner's results show quite convincingly that a more volatile high-growth strategy can lead to impressive returns, too. Either strategy can yield exceptional profits over the long term -- a 17% annual return can turn $10,000 into a cool half-million in 25 years -- so pick the strategy that appeals the most to you.
Of course, the key to implementing a growth or value strategy successfully is to find the stocks that will yield such returns. If you're interested in seeing how we do it, we offer free trials to both newsletters. You can see every stock we've recommended since inception, compare the two strategies, decide which strategy suits your investment personality, and get a head start on finding the spectacular growth stocks for the next 10 years. To check out Rule Breakers, click here. If you're more interested in Inside Value, click here.
Richard Gibbons , a member of the Inside Value team, hates clicking here.He does not have a position in any securities mentioned in this article. Pixar is a Motley Fool Stock Advisor recommendation. The Motley Fool has adisclosure policy.
