In the dog-eat-dog world of investing, companies that can sustain strong levels of growth for long periods of time give their shareholders some of the best investment returns you'll ever find. When you look back at the top performers of the past decade, you'll inevitably find companies that have defied expectations by growing leaps and bounds, going from unknown niche players to major and sometimes dominant companies in an industry.
On the other hand, the Dow Jones Industrial Average (INDEX: ^DJI) isn't exactly the first place most growth investors go to find interesting prospects. By the time a company gets big and prestigious enough to gain entry into the Dow, its best growth years are typically well behind it, as it settles into middle age with much slower growth and the more stable returns that typically accompany it.
But that doesn't mean you won't find companies in the Dow that are growing. Let's take a closer look at the Dow's growth stars to see just how important growth is to a Dow stock's prospects.
Sales or earnings?
The first thing you have to decide on is exactly which type of growth you're looking for. Early in a company's existence, looking at revenue growth makes sense because start-up companies often don't have any net income. Their primary goal is to build up business. Later on, though, revenue growth is worthless if it doesn't enhance a company's profits. So looking at net income growth becomes more compelling, giving you a better picture of how a company's stock is likely to grow over time.
That idea is borne out by the Dow's performance. When you look at revenue growth over the past five years, the two companies that rise to the top are Merck (NYS: MRK) and AT&T (NYS: T) , with annual growth of 16% and 15%, respectively, since 2006-2007. But their share prices have hardly budged over that time, putting them both among the 10 worst-performing stocks in the Dow.
It's easy to put those figures into context at each of those companies. For AT&T, the iPhone has greatly enhanced revenue but at the cost of AT&T's margins. Even when you consider the impact of the T-Mobile merger breakup, the impact on net margins is fairly clear.
For Merck, you can see the same lower-margin trend. As Merck and its peers partner up with companies to serve emerging-market countries like India and China, they increase their revenues substantially. But because they can't earn anything close to the profits they get in the U.S., those revenues result in far less profit than you'd expect.
By contrast, the top growers of net income have seen much better stock performance. Intel (NAS: INTC) leads the way with more than 20% annual earnings growth, and shares have jumped more than 60% over the past five years as a result. Granted, the drivers of net income growth -- continued success in the PC chip market and attempts to get into lucrative new areas like mobile devices -- will also tend to push revenue up as well. But unlike some companies, Intel isn't sacrificing margins to get new business.
IBM (NYS: IBM) can point to similar strength in income as responsible for its 134% stock gain. Unlike Intel, though, IBM has had negligible sales growth, instead driving earnings through more efficient operations and focusing on more profitable lines of business.
Stick with growth
Growth doesn't always produce good returns. Microsoft, for instance, enjoyed 9% sales growth and 14.5% earnings growth over the past five years, but its stock is up only about 20% during the same period. Sometimes, that just means investors haven't recognized the value in a stock, but it can also indicate a lack of confidence that those growth rates are sustainable.
Even with blue-chip stocks, though, it makes sense to pay attention to growth. Companies that can produce increasing sales and earnings constantly prove to their shareholders that there's potential left in them, and nothing's more important than that in coming up with new, lucrative opportunities.
If you like stocks that combine growth and stability, you'll love The Motley Fool's special report on long-term investing. Read it and you'll find three promising stock picks for investors looking for long-term opportunity that will take you to retirement and beyond. Get your free copy today before it's gone forever.
At the time thisarticle was published Fool contributorDan Caplingerdoesn't own shares of the companies mentioned. You can follow him on TwitterTwitter. The Motley Fool owns shares of Microsoft and Intel.Motley Fool newsletter serviceshave recommended buying shares of Intel and Microsoft, as well as creating a bull call spread position in Microsoft. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Fool has adisclosure policy.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.