Tom Gardner's Top 5 Watchlist Stocks

Those who cannot remember the past are condemned to repeat it, or so the cynical old saw goes. As a stock-picking investor, I spend plenty of time studying investment ideas that went wrong. But as a Foolish optimist, I find it much more rewarding to look back at investment ideas that went right, and to try to learn why that happened. Since most of us own only a handful (or a few handfuls) of companies, this sort of backward-looking endeavor works best when it considers a larger group of individually selected stocks. For me, that means studying a watchlist.

It all begins with a watchlist
As the co-advisor of Motley Fool Hidden Gems, our premium small-cap stock-picking service, I find a well-stocked watchlist to be vital to generating future investment returns. Hidden Gems founder Tom Gardner knew how important a watchlist could be way back when he started the service, which is why the Hidden Gems watchlist has been as long as the service itself, with its official recommendations. (In May, both turn eight.)

What constitutes a "watchlist stock"? For us at Hidden Gems, it is mainly an idea we find interesting, but for some reason, we're not quite ready to commit. The issue could be price (looks too expensive) or uncertainty (not enough clarity on future potential) or risk (a potential problem we'd like to see resolved). Often, however, we just want to get to know a company a little bit better before moving it up to the big leagues.

Tom's top watchlist stocks
Since I'm dedicated to studying past investment decisions, I have built an all-encompassing database of Hidden Gems activity. I am constantly reviewing my own watchlist stocks, but I recently turned this system's analytical power toward analyzing Tom's best watchlist stocks. Even though I have been doing this for years, I figure Tom still has a few lessons to teach me -- I'll only consider myself adequately wise when my scalp is as hair-free as his. Moreover, I have only been at the service for three years, while Tom was heading it up for more than half a decade, so he's got a larger pool of picks to study.

Let's start with some important news: A watchlist doesn't mean a list of losers. Across 121 watchlist stocks, Tom's average return was 37.7%, versus 18.5% for the S&P 500 index ETF. In other words, even this overly large group of "maybe" stocks has pounded the wider market. And there have been some major home runs in the mix.

Watch Date

Watchlist Stock

Return

8/28/2003 Healthcare Services Group (Nasdaq: HCSG  )

555%

8/26/2004 Atheros Communications

468%

3/22/2007 SXC Health Solutions (Nasdaq: SXCI  )

365%

2/26/2004 Buffalo Wild Wings (Nasdaq: BWLD  )

334%

4/28/2005 Darling International (NYSE: DAR  )

281%

Source: Capital IQ, a division of Standard & Poor's. Returns calculated from end-of-day, dividend-adjusted prices on date that company was first added to Hidden Gems watchlist.

What can we learn from this list? Here are a few of my top takeaways.

Boring = beautiful
This has long been one of the primary themes at Hidden Gems, and I'd argue that every one of these companies was and remains pretty boring. Darling International renders animal carcasses and other waste products into useful products. Its most exciting line of business is a biofuels joint venture with Valero (NYSE: VLO  ) .

To me, the two health-care companies in the top 5 tell an even more interesting story. Healthcare Services Group offers laundry, housekeeping, and food services to nursing homes, retirement complexes, and hospitals. SXC Health Solutions provides back-office support to the pharmacy industry in the form of transaction processing and other information technology services.

Are you asleep yet?

Contrast these boring, nuts-and-bolts companies with the strategy that many would-be health care investors take: looking for that one, big, exciting, fence-clearing swing. I've been interested in MELA Sciences (Nasdaq: MELA  ) for a while now, but the entire fate of the investment thesis rests on whether it gets FDA approval for its MelaFind handheld scanner, which aims to take some of the guesswork out of identifying potential skin lesions for cancer-testing biopsies. This will mean a major payoff for those who hold if the device is approved, but the odds look bad, and the alternative scenario isn't pretty.

Price is relative
One common thread among all these companies in the time I've been watching them is that they rarely, if ever, looked cheap. In fact, here are the average price-to-earnings ratios for the group over the past five years.

Watchlist Stock

5-Year Average P/E

Healthcare Services Group

31

Atheros Communications

53

SXC Health Solutions

35

Buffalo Wild Wings

25

Darling International

31

Source: Capital IQ, a division of Standard & Poor's. P/E estimated from annual P/E averages based on trailing 12 months' earnings.

Listen, I'm usually as cheap a guy as you can find in an investor. I like to think I'm contrarian, value oriented, and all that. I'm not saying a high P/E is a buy signal, because I've read all the research that shows that high P/E stocks underperform in the aggregate. What I am saying is that some stocks that carry high P/E ratios are going to continue outperforming the valuation those ratios imply. So, don't write a stock off entirely just because it doesn't look cheap enough.

Check out the most "expensive" stock on that list, Atheros Communications. We purchased this with real money for our collection of Hidden Gems, even though we couldn't really model it to look cheap. Our blended real-money return came to 128%, with a 76% gain on the additional shares we held for just four months, and I'm convinced our returns would have been even bigger if Qualcomm (Nasdaq: QCOM  ) hadn't acquired our "expensive" shares at an even more expensive valuation.

Think Small
I don't want to push this final point too far, because it's a bit of a chicken-and-egg observation. However, it's worth noting that the majority of the companies at the top of Tom's small-cap watchlist were small, even by small-cap standards. Smaller companies not only have more room to run when they're successful, they are generally not followed as closely as larger stocks, meaning there's better opportunities for us to find gems that are actually hidden.

Watchlist Stock

Market Cap at Watchlist (mm)

Healthcare Services Group

$187

Atheros Communications

$368

SXC Health Solutions

$397

Buffalo Wild Wings

$191

Darling International

$246

Source: Capital IQ, a division of Standard & Poor's. Market cap as of date added to Hidden Gems watchlist.

Tom's thoughts
When I discussed these findings with Tom Gardner, recently, he revealed that he'd already been pondering some of these issues, especially price, and how in the long run, it's one of the less important metrics for him:

The most primary way that my investment approach has changed over the past few years is that I now spend 60%-70% of my time evaluating the leaders, the culture, the ownership structure, and the sense of commitment throughout the company. Health care Services Group, Atheros Communications, and Buffalo Wild Wings have that in spades. I am simply strongly disinclined to sell these sorts of stocks unless they strike me as massively overvalued.

If I find people I like, doing something they believe in with total passion, and if they have a big stake in the business, I am inclined to buy and follow Buffett's direction...never sell. For me, this is the single most effective way to beat the market massively over rolling 10-year periods, with low transaction costs, deferred cap gains taxes, and a low-anxiety way to win. I am buying the people, their love for their business, the strength of the business, and hoping I find something I can own for at least 10 years.

Foolish final thoughts
A well-stocked watchlist becomes more than your go-to source for buy candidates when you've got money to invest. By selecting companies you like -- but may not be quite ready to back with real dollars -- you're more likely to expand your investing horizons and shake yourself free of the limitations we all tend to put on ourselves. At Hidden Gems, Buffalo Wild Wings and Atheros both became major winners for the service, even though Atheros is the kind of tech company I would normally have avoided. The fact that it was on my radar from early days as a watchlist stock meant that I followed it and was ultimately well-enough informed to help Hidden Gems members reap real profits on the company.

Finally, don't sweat the losers too much. Among those watchlist stocks are plenty of big losses. The worst, LECG Corporation, trades for only 1% of the price at which it entered the Hidden Gems watchlist. Body armor maker Point Blank Solutions, an absolute darling at the time it came on board, lost nearly all its value, and its CEO was convicted of fraud. The big winners that come from a carefully selected, diversified portfolio of small cap stocks can significantly outweigh the dogs.

To begin tracking any of these stocks in our free watchlist, and receive up-to-date news about each, use the links below.

At the time of publication, Seth Jayson had no position in any company mentioned here at the time of publication. You can view his stock holdings. He is a co-advisor of Motley Fool Hidden Gems, which provides new small-cap ideas every month, backed by a real-money portfolio. SXC Health Solutions is a Motley Fool Rule Breakers recommendation. Buffalo Wild Wings is a Motley Fool Hidden Gems selection. The Fool owns shares of QUALCOMM. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (78)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 30, 2011, at 2:28 PM, jrusso9722 wrote:

    People continue to die from Melanoma!!! Anything that can help prevent that, especially if it is non-invasive, accurate, and an aid to a Dermatologist, cannot be prevented from protecting and preserving life. If FDA has another agenda, it may want to consider what the results could be if it delays much further. 15 members of the FDA board should act to enhance LIFE. Let the Dermatologist/patient, in consultation make the decision to scan a lesion with a NON-INVASIVE imaging system.

  • Report this Comment On March 30, 2011, at 2:54 PM, TMFBent wrote:

    It is a very serious disease, but that doesn't mean that any and every potential diagnostic and treatment option is necessary or even desirable.

    Biopsies aren't so invasive that I think they'll be retired by this product, and I think there is a lot of truth with the FDA remarks that such a product might do more harm than good.

    Sj

  • Report this Comment On March 30, 2011, at 4:55 PM, drillerjim101 wrote:

    I strongly suspect MELA will soon receive FDA approval for their cancer scanning device. I have just purchased a very similar device for scanning intra oral lesions...the Velscope. It is the future of any diagnostic examination and patients are thankful for the non invasive nature of such a useful product. It is easy to use and eminently practical for the entire staff to use.

    James Fregia, DDS

  • Report this Comment On March 30, 2011, at 5:09 PM, xetn wrote:

    Rather that aiding the health industry, the FDA is a major roadblock. It goes so far as to prevent terminal patients for trying new drugs that maybe could provide relief or maybe even a cure. Why do we need government in this process? We have a great example of a private testing company (UL) that has been around for decades and continues to expand their testing arena. I am not saying the UL should do medical evaluations, but that there are many viable testing labs that could.

  • Report this Comment On March 30, 2011, at 5:51 PM, TMFBent wrote:

    I'm not sure I can agree with the idea of getting the government out of the drug approval process. The FDA may have its problems, but I don't see a better alternative.

    As for "viable testing labs" conducting trials, that's what goes on now.

  • Report this Comment On March 30, 2011, at 6:24 PM, learning111 wrote:

    DAR, brings back memories from when I was a kid and we had a rendering plant in the neighborhood. Depending on the wind direction, the stench was overpowering. Although the town needed the industry and jobs, they finally had to force the company to build a machine to capture most of the odors. Still remained a problem when the company would frequently "forget" to turn on the odor capturing unit because it was expensive to run. Eventually, DAR was forced to close the facility.

  • Report this Comment On March 30, 2011, at 7:25 PM, TMFBent wrote:

    @learning

    I lived a mile from a pulp mill in Muskegon, Mich. I feel your pain.

  • Report this Comment On March 30, 2011, at 8:27 PM, YosemiteGuy wrote:

    I certainly agree whoever comes up with an approved noninvasive Meloma dection technology will surely score big in the marketplace. Possibly you are unaware of Verisante Technology in Canada (VRS.V). They have the device, 100% accuracy in all tests and the hit at the Dermatology convention in New Orleans Feb 4-8 this year. I invested on Feb 2, the day after it hit the NYSE. I doubled my money and got out very quickly. Why? They are faced with the same pending approval in Canada as is MELA in the States. It certainly is an option to monitor, possibly the Canadian approval will come first and then you score. You can buy a ton of stock at $.61 today.

  • Report this Comment On March 30, 2011, at 8:29 PM, peters46 wrote:

    The FDA definitely has major problems, not just drugs, but also food. They are seriously in need of major reworking of the way they are set up and operate. Every year there seem to be at least two new treatments for major illnesses currently being used by millions of Europeans and others, but American doctors are not allowed to use them even experimentally because they haven't been (and won't be for years) approved by the FDA. The food side is just as bad. Ingredients (some of which are deadly for some of us) don't necessarily have to be included in the ingredients list. E.g., sulfites are deadly to me, because of a genetic enzyme deficiency (in about 10% of world population), but they are included in high fructose corn syrup and a dozen other ingredients as a residue of the processing method. Also because they don't affect everyone (only 10% of us). Also MSG doesn't have to be labeled as such because it only causes death of new brain cells and until about ten years ago they thought only newborns had any new brain cells. All they have to do is make the processing cheaper by stopping it partway in the process and then give it a new name (hydrolyzed vegetable protein, natural flavoring, yeast extract or any other of a dozen other names.)

    jrusso9722 'cannot be prevented'? Read more. Such things are prevented every year by the FDA.

  • Report this Comment On March 31, 2011, at 11:15 AM, jrj90620 wrote:

    "If I find people I like, doing something they believe in with total passion, and if they have a big stake in the business, I am inclined to buy and follow Buffett's direction...never sell. For me, this is the single most effective way to beat the market massively over rolling 10-year periods, with low transaction costs, deferred cap gains taxes, and a low-anxiety way to win. I am buying the people, their love for their business, the strength of the business, and hoping I find something I can own for at least 10 years."

    Never said better.I think you're right.Not many do this type of investing.Most going for short term gains.Lots of stress and not much to show for it.

  • Report this Comment On March 31, 2011, at 11:44 AM, mikecart1 wrote:

    BBW is definitely on the upswing. If you compare their restaurants now to back then, they have improved a lot. The best TV's, the best beer, nice layouts, great food, and better service.

    Oh and it is extremely clean.

    Funny how so many restaurants underestimate the power of clean. A clean place can take your business to the next level.

    No wonder why Wendy's has been stuck in trash for years. Their places are filthy.

  • Report this Comment On April 03, 2011, at 8:53 PM, mhgraet wrote:

    The FDA is not always doing a good job (it's been understaffed by the Republicans), but the idea that somehow drug companies would regulate themselves is unbelievably naive. Look at how well that worked with Wall Street. There's plenty of drive to get new drugs approved, and it's harder now (I work in the industry). But to do away with the FDA is myopic and reactionary. Bad drugs do kill people, and because industry works for profit, the pressure to produce $ that would surely outweigh the pressure to assure patient safety, in some cases. It already has...witness the data "selection" (coverup) around Vioxx, and others.

  • Report this Comment On April 06, 2011, at 7:16 PM, Tempburger wrote:

    I guess I am showing my age, but I was a Fool back when you recommended Point Blank Solutions (DHB at the time) and I think you are selling yourself short. The articles I read talked about the CEO and how he had a bad record with fraud and it wouldn't be a surprise if it happened again. I bought that winter for $7 and sold when it reached $20 at the beginning of the summer. Since I was using a lot of Fool articles and other information I found on the web, my only surprise is why didn't the Fool team sell as well?

  • Report this Comment On April 08, 2011, at 6:52 AM, dbtheonly wrote:

    SJ,

    I've got to tell you that playing penny-health care stocks, on the hope/prayer that their "REVOLUTIONARY NEW PRODUCT" receives FDA approval; takes more guts than I've got.

    I'm more troubled by your seeming assertion that the P/E ratio is not important. If these stocks are expensive, in a relative term, now; then the odds of them getting even more expensive is remote.

    Or is that just your specialty in "Hidden Gems"?

  • Report this Comment On April 11, 2011, at 7:44 AM, TMFBent wrote:

    "If these stocks are expensive, in a relative term, now; then the odds of them getting even more expensive is remote."

    You're forgetting that the E doesn't need to be static. That's why the P on those stocks kept going up so far.

    "I was a Fool back when you recommended Point Blank Solutions (DHB at the time)"

    It was never recommended in HG. It was an HG watchlist pick.

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