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.

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.

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.

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.

• Add Healthcare Services Group to My Watchlist
• Add SXC Health Solutions to My Watchlist
• Add Buffalo Wild Wings to My Watchlist
• Add Darling International to My Watchlist
• Add Valero to My Watchlist
• Add MELA Sciences to My Watchlist
• Add Qualcomm to My Watchlist