5 Major Money Makers From Our Small-Cap Watchlist

As part of an ongoing series examining watchlist stocks from Motley Fool Hidden Gems, I've already detailed our co-founder Tom Gardner's 5 Best Watchlist Stocks, as well as his five worst. This week, I opened up the field to watchlist stocks chosen by other members of the Hidden Gems team.

It all begins with a watchlist
As 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 around with its official recommendations as long as the service itself,. (Next month, 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. Because many of the stocks we look for are underfollowed by Wall Street, they can easily slip through the cracks for us as well. The watchlist helps us keep on top of our opportunities, especially those that aren't under our noses in the daily and weekly business press.

For us at Hidden Gems, a watchlist is more than just a day-to-day tool. Through the use of some sophisticated (which is to say, nerdy) tracking tools, I constantly review our watchlist successes (and failures) not only to keep the new ideas flowing, but to try to learn what has worked in the past. Knowing what has worked, what has failed and why, I can get a better handle on the kinds of stocks to invest in for the future.

5 top watchlist stocks
Although we work hard to try and get the best-returning stocks into the service as official recommendations, it's a mistake to write off our watchlist stocks as also-rans. Of the 223 watchlist recommendations that I have tracked since the service's inception, the average return is 46%, and 64% of the stocks are in positive territory. That average return beats the S&P 500 by 25 percentage points, and nearly 20% of the watchlist stocks have doubled or more.

I've excluded Tom's big watchlist winners from this list, but the remainders look just as amazing.

Watchlist Date

Watchlist Company

Return

SPY Return

IWM Return

8/28/2008 Green Mountain Coffee Roasters (Nasdaq: GMCR  ) 700% 9% 18%
2/26/2009 Deckers Outdoor (Nasdaq: DECK  ) 444% 85% 120%
2/26/2009 Innophos Holdings (Nasdaq: IPHS  ) 326% 84% 114%
6/26/2008 Tractor Supply Co. (Nasdaq: TSCO  ) 324% 11% 26%
5/21/2008 Fossil (Nasdaq: FOSL  ) 215% 2% 21%

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. SPY = SPDR S&P 500 ETF. IWM = iShares Russell 2000 ETF.

Green Mountain Coffee Roasters has been on a tear since then-Hidden Gems analyst Bill Barker put it on our watchlist two-and-a-half years ago. It's hard not to envy an eight-bagger, but there are good reasons this company has never made our official recommendation list. I understood the popularity of the Keurig coffee machines, even if I underestimated it. That wasn't the issue.

Gross margins have been in free fall for years, and Green Mountain's growth has come through huge, expensive acquisitions. Operating cash flows dried up, from near 10% of revenues a few years back, to negative in fiscal year 2010. That meant this traditionally debt-light company had to take on a huge slug of IOUs. We were never confident that this gradual decrepitude would be reversed, or that the market would continue to ignore it. We have been ... ahem ... wrong on the latter.

I'm not crazy enough to advocate the increasingly popular short position on Green Mountain. (I don't like standing in front of trains, either.) However, I'd still urge investors to be wary. Like Paris Hilton, Pontiac Fieros, and pet rocks, some stocks are popular just because they're popular, until they're not.

By the way, if you consider my money-losing skepticism on Green Mountain to be an excellent contrary indicator on the home beverage machine business in general, you probably want to look into SodaStream International (Nasdaq: SODA  ) , which markets an increasingly popular line of in-home water carbonators that allow you to make seltzer and soda -- all for double the price that I can buy the stuff pre-made at the grocery store. Yeah, it makes no sense to me, but neither did Green Mountain.

  • Lesson? Sometimes you can be right about the trajectory of a company's financials and 180 degrees wrong on where the stock price will head.

With Decker's Outdoor, we have to plead temporary insanity, shortage of brain tonic, or just plain mistaken analysis. Hidden Gems Analyst Stan Huber put this back on our watchlist at the height of the market panic in early 2009, and like many small caps, it's gone nowhere but up since then. We ought to have known better, because this is a company we already knew very well at Hidden Gems, where it had previously been a recommendation that earned members a double from 2004 to 2006. It was sold (before I was co-advisor at Hidden Gems, I swear!) on the belief that its Ugg boots were more of a fad than a sustainable cash producer for the long run, and the company was likely at a cyclical high, ready to kill investors when the good news stopped. In other words, we confused it with what Crocs (Nasdaq: CROX  ) would later become. Doh!

Deckers has continued to increase margins, barely saw sales dented in the recession, and has produced a ton of cash, and the market has rewarded the stock's faithful with millionaire-making gains. (To make amends for that cheap shot at Crocs, above, I should note that it too has expanded its product line, cleaned up its act, and been a great-performing stock -- but only from the depths of its lows.)

Had Hidden Gems simply held the stock from the original recommendation in 2004, it would have returned 10 times the original investment, dwarfing even that impressive, shorter-term watchlist gain highlighted above.

  • Lesson? Sometimes the best new stock idea is an idea you've already had -- even if you've discarded it in the past.

It's about time we got to one that we got right, and with Innophos, we're there. Hidden Gems analyst Jim Gillies tagged it for the watchlist at the bottom of the market swoon, and I made it a Hidden Gems portfolio candidate soon thereafter. We backed that recommendation with real money soon after, and we recently sold the position for a 170% return. The four-bagger we'd have earned had we bought four months earlier (when the stock hit the watchlist) would have been preferable, but buying anything at the height of that panic was tough, and Innophos required more guts than most.

The company, a maker of specialty phosphates, operates in a business which had exhibited wild price swings, and adding to the risk was the reality that this was a deleveraging story. Buying a debt-laden company facing wild input-cost swings, possible annihilation of its end-markets, and juggling a heavy balance sheet at the height of a debt crisis -- well, that seemed insane. Fortunately, Innophos' management handled the complex business as well as we expected, and the Street eventually came to appreciate it.

  • Lesson? Again, sometimes the best new idea is an idea you've already had -- and sometimes, we manage to remember that.

Tractor Supply Co. is a story we just didn't appreciate well enough. First off, the stock has often looked pricey to us. But by pinching pennies, we've missed out on the major returns. This small operator of fleet and farm stores has grown to nearly 1,000 locations with a presence in nearly every state. We city folk have probably never seen one (I visit the locally owned fleet store for my mud boots, trailer hitches, and mower blades when I'm in the boondocks), but this is a company that is quietly gathering a huge customer base.

The results prove it: Over the past five years, revenues have grown at a steady 12% per year, while free cash flow grew at a compound annual growth rate of more than 35%. That's an especially amazing feat given the heavy capital spending the company has engaged in during the expansion process. Gross, operating, and net margins have consistently climbed as well. It's no wonder the stock has produced four-bagger returns in just under three years. My guess is that those returns continue.

  • Lesson? Don't discount the company just because you don't shop the store. Remember the "hidden" part of Hidden Gems.

Last, we get to another success story, Fossil. Despite the ridicule I knew I'd have to endure for choosing a company with connotations of fashion trends past, I watchlisted this watchmaker in spring of 2008, at around $31 a share. I made it an official recommendation that summer, when it had fallen to $27. We invested real money in the stock in March and June of 2010, but at higher prices, around $39 per share. At the time, it seemed like we were paying a lot, maybe even too much. But as an owner of the stock myself, I was very impressed with the way Fossil was increasing margins, funding a domestic and international retail growth strategy out of cash flow, and consistently beating my greatest expectations. (To top it off, the CEO, a major owner of the stock, works for free: no salary, no bonuses, no nothing, except the potential returns on shares he already owns.)

Today, even those higher-priced, real-money buys have produced outstanding, market-trouncing returns of 150%, because Fossil has continued to astound the Street. Count me among those happily amazed. Fossil's sales growth hasn't been exciting enough to attract a typical, Wall-Street-growth-stock feeding frenzy. So much the better for us. Over the past five years, its operational excellence has turned 14% annual revenue growth into a 28% compound annual growth rate for net income. Free cash flow production has also been outstanding, despite heavy capital spending for store expansions. Operating income recently reached 18.9% of sales, about three percentage points better than I ever expected to see. This is a company that keeps finding new ways to sell a product (watches) that many claim no one needs or wants. Moreover, it continues to expand its accessories business, leveraging its globally recognized brand to hit a wide spectrum of consumers.

  • Lesson? A well-known brand and excellent management can generate major growth for companies the growth crowd ignores.

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, Fossil and Innophos became major winners for our members and our real-money portfolio even though Innophos is the sort of complex, commodity-price-driven company I normally avoid. 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.

If you'd like a shot at those returns, a risk-free trial of Hidden Gems is available, on the house.

If you would like to create your own free watchlist and get customized news sent your way on the stocks you're watching, simply use the links below.

At the time of publication, Seth Jayson had shares of Fossil, but no position in any other company mentioned here. 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.

Green Mountain Coffee Roasters and SodaStream International are Motley Fool Rule Breakers recommendations. Fossil is a Motley Fool Hidden Gems selection. Motley Fool Options has recommended buying puts on Green Mountain Coffee Roasters. Alpha Newsletter Account, LLC has opened a short position on Green Mountain Coffee Roasters. 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 (41)

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 April 28, 2011, at 4:37 PM, STOEBNER wrote:

    GOOD LORD, I AM NOT SURE WHERE MR. JAYSON IS GETTING HIS NUMBERS. I OWN A SODA STREAM MACHINE AND NOT ONLY IS THE COST OF MAKING SELTZER AND TONIC ABOUT 1/3 CHEAPER, I ALSO DO NOT NEED TO CARRY IT FROM THE STORE, STORE IT AND THEN FIGURE OUT WHAT TO DO WITH THE TRASH. I COULD CARE LESS IF HE OR ANYONE ELSE EVER BUYS THE STOCK BUT FOR GOODNESS SAKE, DO THE MATH.

    WITH THESE COMMENTS BEING SO FAR OFF BASE ONE MUST WONDER WHAT ELSE HE IS IGNORANT ABOUT.

  • Report this Comment On April 28, 2011, at 4:53 PM, TMFBent wrote:

    It's pretty easy to do the math on selzer from a sodastream machine. Many of the reviews on amazon.com do it, and come to the same conclusion I did: 2x the cost of store bought selzer, and that's before you factor in their expensive bottles.

  • Report this Comment On April 28, 2011, at 5:11 PM, landoncz wrote:

    With Sodastream, even if it is 2x (which I disagree with), how else would you make your own carbonated beverages? There is no alternative.

    They stock and sales are doing great because they are the first in a non-existent market where there are no competitors. It's pretty easy to see that there's a certain percentage of the population that will enjoy being able to carbonate things themselves, whereas they could not before. So, as we go from zero to that percentage, SODA will thrive. I don't see why this is hard to grasp...

  • Report this Comment On April 28, 2011, at 5:40 PM, a2badger wrote:

    Have a Coke.

  • Report this Comment On April 28, 2011, at 7:00 PM, STOEBNER wrote:

    The Soda Stream machine I purchased came with 2 one liter plastic bottles and a CO2 bottle. I am not sure how to factor in the cost of the machine itself ($90. on Amazon) but the 1 pint bottles of flavoring cost $6.95 and makes 12 liters = 33 cents/liter. The refilled CO2 bottle is $20 (Bed Bath and Beyond) and makes 60 liters = 59 cents. Total cost per liter in my area is then is 92 cents per liter. Can you really find a liter of tonic or seltzer in the store for $.46??

  • Report this Comment On April 28, 2011, at 9:12 PM, luckyspike01 wrote:

    Re Sodastream's business model --- have you priced Pellagrino water? This is a great product, even without the flavors ... try it with some fresh lemon juice. Kids on campus are crazy about it, too.

    Having said that, regarding the stock, I got turned off when they did a secondary so soon after the IPO and before even reporting earnings twice and sold my shares. But it's on my watchlist.

  • Report this Comment On April 28, 2011, at 9:13 PM, TMFBent wrote:

    I get selzer for $0.25 a liter regularly. So that's why I figure it's about 2x the price...

  • Report this Comment On April 28, 2011, at 10:16 PM, greedwhenfearful wrote:

    The Keurig simplifies a complicated process. Soda Stream complicates a simple process.

    Their Cola is no Coke. A more complicated process should improve the taste, not worsen it. The Keurig is still no match for a fresh pot but the simplicity makes it worth it.

    If I believed in shorting, I would short SODA.

  • Report this Comment On April 28, 2011, at 10:24 PM, lhardister wrote:

    With regard to the TSC comments, when you're out in the boondocks visiting your local fleet store, you should also check out some of the local feed stores. Most of us TSC store patrons have learned that you can often find a good selection of mud boots, trailer hitches, and mower blades at the feed stores, too. And they seem to be a lot easier to find out here in the boondocks than a fleet store.

  • Report this Comment On April 29, 2011, at 1:36 AM, Clint35 wrote:

    I can't believe you guys sold Innophos already. I think they're just getting started and the dividend is good. But still, a very good article.

  • Report this Comment On April 29, 2011, at 6:22 AM, midnightmoney wrote:

    you warn and warn about green mountain, and it just keeps laughing in your face. I kick myself in three spots for not buying it at 24 last year.

  • Report this Comment On April 29, 2011, at 9:29 AM, Cubbob wrote:

    I have "done the math' and it is cheaper for me to use a Soda Stream machine. In addition. I am using re-useable bottles and am not continuing to pollute the environment with more plastic bottles. Also, I can make seltzer in smaller quantities and keep it's fizz throughout use. It's cheaper, a better product and is far more environmentally friendly.

  • Report this Comment On April 29, 2011, at 12:49 PM, TMFBent wrote:

    @lhardister

    My boondocks doesn't have so much in the way of feed stores because there's not much agriculture. It's a mining area, surrounded by lakes, so the fleet store is the go-to location. I was wearing my boondocks mud boots (1,300 miles from where I bought them) to do a bit of lawn work just the other night.

  • Report this Comment On April 29, 2011, at 12:51 PM, TMFBent wrote:

    @clint

    It wasn't the easiest of sell decisions, but we have a tighter range of what we believe are the likely valuations for that one, and figured we'd sell when we reached our top end. In this market, any kind of a sell has looked wrong...

  • Report this Comment On May 03, 2011, at 2:09 PM, mikecart1 wrote:

    Ok, let me see your worst 5! :D

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