6 Stocks David and Tom Gardner Think You Should Be Watching

Every smart investor has a watchlist. Serving as a clearinghouse for all your possible investment opportunities, it slows down the process and helps you avoid emotional, overheated, kneejerk reactions. But what to put on a watchlist?

The fact is that you can't buy every stock that comes to your attention, even all those that sound vaguely promising. A well-constructed watchlist, then, is your holding area for all your next-best companies, the realm of good ideas you hear about but want to gain a measure of comfort with before pulling the trigger.

This free report provides six companies that David and Tom Gardner believe merit your attention. Some might strike you as immediate buying opportunities, others you might want to file away for future consideration.

But overall, these six are solid, well-run companies that might deserve a spot in your portfolio. Add them to your watchlist, get to know them, see how the catalysts play out, and see if they're right for you.

Click below to see the first company...

David's Stock No. 1

Rosetta Stone

If you had a strong desire to learn Portuguese, you could spend some time in Mozambique, try to find a course at your local community college, immerse yourself in a Berlitz class, or pick up the yellow box from Rosetta Stone [NYSE: RST]. The company has built a strong reputation for teaching new languages relatively painlessly and affordably, making it the brand-name leader without rival. As David says, "I can't find the Pepsi to Rosetta Stone's Coke. There's no comparable competitor."

That's a large part of the reason David feels the company -- which shoots to make learning a language fun, easy, and effective -- has the potential to be a 10-bagger. It shares many of the characteristics of some of David's very best recommendations, specifically:

• It has a purpose and a mission that is important and relevant.
• It is an undisputed leader in its field.
• It has created a brand and identity that resonates directly with consumers.

The company started with an idea and developed an innovative solution. Instead of parsing sentences, conjugating verbs, and memorizing vocabulary lists, users of Rosetta Stone software -- of which there are millions -- learn through something the company calls dynamic immersion, which incorporates images, text, and sounds to teach using the natural language learning ability we had as kids.

Just Getting Started

And the nineteen-year-old company would seem to have its greatest opportunity ahead of it. It's just starting to develop its international presence, even though the United States accounted for only $2 billion of the $32 billion spent worldwide in 2007 in an attempt to learn a language through self-study.

With an average sales price of $355, Rosetta Stone's software makes learning a foreign language relatively affordable for motivated learners, but it still carries a high gross margin north of 80%. With that kind of margin and strong organic growth potential -- both internationally and domestically in what remains a relatively fractured market -- Rosetta Stone should be able to grow profits as it gains scale.

Additionally, its innovative origins remain today as the company constantly seeks to build features that allow it to make the learning process easier, more fun, and more accessible for its lovers of language. While Berlitz stretches only as far as audio CDs, a Rosetta Stone package of Level 1 and 2 Portuguese -- retailing for $399 and designed to build intermediate-level conversational skills -- comes with interactive software, an audio companion for your MP3 player, a headset and microphone for use with its speech recognition software, live online sessions, games, access to its community, and a mobile companion for learning on an iPhone or iPad Touch. The idea behind the product extensions -- a subscription model the company tags Version 4 Totale -- is to build more engaging and longer-term relationships with its customers.

What's Not to Like?

But not everything is sol e pirulitos (sunshine and lollipops in Portuguese) for Rosetta Stone. The company, which went public in April 2009, took a hit later that year when it canceled a secondary offering and lowered earnings guidance, citing ill-spent sales and marketing costs and higher-than-expected product development expenses -- not exactly the quick jump off the public starting blocks that analysts like to see.

More recently, the company's CFO resigned, and the COO followed him out the door, raising some questions in David's mind about Rosetta Stone's culture. While he likes CEO Tom Adams (who has been running the company since 2003 and is still under 40), David wants to see a sense of stability and maturity among the leadership, along with a shift away from its unfortunate approach of overpromising and under-delivering on its financial results.

Rosetta Stone's business is growing, though.

What's more, with a vast advantage in brand recognition, an evolving business model that appears to be paying off on two significant fronts, and a world of people who want to communicate with more people than they can in any one language, Rosetta Stone has the look of a long-term, big-time winner.

Catalysts

• Keep an eye on turmoil in the management suite. Two high-profile departures make a line, three could indicate a trend.
• Monitor the progress of international and subscription services -- the company has plotted a big chunk of its future on these bets, so make sure the growth continues on both fronts.
• Management has made a habit of disappointing the market, and its stock performance has been whiplashed as a result. There's a reasonable chance that shares will take another hit at some point, which could present a buying opportunity for what remains, despite management missteps, an outstanding business.

Watching on the way up

Which brings us to...

David's Stock No. 2

Universal Display

That helps explain why David's urging smart investors to keep an eye on Universal Display [Nasdaq: PANL], a pioneer in the development of organic light-emitting diodes (OLEDs). Using organic compounds that emit light when an electric current is passed through them, the electronics equipment company develops sharper, brighter screens for TVs, computers, tablets, and smartphones while using less energy than traditional liquid crystal displays.

The market for OLEDs in 2009 was only about $600 million, but market researcher DisplaySearch anticipates it will swell to a staggering $7 billion by 2016. So when most investors would be thinking about selling shares of this innovator after it has climbed 433% since David's recommendation in June 2005, David jumped back in for more last July. That pick is up nearly 173%. Still, he thinks it's at least worth watching with such a large market opportunity and so many untapped ways this game-changing technology could be incorporated.

Rise of the Smartphones

After all, the technology got off to a relatively slow because no applications spurred enough demand to entice manufacturers to invest in the production of OLEDs and, in turn, bring down costs. Smartphones have changed that. And with monochromatic screens going the way of the rotary phone, companies that make smartphones are in a race to make OLED-using handsets that are brighter, crisper, and (critically) that offer a longer battery life. As David wrote in his re-recommendation, "Apple [Nasdaq: AAPL] reportedly rejected an OLED display for the latest iPhone because no manufacturer could meet production demands. As problems go, that's a pretty bullish sign for Universal Display, and one that's unlikely to linger."

As the miss with Apple demonstrates, royalties are key for Universal Display. Getting into the right TVs, computer monitors, smartphones, and beyond will determine how successful the company will be. Signs are good thus far -- Samsung, the world's largest manufacturer of OLEDs, is a licensee of Universal Display and the company's primary source of income, and it also has licensed technology to LG Display [NYSE: LPL]. Universal also took the bold step of opening a new facility in Seoul, South Korea -- right around the corner from Samsung and LG (or at least a whole lot closer than New Jersey). That move bodes well for the long-term relationship with its existing -- and potential new -- clients.

Waiting for Profits

With all this apparent success, Universal Display is still not profitable. David and team expect the company's revenue to double or more over the next two years and for the company to break even (or at least get a whiff of even) in 2012. The company also needs to maintain its focus on research and development -- it's been spending an average of $16 million to $20 million a year since 2002. While that might climb, it won't increase as rapidly as revenue. "So once the company is in the black," says David, "we think profits will grow very quickly."

OLEDs still aren't cheap, which might prevent adoption on the scale or at the pace that David would like. And to date, they haven't been good enough for Apple. But they have reached the tipping point, and other applications are on the horizon -- Universal Displays is working with the Department of Energy to develop lighting solutions, but it doesn't appear a solution will be viable for five to 10 years. As David says, if you think that low-power, high-contrast displays have a bright future, keep an eye on the brainpower behind the technology.

Catalysts

• Watch for profitability. There's not much transparency into the economics of Universal Display's relationships with the display manufacturers -- what is the company making for each display sold using its technology? Massive adoption will take care of that concern, but the proof will be in the profits.
• The company must keep locking down licensing agreements. It's well positioned, but not without rivals. And there's nothing to say another game-changing technology isn't being developed in someone's laboratory.
• Kyocera got out of the OLED business, but Apple is rumored to be ready to ditch its Retina Display once the supply of OLED panels is strong enough. Further adoption or departure could send the stock spinning in either direction.

The title on David's business card is Chief Rule Breaker and as an investor, he loves when a company is willing to challenge the conventional wisdom, offering a new solution to a problem that many viewed as solved. His unofficial motto is, "Top it!" Which leads to...

David's Stock No. 3

PetMed Express

Smartphone screens and heartworm medication for your dog have a lot in common. OK, they have nothing in common, except that pioneers willing to explore new ways of looking at each of them are worth keeping an eye on. PetMed Express [Nasdaq: PETS] aims to break pet owners of the bricks-and-mortar habit in the same way Netflix [Nasdaq: NFLX] convinced movie fans that they need not get in the car to pick up the latest video.

"I love a direct-to-consumer subscription model that's a pain to cancel rather than a pain to renew," David says.

A Business for the Dogs ... and Cats

In a nutshell, 1-800-PetMeds bills itself as the country's largest pet pharmacy, delivering prescription and non-prescription pet medications as well as health and nutritional supplements for dogs, cats, and horses at a savings to customers. Taking orders by phone, fax, or the Internet, the company is trying to make the purchase of pet meds easy, convenient, and economical. It offers the exact same stuff that you get from your vet, but you don't have to driver there every month when you run out of flea collars, heartworm pills, or Flys-Off for your horse. Especially for the items that require seemingly eternal refills, this allows PetMed to compete on convenience while its lower overhead and economies of scale allow it to undercut the vet on cost.

And the pet med market is nothing to sneeze at. According to research, 71 million U.S. households own a pet and we are spending nearly $50 billion a year on them. Of the $47.7 billion spent on pets last year, $3.7 billion went toward medication. A decade ago, this market was a near monopoly controlled by vets. Today, PetMed Express and its rivals are taking a healthy chunk, and they're doing their best to maintain customers through conveniences such as reminding you when Fluffy is running out of medicine and calling the vet for you to refill the prescription. Reorders account for 75% of sales. Created in 1996, PetMed struggled to gain traction, but today has a 6% market share, which puts it in the dominant position among mail-order businesses -- all of its competitors combined control 5% of the market.

Not Rolling Over

But vets still own 72% of the pet medication market. Major sellers of nonprescription meds and other pet supplies, such as PetSmart [Nasdaq: PETM], Wal-Mart [NYSE: WMT], and Amazon.com [Nasdaq: AMZN], also compete here. But PetMeds has the advantage of being a licensed pharmacy in all 50 states, which allows it to deal in prescription medications, where these others can't. The extra regulation that comes with being a pharmacy, combined with the 1-800-PetMeds brand and high customer satisfaction, has built the company a burgeoning moat.

Not everyone agrees. In fact, shares of PetMed Express are heavily shorted, weighing in at a high 25% short interest, which likely indicates that large institutional investors are betting against the stock. But the company has a low P/E, a head start on its competitors, a huge growth opportunity, no debt, a long-tenured management team, and a rabid customer base. David hasn't made up his mind which side is right, and he's certainly not ready to pull the trigger on a formal recommendation here. But he is intrigued by the business model and feels PetMeds is a company worth watching.

Catalysts

• As it showed when it decided it wanted to be the diaper king, Amazon.com has ample resources to put a hurting on a smaller player. While PetMeds holds the pharmacy advantage, watch for one of the big guys to try to swoop in, especially on non-prescription products.
• Keep an eye on the short interest. If the stock rises rapidly, it could lead to a short squeeze, in which prices shoot up quickly as those with short positions might have to liquidate to cover their position by purchasing the stock.
• Watch for an expansion of PetMed's product line to offer more pet food options and to a broader range of pets. That could help the company broaden its market and become a one-stop shop for pet owners.

David and Tom share a last name, Thanksgiving dinners, and a penchant for buy-and-hold investing. But how they reach their investing decisions is an entirely different process, culled from an entirely different set of companies that earn spots on each brother's watchlist.

Let's now look at three companies the younger Gardner feels merit your attention.

Tom's Stock No. 1

Danaher

Reading through the company description on the Danaher [NYSE: DHR] website doesn't get you any closer to understanding what the company actually does. In its words, it's "a diversified technology leader that designs, manufactures, and markets innovative products and services to professional, medical, industrial, and commercial customers." In short, Danaher makes stuff.

More importantly, it's a consummate consolidator, an industrial conglomerate that buys poorly run companies and cleans them up. And it exemplifies several of the principles that Tom regularly calls upon in his investing research.

• The men who founded the company are still involved and invested.
• It isn't sweating quarterly results, rather it has a clear vision of how it will achieve success over decades.
• It is focused on processes, not on the outcomes.

Building a Business for Life

As Tom said of the businesses that most appeal to him, "It starts with a passion, it starts with something you believe, and you give your life to it, rather than just try and start up something great, raise money, and sell it to somebody else." CEOs such as Jim Sinegal of Costco [Nasdaq: COST], Kip Tindell of The Container Store, and Jeff Bezos of Amazon.com [Nasdaq: AMZN] are making decisions based on what they will mean for their companies 10, 20, or 50 years down the road.

Nearly three decades ago, while fishing on the Danaher, a tributary to the Flat Head River in Montana, Mitchell and Steven Rales came up with their vision of a manufacturing company dedicated to continuous improvement and customer satisfaction. Today, Mitchell is chairman of Danaher's executive committee and Steven is the chairman of the board.

It's All About the Process

The company has acquired hundreds of companies in fields including hand tools, test and measurement, medical technologies, product identification, and environmental, and it now boasts nearly 50,000 employees and a market cap of over $30 billion. It incorporates new businesses through what it calls the Danaher Business System, which stems from the principles of lean manufacturing. Today, this system drives the company through a never-ending cycle of change and improvement. They bring in a company whose performance left something to be desired, apply their processes, wring out any inefficiencies, and boost the margins. In retrospect, it usually looks as though Danaher picked up its acquisitions at bargain prices.

The problem is that Danaher's success isn't exactly a secret. Shares have marched steadily upward for more than two decades, and today they are priced at a premium to its peers. They will likely never be cheap. Still, the company always manages to perform beyond expectations, so it might just be a matter of biting the bullet and getting a piece of this reliably outstanding company.

Catalysts

• Although it's worked to smooth the cyclicality that is inherent in industrials, Danaher still sees its share of periodic dips. If the stock drops back to the mid-$30s (shares trade in the mid-$40s today), it'll be a good time to buy.
• Another round of recession would be advantageous for Danaher as the company could take the opportunity to buy out even more small companies that were ill-equipped to deal with down times.

Companies that boast a reliable process for getting the most out of other businesses is a very compelling feature to Tom. And that leads us to his next pick.

Tom's Stock No. 2

Ascena Retail Group

To some, it would be akin to naming your new restaurant Gluttony, or rolling out the new Chrysler Guzzler line of SUV. Yet dressbarn has somehow overcome the unfortunate imagery of its name to successfully run nearly 2,500 dressbarn, maurices, and Justice retail stores that sell fashionable clothes to women and girls.

The company recently rebranded itself as Ascena Retail Group (Nasdaq: ASNA) to reflect that it's more than just dressbarn, but those stores will keep the farm-centric moniker.

Ascena and its founding family have been building relationships with shoppers for more than four decades, and it's well-positioned for continued success. But the market has put the stock on the discount rack.

Roslyn Jaffe opened the first Dress Barn store in 1962 as a place for working women to find stylish clothes at value prices. Soon her husband joined in, and today he and his son David -- with Roslyn sitting on the board -- are expanding Ascena, offering women and tween girls low-priced clothing under three brands: dressbarn, maurices, and Justice.

Tailoring a Business

Echoing Danaher's ability to bring in a new business and improve operations, Ascena has shown it has a repeatable process on the retail side. Its maurices stores (another family business before the Jaffes acquired it five years ago) aim to serve young women with a "twentysomething attitude" who live in small-town markets. Sales doubled not long after Ascena bought the chain. Justice, which was acquired when Ascena bought Tween Brand, focuses on the tween girl market. Justice's business should start benefiting from economies of scale in inventory sourcing, real estate, and logistics.

Overall, the company has a proven concept led by a family that has delivered for shareholders for years -- and with 20% ownership of the company, they have every incentive to continue to deliver. (The top-notch small-cap Royce fund family owns another 6.7%.)

Bargain Basement

 Investors today can buy the stock for less than 14 times trailing earnings. Once the Justice stores are fully integrated, Ascena's free cash flow should grow to be $180 million to $200 million per year (including lease expenses). If that happens, the stock will resume its upward march.

Catalysts

• The Tween Brands acquisition cost Ascena shareholders $415 million (including bank debt) in shares and cash (about 7 times operating profit). The Jaffes need to integrate sourcing clothes and back-office systems to make it worthwhile. The company successfully integrated maurices a few years ago, so we have faith.
• The American consumer is fickle these days, and Ascena depends on discretionary spending to deliver for shareholders. History is on our side, though, because the Jaffes have thrived through tough days before.

Tom also likes the growth prospects of another company that isn't exactly feeling the market's love. Which brings us to...

Tom's Stock No. 3

Corning

The demand for LCD televisions has stalled. The price of glass is falling thanks to an oversupply in the market. Gorilla Glass is a goofy name for a product. We've heard all the complaints about Corning [NYSE: GLW], the world leader in specialty glass and ceramics, and the market has priced the critiques into its shares.

But while there might be some headwinds at the moment for some of its products, those who discount the company based on the monthly sales of its latest new thing are missing the story of this venerable company. Sure, management warned recently that major LCD television players such as AU Optronics [NYSE: AUO] and Sony [NYSE: SNE] will soon be buying less of its glass at a lower price. And yes, its critical display business (the glass used to build LCD TV sets) is on the decline.

But more importantly, Tom views Corning as an R&D machine.

Much More than LCD

The company is constantly pumping profits into research and development, essentially creating new industries along the way. When Corning engineers made the glass for Edison's first light bulb, they weren't necessarily thinking about large-screen television sets. And when the company started making large-screen TV sets, it wasn't necessarily thinking about changing the composition of that glass in order to make it more durable and scratch-resistant (the aforementioned Gorilla Glass) for handheld devices.

But innovation is hard-coded into Corning to the point that it is an ever-changing company. From generation to generation, from decade to decade, it's a constantly evolving entity so that it could well be a different company in 10 years from what you might buy today. Corning constantly has an eye toward the next wave and adapts to capitalize on the industries that others can't yet envision.

As CEO Wendell Weeks told the Fool in an interview in 2005, "Corning has never been an easy company to categorize. Even during the explosive growth of our telecommunications business in the late 1990s, we were about more than communications equipment. While display is our fastest-growing and most significant segment today, we are not narrowly defined as a TV parts supplier.

"Simply put, Corning is a diversified technology company with a unique history of innovation. We combine our materials and process expertise to solve difficult systems problems for customers. We develop unique products -- keystone components -- that enable new complex systems. We don't play in one market or industry. We invent technologies such as optical fiber, which revolutionized telecommunications networks. We invented and perfected the glass-fusion manufacturing process that enabled our leading position in the production of liquid crystal display glass substrates for desktop monitors, laptop computers, PDAs, and now, flat-screen televisions. We invented the ceramic substrate that is the centerpiece of emissions control systems on gasoline-powered automobiles and diesel engines, and we are heavily involved in the life sciences field. So, Corning doesn't fit neatly into Wall Street's industry categories."

Missing the Big Picture

So analysts who downgrade Corning and investors who sell their shares based on the latest quarter or the success or failure of a particular product line are a benefit for long-term investors. Adoption for Gorilla Glass is heating up, and the company's CFO thinks it could bring as much as $1 billion annual revenue by 2012 -- nearly half what Corning's display unit brings in today.

That's great. But a decade down the road, the primary driver could well be within its environmental technologies division. Corning's ceramic substrates and diesel particulate filters are integral in pollution control systems, which could become more important as we look for green solutions. But to try to pinpoint the exact area that will be driving Corning's success is a difficult -- and ultimately unnecessary -- challenge.

As Weeks said, "We are committed to spending about 10% of our total revenues on research, development, and engineering. We must invest in the future in order to grow through global innovation and create a sustainable stream of earnings from new products and processes."

Catalysts

• TV sales are cyclical, a condition exacerbated by a recession when people are more concerned with paying the mortgage than getting the latest flat-screen TV. As the market reacts to that cyclical nature, it might offer cheaper buying opportunities for investors.
• Watch where else Corning's glass and ceramics are showing up. It might give us a sense of where Corning is placing its biggest bets for the future and will provide insight into the market opportunity that awaits.

There you have six outstanding companies, warts and all. Over time, you'll get a better understanding of how these businesses operate, how their share prices move, and if they're worthy of an investment. So I encourage you to add them to your own personalized My Watchlist.

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Rule Breakers returns as of November 18, 2011. Stock Advisor returns as of November 30, 2011. All other numbers as of December 7, 2011.