Tom Gardner's 5 Worst Watchlist Stocks

After I published a recent article examining Tom Gardner's Top 5 Watchlist Stocks, our Motley Fool Hidden Gems founder suggested we take a look at the opposite end of the watchlist scorecard and examine the worst of the bunch.

After all, if you want to learn what to look for in future 10-baggers, you might also want to look for ways to reduce your exposure to stocks that lose 80%, 90%, and nearly 100% of their value.

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.

The biggest losers
In the interests of fairness and horror-show-type fun, let's dive right in and take a look at Tom's 5 worst Hidden Gems watchlist performers and see if we can learn what to avoid. And yes, you're counting correctly. There are more than five rows in the table below because some of these ultimate losers were watchlisted multiple times. Seven watchlist picks, five horrible stories.

Returns information source: Capital IQ, a division of Standard & Poor's.

LECG Corp. had a big net cash balance at the time it made the watchlist in August 2005, with a chairman and founder holding a large ownership stake. Unfortunately, none of that mattered. The provider of "expert testimony" and other legal and consulting services saw revenue peak in 2007. It's been all downhill from there. Facing deep-pocketed competitors, margins fell apart in the wake of lower revenues. Taking on a big slug of debt in 2009 and 2010 resigned the stock to the market's dustbin.

• Moral of the story? A founder-owner and cash are no protection against entrenched competitors, and you can't borrow your way to prosperity.

Point Blank Solutions was known as DHB Industries when Tom first tapped it for the watchlist in January 2004. The provider of body armor was led by David H. Brooks, who was previously charged with insider trading. Investors hoped he was going the straight and narrow. Not so much. In 2010, Brooks was convicted of having misrepresented the company's numbers and looting the company (as well as trading on material information). All in order to fund his ego. Diamond-studded belt buckles, bat mitzvahs featuring Aerosmith and 50 Cent. This Gulf-war story stock had it all, except a truthful story.

Looking back, it's not tough to see why investors were enticed. In the post-9/11 United States, plenty of small law enforcement and security-related companies were making investors feel rich. Unfortunately, there were a lot of scams in this space. (I wrote about them at the time.) Even the best of the highfliers provides a cautionary tale: TASER International (Nasdaq: TASR) ran from about $1 a share to more than $80 between 2003 and 2005. TASER wasn't run by DHB-style crooks, and its stun-gun business remains intact. In fact, its revenues are much higher than they were back when the stock peaked. The stock still retreated to the sub-$5 level. Buying what's hot can often get you burned.

• Moral of the DHB Industries story? Beware the hot story stock, and don't trust crooks. Especially when they tell a great story. Especially when they're in charge of the books. Especially when they name their companies after themselves. Especially when they spend tens of millions of dollars on parties.

What happened at Tuesday Morning? Tom's original watchlist write-up pointed to a clean balance sheet and experienced management, and predicted 15% to 20% annualized returns from 2005 to 2010. Unfortunately, Tuesday Morning proved to be every bit as exciting as its name, which is to say, not exciting at all. Operating margins nosedived and have not recovered. The stock has also fallen and can't get up.

Anyone ought to be able to guess why, even without looking at the numbers. Revenues have been relatively stable, but ongoing price wars in the tough economy have destroyed Tuesday Morning's margin. Rent and other relatively fixed costs make it pretty hard to win a race to the bottom, especially against big, well-funded competitors. Hard times and expanding e-commerce mean that Tuesday Morning's competition isn't just closeout retailers like those under the TJX (NYSE: TJX) umbrella. It's competing against anyone who can cobble together a website.

• Moral of the Tuesday Morning story? Third-rate retailers often look "cheap," but they can get lots cheaper.

Even at the time of its August 2004 watchlist entry, many investors weren't holding much hope for Credence. At the time, Credence Systems, a small maker of test equipment for circuits, was "struggling toward positive free cash flow, with strong sales and a balance sheet loaded with cash." Unfortunately, it was also loaded with debt, becoming more debt-heavy over time, and the strong sales didn't materialize. After inflicting substantial pain on shareholders, it eventually merged to form LTX-Credence (Nasdaq: LTXC). Once more, competition was the problem. Big competitors like Teradyne (NYSE: TER) never make life easy in this business, and the survivors are often not much better off than the dead. (Teradyne's shares trade for roughly half the price they commanded a decade ago.) Tech companies generally hoard cash. Those whose balance sheets move in the opposite direction should strike fear into the hearts of all investors.

• Moral of the Credence story? Tech is tough, so tread carefully and keep an eye on the balance sheet.

Craftmade International is a manufacturer of products that greased the wheels of the housing bubble: fans, light fixtures, door chimes, patio furniture, and more. You know, just like the low-margin junk you can pick up at Home Depot that's all made to exacting low tolerances in China. And that, of course, tells you all you need to know about what happened at this business. Even the housing bubble couldn't save it from low-margin competition.

When Tom tapped it in September 2003, it looked "substantially" cash flow positive, but a closer reading would have shown that much of that was owed to recent, unsustainable, one-time swings in working capital. Insiders owned nearly 30% of the shares. That hasn't changed, but the shares are now nearly worthless.

At least investors had plenty of chances to see just how Craftmade was falling apart. Margins declined steadily from 2003 on, the cash flow statement shows increasing decrepitude, and if that was too arcane a tip-off, the steadily worsening balance sheet was all you needed to see. And if misery requires company, investors can look to much larger, stronger building products companies. Once-mighty NCI Building Systems (NYSE: NCS) saw its stock drop to the low teens from the mid-$300 range as the financial bubble popped. USG (NYSE: USG), an even bigger player, has been similarly stunted by the double whammy of disappearing demand and ubiquitous competition. Its shares did a similar "five for one split the hard way" as revenues dropped by half in the wake of the housing bubble.

• Moral of the Craftmade story? Commodity manufacturers barely benefitting from a huge financing bubble are living on borrowed time.

The mother of all morals
After all those stories of failure snatched from the jaws of victory -- or so it seemed at the time the stocks entered Tom's watchlist -- you might wonder why anyone would bother. After all, didn't these companies feature good balance sheets, motivated founders and managers with high insider ownership?

There's a simple answer: Over time, these losers matter little. Sure, when you are interested in a lot of stocks, you're going to run into quite a few that miss your expectations. You're even going to be taken for the proverbial ride by a few select bad apples, like David Brooks.

But at the same time, by concentrating on companies that display these Hidden Gems-type characteristics, you will also find yourself following -- and hopefully putting real money behind -- a number of multibaggers that greatly surpass your expectations to the upside.

As Tom explains it (in one of the same Hidden Gems issues in which he watchlisted serial disaster Tuesday Morning):

One great area for both profit and learning sits over on the Watch List, where each month we feature three intriguing small companies. ...

Since we launched the service, I've made about 70 Watch List selections. Out of those, there's a single performance statistic that captures why I think Hidden Gems will help disciplined members build extreme wealth in the decades to come. It's the result of combining the five worst with the five best performing stocks on the Watch List. Let's take a look.

The first group is disgusting. To lose anything between 25% to 60% in less than two years says that my research here was badly flawed. But those spills are outdone by the thrills in group two, with stocks doubling or trebling. You might wonder what agony and ecstasy would await those who owned all 10. And herein lies a great lesson. Would it surprise you to hear that the combined performance of the stocks above is a market-smashing 67%?

I prefer to look at the entire watchlist to calculate returns, but it's still market-beating. Measured to this week, Tom's average watchlist stock return is 42%, 22 points better than you could have achieved buying the S&P 500 ETF.

Losers like those profiled above were overwhelmed by winning returns like these:

Returns information source: Capital IQ, a division of Standard & Poor's.

Foolish final thought
A watchlist is vitally important as a source of investing ideas and also an analytical tool to help you understand how your investing ideas have panned out over the years. Keeping a robust watchlist has helped us earn our members huge returns on stocks like Buffalo Wild Wings and Atheros Communications. (The latter was also a big winner for us in our real-money portfolio at Hidden Gems.) Remember to keep track of stocks that interest you, even if you're not ready to put real money on the line yet. We offer a free tool to help you stay on top of any stock. To begin tracking any of these stocks in your personalized watchlist, and receive up-to-date news about each, use the links below.

• Add Tuesday Morning to My Watchlist
• Add TASER International to My Watchlist
• Add LTX-Credence to My Watchlist
• Add Teradyne to My Watchlist
• Add NCI Building Systems to My Watchlist
• Add USG to My Watchlist
• 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