I'm a big fan of Elmer's Wood Filler for anything that is wood on my rockets. As you've said, water it down so that you can easily brush it on. My procedure is as follows:
Paint on first coat of filler, and sand almost completely off. Just trying to fill the grain.
Paint on second coat, again sanding almost completely off
Spray on a coat of high-fill primer and look for major imperfections
Fill imperfections with undiluted filler, sand again
Prime again
Lather, rinse, repeat until you're happy with the finish
Wet sand with 400 grit to prep for the color
You've mentioned the 'plastic' look - generally, I'm happy at the primer stage if I don't see any spirals, grain or other imperfections. The rule of thumb is that anything you can feel with your fingers will show in the color coats. Getting that 'plastic' look when painting is a whole different animal. Now you're talking about wet sanding the color coat (or clear coat if you're doing 2 part), compounding and polishing. If done by hand, it can take hours and hours of work to get a perfect finish, even on a small rocket. It's possible to use machine tools on larger rockets, but you've still got a LOT of work ahead of you. If you go this route, just remember that it'll only look perfect till it's first flight