Monday, March 29, 2010

Thoughts on "Fad" Stocks

I've collected a few random thoughts on some of the characteristics of "fad" stocks in my view. Of course, most thoughtful investors know one when they see one, but I have not seen a thorough write-up on the topic. Let's take a look at some common threads that I have seen over the last few years.

Business: many fad stocks are consumer-related stocks. Why? There are two logical fallacies at work here. One is that "seeing is believing": many people can see, touch, taste, or wear a product; this creates a familiarity, may be even a strong relationship with the brand, which then translates into the assumption that the business is a good investment ("because I buy it all the time for the kids"). It also creates popularity and recognition in a wider investor base, which helps drive the stock price up. People do not get psyched up about steam valves or workers comp insurance underwriters, but they do love to eat at X or to wear Y or to shop at Z. The second logical fallacy at work is the "worship" of simplicity, and the associations "simple=true" and "simple=good". Less sophisticated investors sometimes think that the presumed simplicity of the business (especially ones with visible, tangible products) makes it a wonderful, honest investment when, in fact, some have turned out to be quite fraudulent.

"A Great Growth Story": most fad stocks have a great story, usually one of growth. Like with all big "bezzles", the story is compelling, tangible, visible, delicious (in some cases), comfortable (in others). The sad truth is that rapid growth is very difficult to manage, and can be value-destructive. Rapidly growing companies often end up with marginal employees, marginal suppliers, marginal locations, marginal franchisees, and so on. Rapid growth also attracts competition from larger, better capitalized and better managed firms. All of this eventually contributes to the demise of the high-fliers.

Cheerleaders and mega-trends: great stories have great cheerleaders who like to drum up the "mega trend" that the company is capitalizing on. Apart from management, there might be a few vocal analysts who actively spew out propaganda on the topic. Dasan calls them "master extrapolators": people who do not get that trees do not grow to the skies, that profitable businesses attract competition and that "on trend" does not mean a good investment. Think of some of the unquestionable mega-trends now. Anything China is "on trend": no wonder so many companies have China-this or China-that in their names, much like the .coms a few years ago. Other often unquestioned mega trends include green energy, hybrid vehicles, recycling and Baby Boomer healthcare demand. These are the ones that induce instant head-nodding and agreement in the investment community, without much consideration regarding whether it is the most optimistic scenario that is priced in, and then some.

Single-product risk: many fad stocks are dependent on a single product, service or concept. This is usually their undoing. Once the novelty wears out, the popularity fizzles or some bad news come out regarding the product, the stock heads south, sometime rather quickly, never to return to its former glory.

Stock characteristics: there are a few of them that I consider typical for fad stocks. One is rapid, sometimes parabolic, growth on volume as the popularity of the stock grows and more people buy into the story being sold. The rapid growth sometimes prompts management to do splits, which in turn, produces even more growth. Another one is behavior on earnings: one can observe double-digit % jump on the day quite often, as analysts hail the king of the day. A third sign is that the stock is just popular: people talk about it, someone has made a lot of money on it, the yahoo boards have the armchair quarterbacks going at full speed and so on. The final characteristic is that the stock is difficult to short: it just seems to defy gravity and common sense.

Non-traditional valuation measures and aggressive accounting: GAAP, with all their flaws, exist for a reason. If the management team is spending a lot of time on explaining how much they are growing based on some self-designed, growth-oriented measure ("adjusted cash operating profit per new store, exclusive of stores less than 3-mos old and Florida stores"), one might be looking at a fad stock. An additional warning sign is a company using aggressive accounting to exceed the quarterly expectations, such as bumping sales by relaxing credit and under-reserving for doubtful accounts. Accounting changes are also possible signs of the steam running out. Sometimes losses are described as a positive because the company is "investing" for the future.

Other potential red flags. Backdoor IPOs via SPACs: these do not have the same process as a traditional bank-done IPO and are sometimes used by questionable operators. Traditional IPO done by a less-reputable underwriter: beware of banks whose business model is "we say yes when others say no". High underwriting fees and/or a "best effort" offering might signal discomfort by the bankers (who often do know what is under the kimono). Management is going at great lengths to promote the stock: they are at every conference, they issue many press releases, they market the stock ostentatiously on their product packaging, they attack their critics with unusual vitriol and so on.

So, let's look at some good examples from the recent past. HLYS, still kicking around at $2-$3, but nowhere near the $40 it once commanded. The kids got tired of sliding around on their heels, and the investors took one on the chin.

Another footwear high-flier, CROX, was at around $70 at one time, but crashed down to $1, currently at around $8. These unsightly colorful galoshes were a hot selling item a few years ago. By the time management got around to doing a brand expansion into apparel, the word was out that the shoes were getting caught in escalators. True or not, it seemed that this is what the market wanted to hear, and the stock started rolling downhill.

KKD, once a sleepy Southern donut chain, embarked on a very aggressive expansion campaign a few years ago. It was a $45 stock, currently at $4, and was under $2 recently. KKD was a mix of poor capital management, dishonest relationships with franchisees, and serious alleged fraud. The former management was not charged formally, if I recall correctly, and the company has shrunk. People loved the donut conveyor belts in the stores but single-store volumes never justified having a machine on-site. LT investors got more hole and less donut.

JSDA, Jones Soda, made a big splash years ago with their cool labels, exotic flavors and the use of sugar (instead of HFCS, something "hot" right now). It was once trading at near $30, but the fizz is long gone, and the stock is under $1 now and is subject to a bizarre take-under (!) offer.

APP, American Apparel, is a company known for its quasi-pornographic advertisements, "made in LA" garments and for running a "Best Bottoms" contest, went public via a SPAC, traded as high as $15, but is now at $3, after the growth slowed, the founder/CEO's idiosyncrasies (to be polite) became public via numerous sexual harassment suits, and the INS arrested about a third of their employees for immigration violations last August.

Other examples include Atkins Nutritionals (remember the Atkins diet?), Boston Chicken, TASR (from under $1 to $30 to $6 now), BBW, Build A Bear, down to $6 from $30 (but possibly a "value" play now), NLS, Nautilus, a fitness equipment maker, an on-trend stock that has done the soft landing over time from $40 to $2 until the recent rumors. One developing situation is DECK. 90% of their sales are the UGG brand boots, and recent news indicate that they are really bad for your feel. Is this the bell tolling? I do not know. Also, I wish I could buy Ed Hardy puts but the brand is 50% private, 50% owned by Iconix, a company with a wide brand portfolio. So, what are your favorite fad stocks?

Friday, March 12, 2010

Thoughts on the New Movies "Futures Exchange"

There is this new "futures exchange" coming which will enable seemingly anyone to bet on the box office receipts of new movie releases. The article was in today's NYT's Media section. The exchange will be based on the existing successful "Hollywood Stock Exchange" (HSX) but with real money. Both are managed by Cantor Fitzgerald and the new project seems to be generating a lot of publicity in today's world of "crowd sourcing" and "crowd wisdom." Is it really such a great idea?

Let's follow the money and look at the participants:
(1) Studios/insiders have a substantially better view of how a movie would do by the time it is released than does the general public. How? They prescreen heavily, make adjustments, sign distribution deals, determine the marketing budget, follow the buzz, and so on. Personally, would you trade against them? Per the article, the studios are allowed to trade "within limits" whatever this means. The fact that they have not been able to "lay off box office risk" with insurance companies (risk pros) ought to tell you something about how great of a deal this is: the informational asymmetry is staggering. Not only that, but also, unlike a wheat producer selling weather risk, the studios CAN affect the outcomes. If this is not moral hazard, I do not know what is. If the studio buys enough "protection" on movie X, guess what, they will cut the marketing budget and # of screens!

(2) Cantor operates the exchange, and is probably interested only in ramping up the hype to attract the largest number of "investors". Cantor certainly does not care if anyone makes money, they just want volume. The President speaks of a "wide audience": quantity of participants is inversely proportional to their quality. I do wonder if there is a level of responsibility here that is ignored: stock brokers have to ascertain that the clients' risk profile matches the investments. How would Cantor do that? Would they accept credit cards? PayPal? Bets from people under 18? Is the whole thing structured as a "futures" exchange in order to avoid gambling regulations? This kind of bets are likely to be seen on European bookie lists, and I personally see no difference between "investing" in a certain outcome for a movie vs. "betting" on next year's SuperBowl champion. Is a win there taxed as a short-term capital gain? Are the losses deductible? And so on.

(3) The public: this is the tuna. The public has no informational advantage over the studios. Look at regular stock investing/trading. Even with huge amounts of publicly available information, audited financials, historical track records, and so on regarding potential stock investments, study after study show that the average active market participant underperforms the market. Compare that to investing in a completely unknown endeavor (a new movie): what are the chances that the average participant will be successful? I am sure that there will be widely publicized "success stories": these will be exceptions. The only market participants that will consistently make money are (1) the studios and (2) the exchange owner.

Think of it this way: the exchange owner charges rent. The studios have a deck of cards that they can look at in advance and place bets accordingly. The public can place bets without seeing the cards. Who do you think will win here?

I am all for markets for ideas, like InTrade, where one can instantly observe the crowd wisdom, even when it is very wrong (like the Great Hillary/Rudy Race of 2008). But it seems to me that on this exchange, the odds are stacked very much against the individual participant.
I will leave you with a quote from Howard Marks, found in his October 2006 memo: "Since I moved to Los Angeles in 1980, my friends in “The Industry” have been unanimous in one piece of advice: never invest in movies. Yet The Wall Street Journal of April 29 carried a story headlined, “Defying the Odds, Hedge Funds Bet Billions on Movies.”
For decades, movie studios have gladly accepted millions of dollars from a group
of investors collectively dismissed as “dumb money”: deep-pocketed dentists, oil
tycoons and other wealthy individuals eager for a piece of the glamorous but
high-risk game of film production. But the biggest influx of money in Hollywood
these days is coming from sharks, not suckers: hedge funds, private equity funds
and investment banks.

Take the example of “Poseidon,” which was co-financed by hedge fund-backed Virtual
Studios. It has brought in gross revenues of $180 million worldwide since May against its
production budget of $160 million, meaning that after the deduction of at least half the
revenues for distribution charges, advertising costs and exhibitors’ fees, it’s still a big loser."
(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Thursday, March 4, 2010

More On Inflation

As I mentioned in an article not a long time ago, inflation has been a favorite topic for barbarians ever since Rome started debasing its precious metal coins. I just wrapped up my annual inflation tracking survey and I would like to share the results with you, along with some commentary.

I track a number of pricepoints in several general categories: consumables, housing, transportation, education, financial assets, clothing and healthcare. To get an accurate picture of the price changes, it is important to track the same item unit price across for the year: be it a gallon milk, gas or a credit hour at a university. I do not weigh the baskets or the items to get an "alternative" CPI number but will highlight a few points in the data set.

Consumables Section:
Food: of 52 items, 26 were up (range 1.90-50%), and 11 were down. Excluding produce items (those should be looked at over longer cycles due to crop variance), leaders were Domino sugar (up 33%), Bud Light (up 23%), M&M's (21%), pork chops (17%) and Lenders frozen bagels (15%). At the bottom, again ex-produce, ribeye steak (-14%), Crisco vegetable oil (-13%), Cheerios and Corn Flakes (-10%ish). The average increase was 3.30%, and the median 0.95%. I fail to see widespread "food deflation". Both General Mills and Kellogg increased cereal pricing last year so there might be some givebacks there.
Household and personal care, over-the-counter medicine: of 14 items, 4 were up and 1 (Tide detergent) was down. On the other hand, Charmin tissue was up 21% (yes, calculated on a per sheet basis) and Huggies Newborn diapers were up 6.7%. All OTC was flat year-over-year. Tracking prescription drug prices is much harder due to scarcity of information and the changes in various plans year-over-year, so I did not even try: I just looked at various Tylenols, Benadryls and the like.

Transportation Section:
The MSRP on the cheapest 4-door Chevy compact stayed the same. So did a one way Chinatown bus ticket from NYC to Washington DC. On the other hand, nationwide gasoline for the year is up 42%, diesel is up 29% and NYC subway single ride is up 12.5%. There was deflation in new cars for most of the year, between the incentives and the stupid stimulus- which increased the prices for the people looking to buy used-, so you might have benefited from that if you were in the market. However, for most drivers, the people that did not score on a new car, there is inflation.

Education Section:

You always hear that education is getting more expensive, so let's look at it. 2009 was a year of deflation according to the official government CPI. Someone forgot to tell that to the members of the self-congratulatory ivory tower establishment. Harvard increased its tuition by 3.5% and Stanford did by 3.75%. But wait, those are the elite schools, who cares about them? Well, SUNY increased resident tuition by 5.47%, SUNY room and board is up by 5.62%, and the University of Minnesota-Twin Cities, increased its resident tuition by 7.24%. No deflation for these folks, by far. If Obama wants to stimulate education, the affordability does not start with more loans and guarantees, but with taking a serious look at how these pig troughs operate and the financial damage they do to our youths.

Healthcare Section:

Gathering pricepoints on healthcare is very difficult, in part because there is absolutely no transparency in pricing. I used several state-level databases to track state median billed prices for hospital procedures. Of the ones that got updated over the last year, normal newborn costs are up 11%, psychoses hospitalization is up 13% and minor bowel procedure without complications is up 27%. Heart failure and shock billing was down 15% in the one state that I tracked that. You can look at your insurance premium, copays, benefit cuts and figure out what your healthcare inflation was. Nevermind the time spent filing forms and being on hold with some clueless insurance adjuster. Here, like with education, I fail to see deflation.

Housing Section:
Housing is the only segment where there was deflation along all pricepoints that I tracked. The most recent NAR single-family median price is down about 1% versus a year ago: this includes the $8k stimulus effect so the real deflation is deeper. Of course, this only helps if you are in the market. Rents (tracked 2-bed apartments in 3 major cities via rentbits) are down in the teens for all three cities. Again, helps only if you move. Interestingly, the national average kWh electricity and cf of natural gas are both down, 2 and 11% respectively. However, this does not mean that your bills are down: the increase in delivery charges and other fees probably gobbled up the cut on the actual energy units.

Clothing Section:
Clothing is not easy to track, either, because fashions do change. So I had to stick to the basics from one vendor here, WalMart, to have a consistent year-over-year read. 6-pack boxers were up 0.3%, cheapest jeans were up 37.5%, single t-shirt, up 22%. Basic work shoes were down 7%. Again, I do not see deflation here. I am sure there are "good sales" with deep markdowns here and there, but what I am trying to do is have something that can be compared consistently year over year.

Assets Section:
On to everybody's favorite part, assets. Well, assets also got very expensive over the last year. A big chunk of that is timing, of course, as we had a major market low last year at around this time. So what has been happening? The S&P is up 30-40%+, gold 20%, oil about 100%, copper 130%, DBC (a wider commodity measure) 21%. 30-year mortgage rates are down marginally. CD yields are down 17% for the 3-year. What does this mean? This means a very strong asset inflation over the last year. If you view your savings as an "expense"- which it is in a way- then your dollar this year will not go nearly as far as it did last year. Not when measured against gold, oil, or stocks. A big part of Greenspan's failure was ignoring asset prices in his view of inflation. Do not do that: there is rampant YoY inflation in financial and some hard assets. Whether this is due to them being mispriced a year ago or due to money supply growth or something else is obviously a matter of discussion. Also, if you were all-in last March, asset inflation is actually good for you.

So, there you have it. There is no deflation if, over the last year, you: ate, used toilet paper, drove a car, saved/invested, used healthcare or education, or bought clothing. There was deflation if you moved to a new apartment, bought a new car or a house. I already wrote about "personal rate of inflation" a few weeks ago: this basket might not be anywhere near your basket, but I think it is a wide enough data set for one to get at least a binary answer as to whether there is inflation, despite the official statistics.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)