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?

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