Don't Confuse the Stock with the Company, or the Market with the Economy

Last week I received the following email.

"Dear Mr. Lutts, My name is Joe C. I am 25 years old and come from Cork in Ireland. I am currently studying and have one year left in my business degree. I find your optimism in these "depressing" financial times refreshing. Would you agree that the most lucrative time for an astute investor may be in times of recession? I understand you are a very busy man and probably will not have time to reply to this email. To finish I am a believer that the international community can talk themselves into recession with only doom and gloom on the horizon. To see a company like yours giving sound, astute investment advice is great."

I replied.

"Dear Joe, Thanks for writing. At times like these (when everyone is complaining about the tough economy) I simply look at a chart on my wall that shows the trend of the past hundred years. Through wars, recessions, depression and the threat of nuclear annihilation, the long-term trend has been up and I believe that trend will continue. In general, I'm more bullish on China and India than on the U.S. and (sorry) Ireland, but that's only because the growth rates of China and India are faster. As to investing at the present time ... undoubtedly, the best times to invest are when people feel worst. The correlation is not as good with recessions, for several reasons, one of which involves the inaccuracies of measuring economic output.

Best wishes, Timothy Lutts"

And now I'll elaborate further, because the topic has broad implications.

A simple rule to remember is that the stock market is not the economy and the economy is not the stock market. If investing were as simple as following economic indicators, we'd all be rich.

The stock market, instead, is always looking ahead, reflecting the hopes and fears of every one of its participants on a daily basis. You could use the market's gyrations to predict the future of the economy, but I don't see much value in that. What's best, instead, is to simply use the market's movements to guide your own investing actions.

Today, we're optimistic that the market bottomed back on July 15th -- when it first appeared to many investors that Fannie Mae (FNM) and Freddie Mac (FRE) were going belly-up -- and that since then a bottom-building process has been evolving. We say that because on the charts of most broad indexes, July 15 still stands as the low. Supporting that theory is the fact that there's been no shock as bad as the FNM and FRE scare since then. Back then, 20% of American were not sure that their money was safe in their banks!

Admittedly, the future is not written, so anything is still possible; but the odds are that that mid-July bottom will stand, and that when this bottom-building process is complete, the market's next uptrend will begin in earnest.

At that time, we may actually be in recession ... but we're not yet. And the way that economic output is measured makes me skeptical of these measures anyway. It's simpler, and far more profitable, to simply watch the action of the market.

Just remember, the stock market is not the economy and the economy is not the stock market.

In the same vein, my father often remarked, "Don't confuse the stock with the company." This advice is particularly relevant for investors in growth stocks, because these stocks can fly to the moon on little more than dreams, but crash to the ground-and worse-when those dreams are dashed.

Consider, for example, Crocs (CROX), which was a big winner for readers of Cabot Market Letter in 2007. The maker of funny-looking shoes came public in February 2006 at $10 and five months later began its big move.

In September 2006 we published a memorable issue of Cabot Market Letter. The headline, inspired by the buy signal from our Cabot Trend Lines, was "Sell Real Estate - Buy Stocks." We had no idea then how right that advice was. But a month later, we added Crocs to the Model Portfolio, writing, "This company's colorful, lightweight, anti-fungal, non-marking, low-priced thermoplastic shoes look funny to us. No one in the office owns them. But that doesn't mean we don't appreciate the company's explosive growth. Fact is, most revolutionary developments are misunderstood-even laughed at-before they're embraced. And Crocs are now being embraced rapidly! Second quarter revenues grew 232% to $85.6 million, sending earnings up 330% to $0.43 per share. Profit margins were 20.1%. And 30% of revenues came from international sales, prompting CEO Ron Snyder to comment, "Our international business is growing much faster than we originally expected." That kind of surprise is a good thing, as is the new price high this week."

Fourteen months later, our profit in CROX had grown to over 340%.

But on November 8, one week after the stock topped, we recommended selling, writing, "On the surface, Crocs' third-quarter earnings looked fine, with triple-digit growth in both sales and earnings. But the company's outlook wasn't as good as hoped, sending the stock over a cliff. You might think that the report didn't warrant such a collapse - and you would be correct, to a point. Earnings estimates were actually hiked following the report ... but the outlook still calls for sharply decelerating growth next year, which can be poison to a growth stock. The bottom line is that CROX is totally broken, and it will take months (at least) before the stock is ready to make a serious, sustained advance. It's disappointing, but your best move is to sell and move on to greener pastures."

Elaborating further in that issue, we wrote, "the stock collapsed because it had been "priced to perfection," and when the company failed to meet Wall Street's lofty expectations, buyers simply disappeared. In our opinion, the pity is that investors were blindsided by the news. In the old days, before Regulation FD (meant to quash insider trading) closed all the leaks, the reality of the situation would have trickled out to investors in the know and we could have learned by reading the chart that "bad" news was coming. But no longer. The chart of CROX showed absolutely no signs of trouble before last Wednesday. So should we have sold before the earnings release? Well, if we did that, we'd never own a stock longer than three months, and that's no way to build big profits."

Finishing up, we asked, "So how do you avoid being blindsided like that? If you're investing in the strongest growth stocks, sometimes you can't ... but there are ways to minimize the pain. First, you need a diversified portfolio. And you need to sell those losers quickly when they fall apart. Finally, you need to be an early buyer when the trends turn positive. Those hurt hardest by CROX's collapse were the late buyers. And what of CROX now? Is the stock attractive at this level? Not to growth investors. Its heavily damaged chart means that every rebound will be met by selling, and getting the remaining disappointed shareholders out will take time. A year or two down the road, if Crocs' management executes its diversification plan as expected, it may become attractive as the next Nike. But it will never duplicate the excitement of its first 18 months of life. Those days are gone."

Today, with CROX off 94% (yes, 94!) from its October 2007 high, those words were right on the mark. And the further bad news is this: Today, when half the staff in our office owns a pair or more of Crocs, the company's sales growth has hit a wall. Revenues peaked in the third quarter of 2007, and the second quarter of 2008 actually showed revenues lower than the year before. Value investors will argue that the stock is now cheap, trading at just 40% of revenues, and brave souls may find profits buying here. But that's not our method; the stock is still in a downtrend.

Going back a little further to illustrate that the stock is not the company, another of our big winners was Taser (TASR), the maker of stun guns that we thought might revolutionize the law enforcement business.

When we added Taser to the Model Portfolio of Cabot Market Letter in November 2003, we wrote, "Excitement about this tiny company's future growth has been driving its stock to new peaks ... Because of its small size, the small number of shares outstanding, the revolutionary product and its big profit margins, we believe Taser has the potential to be a big winner."

Less than nine months later, our profit was over 240%. But the stock began lagging, and even while the company's numbers looked great, we recommended selling, writing, "The Taser story is one of surging demand for the company's non-lethal weapons and explosive revenue and earnings growth. While those fundamental factors are great, what's more important to us as investors is the stock's strength and momentum. Even though we've taken big profits in the stock, the stock's underperformance has troubled us for months. This week, as the market was bouncing TASR struggled to hold above its important 200-day moving average ... signs of decreasing sponsorship. Another thing that troubles us is how bullish many investors remain about the stock's future prospects. They believe it will head to the moon again. While this is certainly possible, until the bulls capitulate, it's unlikely the stock will make any sustainable headway. Taser is our weakest stock so we're taking our final profit. If you're still holding, sell now and sideline the cash."

When that was written, the stock was 27 and the company's revenues (in that quarter) were $18.9 million. Today, I see that the company's most recent quarterly revenues were $21.1 million, but that the stock is down at 6. The trouble, of course, is that the growth is gone. The company's revenues peaked in the fourth quarter of 2007 ... but the stock peaked more than three years before.

Don't confuse the stock with the company.

Comments

[ksmithdc:]

Interesting read. Thank you.

2008 Aug 26 11:08 AM

[Grandpappy:]

You hit the nail right on the head.I had some Crox stock,but got out in time,but still have 2 pair and enjoy wearing them.

2008 Aug 26 12:22 PM

[whidbey:]

To your larger point, the economy has me concerned at present but according to ECRI we have been in a recession for a while (well before I sensed what their indicators say at present). The stock market is likely to reflect the downer for a time, then turn before the economy shows much life. They say 6 months before any significant movement in employment or output. Over the years that has been my experience. Apparently you do not share those views. or do you?

2008 Aug 26 06:43 PM

[Gumby:]

Nike was like Crocs back in the 1980's or 90's. Nike was cratered badly and rebounded. Crocs acquired Bite which use same croslite material but comes with much better designs. I ordered some Crocs before looking at Bite website. I returned the ugly Crocs and ordered some at Bite.com. Check it out!!

2008 Aug 26 07:01 PM

[Gumby:]

Maybe Michael Phelps will be the point guy for Crocs/Bite like Tigers Woods did for Nike...

2008 Aug 26 07:02 PM

[Luvnrio:]

I'm relatively new at this with almost a year under my belt. My question is, "what constitutes a recession?". I believe we have all heard we are and we aren't in a recession. Seems to me everyone has their own reasoning. Could someone please shed some light on this issue. Are we, or are not it a recession.

Thanks,

2008 Aug 26 07:41 PM

[User 250263:]

crocs is dying
it costs 1.5usd to buy a mimic of crocs in china
and china is exporting hell of mimics to europe and usa
as far as i know there's only limited patent protection on crocs's feature plastic footware and it can be easily jumped over by chinese low cost mfg rivals.

2008 Aug 26 11:06 PM

[Steven Hansen:]

i also want to commend your article. i know that you must buy the stock and not the company. but coming from the operations side in a company, this has always seemed wrong to me. should we ponder how healthy this approach is to a companies long term competitiveness?

2008 Aug 26 11:57 PM

[User 236735:]

"I look at a chart on my wall" ... dear, I haven't been to "business school" for many a year, but I thought this kind of reasoning and thinking had been dispelled of decades ago, you know, with William Sharpe and Harry Markowitz and the Capital Asset Pricing Model. For a more colloquial account, see Pery Mehrling's "Fischer Black and the Reveolutionary Idea of Finance." The dear boy in Cork, Ireland is living in never-never land if he thinks he can on a consistent basis outperform the market rate of return. The marekt rate of return is contingent on the economy, so I am not sure what the hell is going on with the question or the answer in this aritcle. It sould like gibberish to me. These days I am not sure who are the greater quacks: those that say they can beat the market, or those that say they can predict it. Look, you follow the mandates of CAPM, hold a diversified portfolio that rids you of alpha-risk, and take the return the market gives you. All else is the thinking of "Professors" much like the one in "Back To School" looking for a place to locate his classroom factory to which Rodney Dangerfield shouts out: "How about Fantasyland?"

2008 Aug 27 08:18 AM

[JREB777:]

Many things in the article are right. But the only miss is that.. No! The market hasn't reached it's low. Every time we get this kind of economic event, it is always followed by a wash out sell of in WallStreet as it gets clensed from the regular investor.
This hasn't happend yet. Unless this time is different, we havn't reached a bottom yet.
Maybe it is getting ready and it will rally some 500 points to then drop 2000 one day and be below 10,000 as it should.
Be carefull out there.

2008 Aug 28 10:54 PM

[Konst:]

them be some ugly ass shoes. their new styles that are more mainstream look better, though who knows if they will catch on with consumers? I think they are changing their image, probably unitentionally, to appeal to the elderly, medical and hospitality industry. I don't know if they are cognizant of the fact that this may be detrimental to the hipness (if any) of the brand. tricky business

2008 Sep 09 01:13 AM

[vloscomp:]

I love your article, what do you think of AAPL? is it another CROX or TASR. I did buy some TASR in the 4 range, hoping that it can make it to six by Jul 29.

Jul 26 12:12 PM