I recently went to Dick's Sporting Goods to replace a lost pair of Crocs for one of my daughters. As most of you know Crocs are extremely hot and the latest fad in footwear. The Company recently went public and the stock (NASDAQ:CROX) and its earnings have been soaring. Now, if I had never met Fast Eddy, I might be thinking "hmmm, Crocs are hot maybe their stock is a good buy also." Instead, I simply smiled as I forked over my $25 for the new pair of flexible rubber shoes.
Now, Fast Eddy is an interesting character -- he's that friend we all know that always has a get rich scheme that is a sure winner. At least that is what they tell us each and every time. One of the classic Fast Eddy stories was the time he bought 10 cases of soda and resold them for a large mark-up out of a cooler he lugged around the lakefront beaches in Chicago. Now in theory this was a good plan, because he was going to make about $10 per case sold on the beach. However, after a long hot eight hour day in the sun, Eddy sold out his 10 cases but only netted about $80 because of giveaways to cute girls and friends and high-priced food and candy Eddy bought for himself. Another friend of ours pointed out to Eddy that he could have made at least that much money working as a waiter or bartender in only about 5 hours of work one night. Ouch, that was the last time I saw Eddy lugging that cooler around the Chicago beaches.
Several years ago I lived in Manhattan. While living there, my wife and I had noticed that the clothing trends we spotted on the subways in NYC often hit the rest of the country about 6-12 months later. We happened to mention this observation to Fast Eddy during one of his visits to the Big Apple. Of course Eddy started scheming -- if he could buy the stock of a designer when they were hot "in the subway" but before they had spread to the rest of the country, then he could really profit from any future stock increase. At the time, a brand of clothing, that we will refer to as Designer X, was all the rage in the subways. We had previously watched other designers' brands spread across the country from their fad beginnings in the subway and we all thought Designer X was next.
So Eddy was sure that Designer X's stock was a great buy. I tried to reason with Eddy, that not every trend in NYC caught on with the heartland. I also asked him how he was going to know when the fad was going to end and therefore time his sale of the stock. "Ahhh, pooh-pooh it if you like Tyler, but you will be sorry as you watch me double my money," countered Fast Eddy.
Now I have to admit, I was intrigued. Once again he made a logical case, but as with other Fast Eddy ideas, I knew there was a catch and I was highly interested in finding out what could go wrong this time.
Well Eddy did buy Designer X's stock and it did indeed go up. In fact within 9 months the stock had increased about 90% from his buy-in price. As you might expect, I heard from Eddy several times during that 9 month period with good natured ribbing about me missing out on his "gravy train". I accepted my bitter medicine each time, while also counseling Eddy that he should consider selling and pocketing his profits. "Nah, I am not ready to sell yet there is more upside in this one," responded Eddy.
Several months went by and I had completely forgotten about Designer X and I had not heard from Eddy until I saw him at a friend's wedding. When I saw him I expected another round of gloating but he was strangely silent on the topic. Later in the evening, I decided to bring up the topic to see if Eddy had ever pocketed his profits. "Aww man Tyler haven't you heard, the stock dropped about 50% a couple months ago because they had a bad quarter. I have been waiting for you to bring it up to me" Eddy said. I told him that I was sorry to hear that and that I had not heard about the stock drop.
Now at the time, Eddy still had about a 20% gain in the stock from his buy-in price and I asked him if had sold, or was he going to, to lock in a gain? "No" he responded "management said that the down quarter was due to some inventory rebalancing and that the problems were temporary. I expect it to bounce back soon."
As you have probably surmised, the stock continued to drop another 70% before Eddy finally sold for a big loss. As it turns out, "inventory rebalancing" was just management-speak for "nobody is buying our product and we have far too much inventory". In the future, if you ever hear a management team use "inventory rebalancing" to explain poor results -- that is usually a cue to turn and run as fast as you can in the other direction.
So, I told you that story to explain why, despite forking over $25 for our household's 5th set of Croc's, I have no interest in buying the stock. I also do not have interest in Heelys (NASDAQ:HLYS) - shoes with wheels in the heels - or any other fad-related stock. Crocs stock is doing well and its future PE ratio, 24x, does not look extreme based upon analysts 2008 estimates. However, eventually consumers are going to "move on" to a new footwear trend, just as they previously abandoned other footwear fads like Docksiders (really dating myself there), Timberland Boots and Teva sandals, and that little fact is not factored into the analysts future earnings estimates. In fact, I am fairly certain that the "cool kids" no longer wear Croc's because everybody else also wears them now. That is the beginning of the end for any fad.
When the "inventory rebalancing" occurs in clothing fads, the downside is swift and powerful. There is no time to nimbly get out of the stock with minimal damage. So, while I do subscribe to Peter Lynch's legendary investment advice, "invest in what you know", I ignore the fad stocks even when I am a follower of the fad.
Note: Except for the actual brands mentioned in this article, the characters, products and events in this article are fictional and were used merely to illustrate my own investment opinion regarding fad-related stocks. Fast Eddy, in particular, is a fictional character loosely based upon investment mistakes that I or others I know have made in the past. I use Fast Eddy to illustrate important tenets in my overall investment strategy.