By Timothy Lutts, Cabot Chief investment Strategist and Editor of Cabot Stock of the Month Report
From Cabot Wealth Advisory 3/31/08  Sign up for free Cabot Wealth Advisory e-newsletter

Last year one of the market's biggest winners was Crocs (CROX), the maker of funny-looking but comfortable shoes made of a thermoplastic resin. Most people just call them plastic. Many people still ridicule them.

But we made a lot of money in the stock, and therein lies an excellent opportunity for a lesson in Romance, Transition and Reality. If you're a long-time reader, consider this a refresher course in the concept. If this is your first exposure to these three terms, I promise it won't be your last.

CROX's first appearance in a Cabot newsletter was October 2, 2006, when it appeared in Cabot Top Ten Report, earning that spot solely on the basis of its momentum.

Here's what editor Michael Cintolo wrote.

"Specialty retail stocks often provide fertile ground for finding market leaders; Deckers was a big winner in recent years, and Coach was a true leader in 2003 and 2004. Now we see Crocs, a company that just came public in February, selling thousands of pairs of its proprietary, patented footwear...The company's growth is the stuff dreams are made of, and by effectively creating a whole new category of footwear, we believe Crocs has big, big potential."

Mike liked it so much, in fact, that he made it Cabot Top Ten Report Editor's Choice. And a week later, we added it to the Model Portfolio of Cabot Market Letter! (Our buying price was about 16, adjusted for a later 2-for-1 split.) We had no idea at the time it would turn into a major winner for us...but we knew it had the right stuff.

At the time, Crocs revenues were growing at a 232% rate, while earnings were growing at 280%.  We love triple-digit growth rates!
Furthermore, profit margins in recent quarters had grown from 12.4% to 14.4% to 18.3%. We love fat and expanding profit margins!
Equally important, but less well appreciated by most investors was the matter of perception. Remember, it's not the growing sales and earnings that make a stock go up; it's the improving perception of a company in the minds of investors.

In the case of Crocs, we noted that because the shoes were so "ugly" and the product category so new and unproven, there was a lot of skepticism about the stock. Yet the shoes were obviously satisfying a need for cheap, comfortable footwear. We reasoned that as more and people bought the shoes, investors would slowly shift their attitude from scorn to mild skepticism to acceptance and then, finally, to love.
We wrote, "Fact is, most revolutionary developments are misunderstood-even laughed at-before they're embraced. And Crocs are now being embraced rapidly!"

Well, in the months after our buy recommendations, the stock soared! It certainly helped that we were in a healthy bull market. But what helped more was the improving perception of the stock by investors, who learned to appreciate the rapid growth numbers being posted by the funny-looking shoe company.

In short, CROX became a market darling. Investors fell in love with the stock, in part because it was going up, and in part because they came to believe that the company was capable of rapid growth over the long term.

That was the Romance Phase of the stock's life cycle...and it was fun while it lasted.

In the end, we held the stock for a little more than a year. At its peak, on the day before earnings were released in November 2007, it traded as high as 75.

And then the "bad news" hit. Revenues were up 130% and earnings were up 144%, but that wasn't good enough. Furthermore, there was a troubling buildup of inventory. Management attempted to explain it away, referring to the transition to new styles, but Wall Street would hear none of it.

The next day, the stock plunged 36%, on 10 times normal volume. We issued a sell signal, saying, "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."

And we walked away with a profit of 194%.

Now, I bring this up today because I recently read a glowing fundamental recommendation for CROX. The author was claiming that CROX is now a good growth stock selling at a value price. So I took a look at it, and here's what I saw.

Pricewise, the stock is now selling at 17, a hair above its low of two weeks ago. It's now more than 60% below our sell point of last November.
And fundamentally? In the fourth quarter, revenues grew 99%. That's good, but there's a steady trend of deceleration. Earnings per share grew just 73%, reflecting the firm's now-shrinking profit margins, down from 22.1% to 17.0%. And the stock's price/earnings ratio today is just 9...which might well be a bargain price.

Trouble is, there's no way of knowing if the stock's downtrend is done, because since November this stock has been in the Transition Phase. Remember: Romance, Transition and Reality.

Most of the red-hot lovers who romanced CROX on the way up have left the stock, and it's their selling pressures, driven by reduced perceptions, that have been pushing the stock down. (The bear market hasn't helped, either.) Every time a diehard who had sworn to hold the stock forever gives up in disgust, the stock is pushed a little lower.

It's not the company's fault. If stocks truly traded rationally, based on earnings, this stock would have been nowhere near as high as 75 last November, and it would be higher now than it was then.

But stock prices are determined by people. People who fall in and out of love. People who buy with visions of profits and sell in disgust when their dreams are dashed. People who drive stocks to irrational heights and sell them to irrational depths. That's what makes investing a challenge...and very profitable, if you know what you're doing.

Eventually, CROX will bottom, the Transition Phase will be over, and the Reality Phase will kick in, and that's when analysis of the stock should become a little easier for investors who base their decisions on fundamentals. If the company's sales and earnings are growing, as I expect them to, the stock will rise, too. But it will do it in a far more rational manner, reflecting the reality of the company's sales and earnings growth.

What you want to be doing, therefore, is hunting for the next CROX, the next stock on which to make your fortune. Ideally, it will have rapid growth of revenues and earnings, and fat profit margins. And, if you want a stock that gives you a very profitable Romance Phase ascent, it has to enchant a rapidly growing group of investors who can fall in love with it and bid its price up rapidly.

It might be Visa (V), which came public two weeks ago and could become a darling of institutional investors who hope it can duplicate the performance of MasterCard (MA).

It might be Gafisa (GFA), the Brazilian homebuilder that's expanding rapidly across the country, and which I and other editors have mentioned previously.

And it might be little Gushan Environmental (GU), recommended by Brendan Coffey, editor of Cabot Green Investor. Gushan is China's largest producer of biodiesel fuel and related products, and thus a key element of the country's plan to reduce air pollution while reducing reliance on fossil fuels. In short, Gushan has a great growth story, and because it's still little-known by U.S. investors, there's tremendous upside potential for a big Romance Phase uptrend.

More information on Cabot Market Letter
More information on Cabot Top Ten Report
Cabot Technical Analysis
General Investing Advice
Cabot Home
Sign up for free Cabot Wealth Advisory e-newsletter