5 Warning Signs Your Stock's a Fad

Crocs(CROX Quote): Crocs, which manufactures rubberized casual shoes, has a similar history to that of Heelys. The company launched its IPO at $21 in February 2006, opened for trading at $30, peaked in 2007 at more than $90 per share, split 2-for-1 and now sells for about $1.21 per share. Crocs lost 76 cents per share in 2008 and is expected to post losses in the next two years.

How to Identify Fad Stocks

There are several warning signs that should tip off investors when a stock is on track to fad status. Not every fad stock exhibits all five of these traits, and just because a stock does exhibit one of the five does not necessarily mean you should avoid it. As a general rule, if two or more of the following warning signs apply, it's probably safe to say the stock's a fad.

1. Narrow Business Models: Many of these companies have very limited product offerings. In some instances, they may only offer one product or model. Don't be fooled by flavor or color differentiation. The inability to diversify into multiple product lines will limit these companies' long-term survival. Heelys and Crocs are essentially one-product companies.
2. Momentum Volumes: A fad stock tends to trade in large volumes relative to its stock float. This will continue well beyond the IPO launch date. Often the stock will be flagged by momentum publications such as Investor's Business Daily. Furthermore, while short-sellers may correctly detect the fad status of a stock, often it happens too early to the game. As a result, early-stage fad stocks might be subject to massive short squeezes.
3. Product Replication: Many of these companies have products that can easily be replicated by the competition. For example, Arizona Iced Tea and Lipton's Brisk (owned by Unilever(UN Quote)) were able to launch competing products, capture market share and crowd out Snapple. Furthermore, cheap knockoffs can often be easily produced overseas, flood the domestic market and force these fad companies to cut prices thus compressing product margins.
4. Financial Deterioration: Initially these fad stocks are flush with cash from the proceeds of an IPO or early-stage sales. However, very quickly (usually after a year) sales and margins will decline. This will result in cash burn, or net erosion in the balance of cash and cash equivalents. Don't be fooled by a fad company's "strong" cash position, because that will eventually evaporate. If you want to see a current example of faddish cash burn, take a look at Skechers(SKX Quote).
5. Transitory Technology: Many fad stocks deliver whiz-bang technologies that are far superior to the existing technology, but these technologies are soon replaced by even better ones. America Online, now part of Time Warner(TWX Quote), was once one of the high-flying fad stocks of the dot-com era. It was the best and cheapest way to access the internet for consumers. Then along came the fiber-optic cable service providers, which made AOL obsolete.

Homework

• Try to identify current companies that exhibit at least two or three of the characteristics I outlined above.
• Follow an IPO from its launch through its early life as a public company. Try to detect if the company has the makings of a fad stock.