BOSTON (TheStreet) -- Legendary investor Peter Lynch's basic investment principle was to "invest in what you know," and that philosophy has paid off richly for consumers of products made by so-called fad companies like Crocs (CROX) and Krispy Kreme Doughnuts (KKD).
Stocks like Crocs and Krispy Kreme soared several years ago, as the companies produced extremely popular items. In the case of Krispy Kreme, it was warm glazed doughnuts fresh off the production line. For Crocs, it was colorful clogs made of foam resin touted for their ergonomic benefits.
Much like Beanie Babies, the Atkins Diet and, more recently, Silly Bandz, the initial craze eventually dies down. Stocks that skyrocketed on big revenue growth expectations experienced sharp declines in share prices as the froth petered out.
Some stocks, like fitness products maker Nautilus (NLS), have yet to recover. Some critics argue that companies like Skechers USA (SKX) or even Netflix (NFLX) could be experiencing the beginning of the fad-stock decline.For a handful of companies left for dead after the public lost interest in their products, 2010 was a winning year. Several fad stocks, like Crocs and Krispy Kreme, handily beat the S&P 500 and even the Russell 2000 index, which measures small-cap companies. However, these share-price rebounds were not accompanied by a renewed craze for the companies' products. The reason for the rebound rally in these fad stocks is simple: Wall Street hated these stocks so much, they became an incredible value for investors. "These faddy stocks become such a joke in the market," says Craig Hodges, portfolio manager of the Hodges Fund. Hodges is based in Dallas and his firm has about $900 million in assets. "They eventually become so oversold and hated that they become good buys. In most cases, the fad won't come back. But there can be enough of an underlying business there to make the company work." Hodges, along with other money managers, has reaped the benefit of comeback stories like Crocs. Of course, the diligence needed to follow these beaten-up stocks is a heavy burden. "I don't like to watch the fad stocks because you can spend a lot of time doing that and not get anywhere," says Brent Wilsey, president of San Diego-based Wilsey Asset Management. "You can like the product as a consumer, but it doesn't always mean it's going to be a great investment. But you can actually do pretty well by looking at the fundamentals." Michael Corbett, manager of the Perritt Emerging Opportunities Fund, notes that looking at fundamentals provides a greater challenge than the individual investor may believe it to be. Corbett's fund looks for deep value plays but it also looks for growth stories at a reasonable price. Overall, the firm has roughly $600 million in assets under management spread across this fund and another microcap fund. "You have to check under the hood and dig deeper to see if management is really bad and will burn the rest of the cash of the company," Corbett says. "That's the most difficult part of the process. And you have to do it in a diversified fashion." Thankfully, individual investors have several ways to help determine if a fallen angel fad stock is poised for a rebound. First, several mutual funds offer investors the ability to find deep value plays with active management, leaving the work up to the fund manager. For those looking to do the diligence themselves, it pays to look for cash-generating companies with little or no debt. "The story for the group is net cash and no debt," says Michael Benoit, equity analyst at Chicago-based Talon Asset Management. "There's not a lot of operating risk, in terms of the company becoming distressed. The downside is limited because you have some type of asset value protection. People view a lot of operating leverage in their earnings." On the flip side, Brent Wilsey says there are several red flags investors can look for to help them determine with companies to avoid, such as negative cash flow and negative equity. Wilsey advises investors to examine the actual product, too. "Look at Polaroid Camera. It was a great thing for a while but the technology was replaced. You want to make sure you're buying something that is low priced but also that they product won't be obsolete." The following pages contain a look at 10 companies harshly branded as fads but that saw outsized gains in share price last year.
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