Your teenage daughter suddenly wants to wear cowboy boots, even though you live in the city. Your son won't tie his shoes. The woman next store dyes her hair pink. And every now and then, a stock surges quickly higher and then disappoints investors who jumped on board for the ride up with an even more dramatic crash.

Fads come and go, and so to "fad stocks." To avoid getting stuck in one on the way back down, you need to understand what a fad stock is and the warning signs to watch out for.

History of Fad Stocks

Fad stocks are nothing new, and you might be familiar with some examples from the past. Many of the stocks still exist today, though likely not in their fad form. Here are a few from over the years:

Snapple: In the 1990s, this iced tea and noncarbonated beverage company was a hot commodity. Howard Stern and Wendy the Snapple Lady popularized the company that was "made from the best stuff on earth." The stock was hot, but management always thought it was worth more than the market was willing to pay for it. Investors agreed and bid up the stock with reckless abandon.

Eventually, in 1994, Quaker Oats, (which was subsequently purchased by Pepsico ( PEP)), paid $1.7 billion for Snapple. Just over two years later, Snapple was dumped to Triarc for $300 million. Now it is part of Dr Pepper Snapple ( DPS).

Heelys ( HLYS): This company, known for its roller sneakers, came public to great fanfare at the end of 2006 at $21 per share. It opened trading that day at $30.30, rose about another 20% in the subsequent few weeks in 2007 and then began a precipitous fall. The stock now sells for around $1.64. After earning 95 cents per share in 2007, the company will earn maybe a penny per share in 2008.

Crocs ( CROX): 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)) 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).
  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), 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.

At the time of publication, Rothbort was long Pepsi, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site TheFinanceProfessor.com.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.

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