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.
Heelys ( HLYS) Company Profile: Heelys is a designer of action sports-inspired products under the Heelys brand targeted to the youth market. Notably, the company's shoes, which feature a wheel in the heel, became extremely popular and were even banned from some schools. Current Share Price: $3.04 (Jan. 6) 2010 Share Price Gain: 40% Comeback Story: Heelys debuted on the Nasdaq in 2006 after an initial public offering and, at the height of the shoes' popularity in 2007, the stock flirted with $40. But by August 2007, Heelys noted that it was "experiencing challenges at retail related primarily to an over-inventoried position of product at many of the company's domestic accounts." By the end of 2007, the stock traded for $6. In 2008, Skechers offered to acquire Heelys for $143 million, or $5.25 a share. By the beginning of 2009, Heelys fell to nearly $1 and the CEO resigned. Heelys announced the hiring of a new CEO in July 2009 and later settled litigations in connection with its IPO. Wilsey says that Heelys does make some sense as an investment. "The debt-to-equity ratio is zero. This company is just loaded with cash. It can't go bankrupt because it has a good balance sheet. It won't be a big boom company, but it's a good business that can actually make money. If they can just increase their sales just a little bit, whether they sell overseas or in emerging markets, this makes some sense." Michael Corbett, manager of the Perritt Emerging Opportunities Fund, which owns shares of Heelys, says he's not sure what the long-term success of the company will be. "We got hold of a big block of stock below basically net-net. It came available from a shareholder who just needed out, so we picked it up significantly below book value. Fundamentally, I'm not really sure longer-term what will happen with the company, but management as outlined some interesting things to us from the standpoint of trying to get back to basics and turn this thing around. But there was really no downside."
Fossil ( FOSL) Company Profile: Fossil designs and sells consumer fashion accessories, including popular lines of watches, belts and handbags. Current Share Price: $72 (Jan. 6) 2010 Share Price Gain: 108% Comeback Story: Fossil shares could be bought in 1993 shortly after the company's IPO for roughly $2 on a split-adjusted basis. The stock rallied to $30 in 2004, but the company was hurt by soft sales and margins heading into 2006. At the time, Fossil's CFO said the company would be forced to hold itself to "more modest sales growth expectations and focus on reducing our expenses accordingly" until it could generate a catalyst to reinvigorate watch sales. By early 2009, shares of Fossil could be bought for less than $12. "This was very much a fad for a while with the watch business," says Hodges. "They restructured and moved into the retail store business. Fossil, of course, has continued with the watch business but I wouldn't consider it a fad now. It's a staple now." Hodges offers the example where Fossil recreated the diamond-crusted white watch Sandra Bullock wore in the popular movie The Blind Side. "They do a lot of that stuff where they hit areas that are popular. Fossil has been the exception in that they've transformed the business and they're fantastic at what they do. They're great marketers."
Krispy Kreme Doughnuts ( KKD) Company Profile: Krispy Kreme Doughnuts, as the name implies, sells doughnuts and related items through company-owned stores. Current Share Price: $7.04 (Jan. 6) 2010 Share Price Gain: 134% Comeback Story: In April 2000, Krispy Kreme went public, touting increased profits due to the popularity of its glazed doughnuts with consumers. The rapid expansion carried the company for a few years until the stock collapsed in 2004, falling from $40 to $12. In 2005, CEO Scott Livengood was removed from the job after the Securities and Exchange Commission probed Krispy Kreme for alleged improper accounting. Livengood denied these claims, instead attributing the company's decline in profits to another fad: the low-carb craze. However, Livengood was slapped with shareholder lawsuits following accusations that he and the company were involved in self-dealing. Shareholders alleged that Krispy Kreme paid a premium to acquire a franchise that Livengood's ex-wife partially owned. "There was a real faddish time with Krispy Kreme, and the company had to restructure to pay off lawsuits," says Hodges. whose Hodges Small Cap Fund holds a position in Krispy Kreme as of Sept. 30. "But they had a turnaround expert come in and re-establish the business. They closed unprofitable stores and returned to a more realistic base of what the doughnut business can make." "It's not hugely profitable, but now they're making money," Hodges adds. "Those doughnuts will never be the craze it was, but people are going to continue to eat doughnuts."
Jones Soda ( JSDA) Company Profile: Jones Soda produces and distributes a range of premium beverages and related products in the U.S. and Canada. Current Share Price: $1.23 (Jan. 6) 2010 Share Price Gain: 153% Comeback Story: Jones Soda initially gained popularity thanks to an offering of unusual flavors of soda, including blue bubble gum, red apple and crushed melon. The company boasted its strong distribution network, as its beverages were available in Wal-Mart ( WMT), Starbucks ( SBUX), Target ( TGT) and Safeway ( SWY). The popularity of Jones Soda pushed its stock to nearly $30 in early 2007, although an epic collapse dropped the share price to 30 cents by the end of 2008. Making matters worse, the company accepted a take-under deal from fellow beverage producer Reed's ( REED) in March 2010. The deal, which valued shares of Jones Soda at roughly 37 cents, was later scrapped, and a series of retail deals with Wal-Mart and Target helped the stock rebound modestly.
Crocs ( CROX) Company Profile: Crocs designs and markets consumer products, mainly casual & athletic shoes & shoe charms, from specialty resins referred to as Croslite. Current Share Price: $17.19 (Jan. 6) 2010 Share Price Gain: 186% Comeback Story: Crocs was poised to be the ultimate fashion fad of the 2000s, with the contempt for the footwear rivaling the evangelical following Crocs shoes garnered. After going public in 2006 for roughly $17, Crocs shares jumped to nearly $70 in October 2007 during the fever pitch of the shoes' popularity. However, the retail environment wasn't friendly enough to Crocs, forcing the company to slash revenue guidance. After issuing lower-than-expected revenue and profit expectations in October 2007, Crocs shares dropped 30% in one trading session. By early 2009, Crocs was a penny stock. However, shares have rallied back to a 52-week high of $19.54 thanks to analyst optimism. For example, Sterne Agee analysts in October said they anticipate Crocs' wholesale revenue will grow at a double-digit percentage pace for at least the next two years. "It's starting to make sense to go back into Crocs. They seem to have turned the corner from before," Wilsey says. "The debt to equity is only 0.9. The company has no debt and a lot in cash and short-term investments. It was an educated risk because the company isn't going into bankruptcy." Michael Corbett, manager of the Perritt Emerging Opportunities Fund, notes that Crocs had similar characteristics to Heelys. "It was so far below book value that you had to think 'Are they actually going to burn through all the cash and go bankrupt?' It's the opposite of greed. There was fear it was going under. Is the fad going to come back? Probably not. But it's not going to zero." Hodges says Crocs was doing $240 million in sales per quarter, totaling almost a $1 billion sales business, but the backlash against the product proved to be too great for a time. "There was a backlash to the popularity and Crocs became a punch line," Hodges says. "I think I saw a skit on Saturday Night Live about Crocs. It went from one side to the other over the period of a year. But we realized that while they may not sell $1 billion of shoes every year, the underlying business has international opportunities and a bunch of new products."