How does the old saying go? “The higher they fly, the farther they fall?” It’s cliché, but true, including in the equity market — the higher a stock flies, the more vulnerable it is to the inevitable pullback.
If you don’t believe it, just ask the folks who bought into a Crocs (NASDAQ:CROX) position at any point in time within the past 12 months. No matter where they stepped in, they’re now in the red thanks to Thursday’s 21% plunge.
That’s not even the most agonizing part about being a CROX shareholder, however. What’s so frustrating is that Crocs was quickly becoming an all-American turnaround story — and the news that torpedoed the stock wasn’t really all that bad. So what happened?
Nothing we haven’t seen a thousand times.
By all accounts, it shouldn’t be that big of a deal. Crocs — the maker of the funky, colorful foam clogs that were a smash hit in 2007 (then already passé by 2008) — began to find firm footing again in 2010. Since then, annual revenue has grown from 2009’s $645 million to 2010’s $789 million to 2011’s $1 billion. Analysts are expecting a top line of $1.14 billion for the current year. Better still, profits have started to expand again, too.
It’s a textbook example of a turnaround story, and given how so many consumers loved the product when the ultra-comfortable shoes were all the rage, it was easy to appreciate the investment opportunity when the company came around again. In fact, it might have been a little too easy for investors to reconnect.
There’s no technical name for it, but think of it as “conceptual investing”: the notion that a great product inherently means the company that makes it would be a great investment. Though they generally know better, investors tend to give these popular companies a lot of leeway, ignoring the fundamental numbers (if they even bother to look at the numbers). Rallies from these stocks begin to be self-fueling — shares are going higher simply because they’re going higher. The stock itself becomes the story, and eventually the bulk of the trading crowd starts to chase that momentum, creating even more momentum.
It’s a fun ride while it lasts, but there’s a problem with chasing these stories: Eventually, when the company fails to meet exceedingly high expectations, all that unmerited euphoria turns into disgust, and the stock gets crushed.
That’s what happened to Crocs.
Though income was up from 33 cents per share in Q3 2011 to 49 cents this year (a solid 49% improvement, and better than the estimated 43 cents), CROX shocked its investor base by announcing it was only planning to break even in the fourth quarter. The prior Q4 profit outlook had been 10 cents per share. Down the stock went.
Had nearly any other company reported the same earnings growth and outlook, it likely would have been digested without much fanfare. Crocs shareholders, however, weren’t planning on any level of disappointment … a dangerous mind-set most of the time.
An All-Too-Familiar Story
Were it just Crocs that turned “conceptual investors” into victims, it might not even be a point worth making. But it’s not just Crocs. We see this story time and time again from plenty of high-profile companies.
Take Netflix (NASDAQ:NFLX), for instance. Through the middle of 2011, when the movie rental company faced little competition and had access to cheap digital content, it was easy to turn a profit. That’s how the stock soared from $29 in 2008 to a peak price of $304.79 in July 2011. To be fair, the stock was merely reflecting the company’s success at the time, and investors were duly rewarded. It was largely a conceptual investment though, based mostly on the service’s premise rather than the company’s performance.
Sure enough, the company’s performance started to suffer — a lot — in 2011 as Netflix started to lose access to its library of movies and television shows against a backdrop of new competition. Die-hard shareholders didn’t see the writing on the wall, though. Convinced the premise of Netflix would be enough to pay the bills, they stuck with the stock, riding it all the way down for $304.79 to the current price of $61.51. That’s an 80% dip, and with last quarter’s net income rolling in much lower than the year-ago period earlier despite higher revenue, it’s not like there’s a light at the end of the tunnel, either.
Chipotle Mexican Grill (NYSE:CMG) is another example of a great product that doesn’t necessarily always make for a great investment.
Though most would agree its food is tastier and of higher quality than the fare at your average Taco Bell, that doesn’t change the fact that Chipotle failed to hit earnings estimates last quarter. Worse, its sales growth rate is slowing down, too. Once considered infallible, Chipotle Mexican Grill investors have now finally been forced to acknowledge what the numbers are saying — great food just isn’t enough anymore. That’s why the stock fell 15% last week, and is off by more than 40% since April.
Bottom line? Great companies usually make great products, but that doesn’t mean every great product is made by a great company. Investors should be looking at the whole picture, because eventually, the stock will reflect that value.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.