Story Stocks or Fairy Tales?

Some companies' growth potential causes investors to go weak in the knees. Herewith, some signs of a hot prospect that's headed for an unhappy ending

Everybody loves a good story, especially investors. Nothing sparks the investor's imagination more than a great investment idea poised to rake in huge profits.

All sorts of companies have a tale to tell, but stocks that truly capture investor enthusiasm—commonly known as "story stocks"—often share some key criteria. They're small companies with a short track record but a great product or idea. The product may be so compelling to a large market that it's easy to imagine the company growing very quickly.

The true test of a story stock? Its stock chart, which shows the appeal of its story as investors bid its stock price ever higher. But the enthusiasm is often short-lived. An examination of such story stocks' long-term record reveals a decidedly mixed record.

The Peaks and Valleys of Volatility

For every success story like Google's (GOOG), there's a dud like Krispy Kreme (KKD), a onetime highflier that has sunk to a fraction of its former market cap. Many more turn in merely mediocre results.

Look at a story stock's price on a chart, and it often looks like a mountain range. The small firm hums along at a cheap price and then, boom, it gets discovered. Investors fall in love with its compelling growth story, and its stock doubles and triples in price. Then volatility follows as the stock hits peaks on more good news and valleys as investors take profits. At some point, enthusiasm wanes and the stock descends again.

There's often a good reason for story stock's initial jump in price, says Bryant Evans, portfolio manager at Cozad Asset Management. Perhaps an earnings report suggests "it's starting to look like what the company promised us is coming to fruition," Evans says.

A Timely Story

In the case of some story stocks, investors fall in love with a particular theme that's starting to show real results. In the last year, China stocks have boomed as investors bet on ever-higher profits from ever-wealthier Chinese consumers. (BIDU), often called the Chinese Google, and New Oriental Education & Technology Group (EDU), which has benefited from the boom in English education in China, are two examples.

Environmental stocks are also popular story stocks lately. Stocks that tell the story of solar power, such as First Solar (FSLR), have boomed.

The key question for investors, according to experts: When does the story get ahead of reality? As a stock price rises, it raises future expectations for the stock. Very often expectations become so high that only a true standout—think: Microsoft (MSFT) in the early 1990s—can meet them.

The Lesson of Crocs

What separates the stories with a happy ending? Look for companies with a "sustainable competitive advantage," says J. Bary Morgan of Baird Investment Management. Any company with a profitable product will inevitably draw competitors and copycats. Crocs (CROX), a story stock that has faltered lately, has tried to maintain its advantage by suing rivals who try to duplicate the technology behind its comfortable shoes.

Also, beware of fads, experts say, though that's easier said than done. In the midst of the excitement over a new product, it's difficult to tell a fad from something more lasting. Crocs would like to be a long-term player in the shoe business, but some doubt its staying power. "You don't know when they're going to go out of style," Morgan says.

Many thought Krispy Kreme's tasty donuts would stand the test of time, but the market was soon oversaturated. A more recent story stock, Under Armour (UA), now struggles to challenge established makers of athletic gear such as Nike (NKE).

Don't Get Too Wrapped Up in the Chart

Investors often look at a story stock's chart and see dollar signs. If only you'd bought $10,000 of Microsoft stock at the end of 1990, you'd have owned almost $600,000 worth nine years later. But even Microsoft hit a wall in the early 2000s. "People get way too wrapped up in…a chart's past," says Cozad's Evans. "That's pretty irrelevant to what will happen in the future. What really matters is the health of the company."

A company's stock price, like its earnings or revenue, won't keep rising at the same rate forever. There's a point of diminishing returns, when even the best-run, best-positioned company becomes too large to sustain double-digit growth rates.

When is a stock price so high that it's gotten ahead of fundamentals? Many investors focus on the stock's price-earnings ratio, but Morgan advises against using just one valuation measure. Use p-e along with other ratios and measures of financial position such as strong cash flow and low debt, he says.

How to Tell When the End Is Near

When the market's sentiment switches, it can happen rapidly. A company can still be growing quickly, but the pace may no longer be quick enough to satisfy investors. Crocs shares fell 34% on Nov. 1 despite reporting earnings that had more than doubled in a year.

For most investors, determining when a stock has peaked will be nearly impossible. You'll probably need some special insight into a trend or industry to tell when the end is near.

Even if you have that expertise, be wary. Story stocks seem specially designed to cloud your judgment: Like a good novel, a stock with a compelling premise can sweep you into an imaginary world where vast riches can be achieved in the final pages. Many investors, and even many independent analysts, get emotionally attached to these issues at their peril. And all too often, an unhappy ending is the result.

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