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. Baidu.com (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.