Forget the Cheese

I don’t want to give the impression of being on a soap box with all the lessons recently, but given the action by Crocs (CROX) on Friday, I just can’t resist. Ironically, I’m writing this on my balcony in Back Bay, Boston, on a sunny Sunday morning … wearing my Crocs flip-flops. No love allowed in the market!

I think the biggest challenge most investors (including myself) have with the market is respecting its message. That is, they ask “why” too much, always wanting to understand a stock’s movement. And if there isn’t reason for the movement, they figure the stock will “come back.”

Hey, that can sometimes work; there are always overreactions in the marketplace. But if you consistently ignore the market’s message, you’re going to get hurt.

We owned Crocs in the Model Portfolio in our Cabot Market Letter from October 2006 through November 1, 2007. We made well over 100% in the stock, but when we sold it, the stock had just gapped down a massive 36% on earnings. Yet the earnings report was better than expected, and analysts were actually upping their estimates -people thought the firm would earn north of $2.60 in 2008.

Well, I know a thing or two about how the market works, and one of my rules is that if a stock suffers a very sharp break on earnings, I sell. Period. End of story. Such massive breakdowns are telling you perception is changing for the worse … and in a hurry. In fact, the bigger the gap down, the more I want out the door.

Yet most investors thought it was an overreaction; after all, earnings beat expectations, the outlook was rosy and growth was still in the triple-digits. Plus, after the drop, the stock was selling at a forward P/E ratio of 17, which is very reasonable for a fast-growing company.

CROX continued to slip significantly, however, plunging from 45 after its big earnings drop, to below 10 in recent months. (Its all-time peak was 75–see weekly chart below.) But even as late as this week, analysts thought the firm was on track to earn $1.52 per share for the year … making the stock seem like a ridiculous bargain, with a P/E of about 6! The market had set its trap well.

On Thursday evening, the company’s management said that earnings for the second quarter would be near break even, instead of the expected $0.41 a share. And that went for all of 2008, too–little or no earnings, as sales slacken and costs rise. All those “cheap” arguments went up in smoke in a minute. CROX ‘s reaction: It fell 45% (!) on Friday. The action of the stock itself for the past many months was telling you something was seriously amiss … even though analysts weren’t.

There’s a story of an old market player who had some strict sell rules. When a stock started going against him in a big way, he was famous for saying “Forget the cheese, let me out of the trap!” Yet too many investors willingly walk into such traps by refusing to respect the market’s message.

The lessons here: Pay attention to the action of the market and your stocks. Buy only strongly uptrending stocks during bull markets. And remember to limit losses (to forget the cheese) with all your growth stocks, no matter how much you like a product or company. For me, I like my Crocs flip-flops … but love the fact we sold the stock many moons ago.