Published: September 28, 2009

I'm not sure who coined the phrase "Romance Stock." It might have been my father; it might have been someone earlier. In any event, it's a phrase we've long found useful at Cabot, because it provides a model that helps us understand how stocks behave.

To understand the model, you've first got to understand that what makes stocks move isn't revenues or earnings or anything you can measure. It's simply the change in investors' perception of the future.

If investors as a whole are revising their opinion of a company's prospects upward, then the stock will tend to rise. As the stock gets better known, and more investors climb on board, it climbs higher. And if it's got an especially attractive story that people can relate to, we sometimes accord it Romance Stock status, acknowledging that "special forces" might take the stock to unusual heights.

But there's a downside to every Romance Stock. When the dreams of investors fail to be perfectly realized (no story ever develops perfectly), the Romance Phase ends and the stock enters into a Transition Phase. And the problem is that even if the company is still growing, the Transition Phase will typically see a stock fall a long way from its high before it gets down to a "rational" level.

The shorthand for this is, "A stock, like love, thrives on romance and dies on statistics."

So, if you want to make big money by investing in growth stocks, you've got to seek out companies that have the potential for major growth, and have the potential for a lot of investors to fall in love with them.

But you shouldn't fall in love with them! Because once the romance ends, the Transition Phase kicks in, and this can be very painful, because it, too, typically goes farther than expected. Generally, by the end of a Transition Phase a stock is actually a great value and bargain hunters start climbing on board, aware of the company's solid fundamentals. And if the company can manage to consistently grow its earnings from there, the stock enters into the Reality Phase, when it advances at a pace more or less justified by the reality of its sales and earnings results. Reality is okay, but Romance is more fun... and can be much more profitable.

So next I'm going to give you a few examples of Romance Stocks that Cabot has succeeded with in recent years. And then I'm going to finish with a couple of recommendations of current-day Romance Stocks.

But first let me say this. The best Romance Stocks tend to be stocks that individual investors can identify with. Being human, we get emotionally attached to products and services that make our lives better, and we can more easily envision these companies achieving greatness.

Crocs (Nasdaq: CROX) was a great Romance Stock in 2006 and 2007, as it revolutionized the footwear industry with inexpensive yet comfortable shoes. They were a true mass-market phenomenon; in fact, I'm wearing a pair of Crocs now. In 2005, revenues were $109 million, in 2006 they hit $355 million and in 2007 they topped $847 million. It was "obvious" to the stock's supporters that the company would soon be raking in billions of dollars by selling all over the world! As a result of their buying, from March 2006 until October 2007 (the market top), the stock gained +650%. But in 2008, thanks to the recession and competition, sales dried up; revenues were just $722 million. Even worse, management couldn't cut costs fast enough; the firm lost $2.02 per share in 2008. And as the romance soured, investors fled. At the bottom, the stock had lost 99% of its value. The moves up and down were particularly amplified by the bull and bear markets of the time.

Another big Romance Stock was Hansen Natural (Nasdaq: HANS), which soared +580% from early 2004 until mid-2006. The maker of energy drinks (some people claimed it would be the next Coca-Cola) had revenues of $110 million in 2003, $180 million in 2004 and $349 million in 2005. And 2006 started out well, with growth of +100% in the first quarter... but then the growth started to slow. By the fourth quarter, growth was just +54% and investors were looking for more energetic companies. The stock didn't crash like CROX; from top to bottom, it lost "just" 70% of its value. The company is still growing. But growth in the latest quarter was an anemic +6%. And the stock is no higher now than it was three years ago.

My final example is First Solar (Nasdaq: FSLR), which was the leader of the red-hot solar power sector in 2007. Revenues were $48 million in 2005, $135 million in 2006 and $504 million in 2007. From its IPO in November 2006 to its top in mid-2007, the stock soared +1,485%. But when the last buyer had bought (pushing the P/E ratio up to 500), and when growth began to slow -- just a little -- the romance faded. In the bear market, the stock lost 73% of its value. First Solar is still growing fast; in the last quarter, revenues grew +97% while earnings surged +148%! And profit margins were the best yet, at 34.3%. But there are a lot of jilted lovers of solar power stocks out there and they hold a grudge. The stock today is no higher than it was in October 2007.

And now today. We have a bull market, which provides a great environment for cultivating Romance Stocks. And we have two nominees for that distinction. Neither is a perfect fit yet, but they have the potential, just as they have the potential to earn early and patient investors major profits.

The first (alphabetically) is Baidu (Nasdaq: BIDU), popularly known as "the Google of China" because it's copied Google's business model and applied it for Chinese-speaking Internet users. The notable facts are that Chinese Internet users now outnumber Internet users in the U.S. (outnumber U.S. citizens, in fact!), even though Internet access per capita is still far lower in China. So Baidu can get much bigger than Google. And it's on the way: In 2006, revenues were $106 million, in 2007 they were $233 million and in 2008 they were $465 million! And Baidu is a relative bargain; while Google's market capitalization is $120 billion, Baidu's is just $10 billion.

Cabot Market Letter editor Michael Cintolo added Baidu to his portfolio back on July 16, when it was trading at $320. Last week, in an update to subscribers, he wrote, "Baidu is acting handsomely, having bolted from $320 to $400 on a line, and now the stock is pausing quietly at that $400 level, a bullish sign. In every bull market, there are usually a handful of well-traded leading stocks that institutions gobble up week after week, and BIDU looks like one of those. We think China's online advertising rebound will surprise on the upside, and, as the hands-down leader in that country's paid-search industry (it has about three times the market share of Google), Baidu will benefit. The stock is extended to the upside, but we're not expecting a huge retreat. If you don't own any, you can buy a little here or on minor weakness -- there should be good support in the $380-$390 area."

My second nominee for Romance Stock is Green Mountain Coffee Roasters (Nasdaq: GMCR). Coffee is a mass-market product, obviously. But Green Mountain's added attraction is the Keurig coffee brewer, which makes a perfect cup of coffee from individual disposable K-cups for less than fifty cents. In 2007, revenues were $342 million, in 2008 $500 million, and in 2009 they may top $900 million. We expect to see a lot of Keurig brewers bought as holiday gifts. Since the market bottom in March, GMCR is up +330%, but we think it has farther to run.

But remember, no matter what I say, and no matter how well these stocks perform, you should never allow yourself to fall in love with them.

-- Timothy Lutts
Editor
Cabot Wealth Advisory