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Cult Stocks: How to Avoid a Bad Ending

This post appeared on RealMoney.

Cult stocks have been around in the financial market for as long as I can remember.

These stocks attract unusual fierce allegiance from owners and equally vehement opposition from short sellers. They usually have some popular new product or service that is typically described as being "game changing" or "revolutionary." The debate between buyers and sellers of these stocks is far more vocal and strident than the usual genteel Wall Street discussion of the merits of various investment opportunities.

And most of the time, like all cults, the end result is less than positive for the enthusiastic bulls of these stocks.

My introduction to the world of cult stocks literally came on the first day of my brokerage career at Dean Witter Reynolds, back in the 1980s.

Right before I started, the company had been the lead underwriter on a revolutionary new toy company — a hot stock that quickly developed a cult following. The fact that Dean Witter was the lead should have been a clue for most investors. There were a lot of things the old retail firm did well, but investment banking was not one of them.

The company in question was Worlds of Wonder, and the product, of course, was the talking teddy bear, Teddy Ruxpin. It was, indeed, a great product, but I have always suspected the bear knew more about manufacturing than the company did. The company eventually floated a junk bond that Dean Witter brokers eagerly pushed to starry-eyed clients. The company never made a single coupon payment and ended up bankrupt, taking all of the enthusiastic Teddy Ruxpin fans with it.

The Internet bubble in the late 1990s was one giant cult, in my opinion. Dot-anything could issue stock and triple in the first day of trading. I can remember arguing endlessly with the frenzied buyers of these companies about the merits of paying 40x or 50x sales for a company.

I got so tired of being told that I just did not understand the new paradigm and the true impact of the Internet revolution. I can remember almost coming to blows with another broker about the absolute idiocy of paying the current valuations for stocks like Netscape and America Online. The man was a deacon in his church, but was willing to engage in a fist fight to defend his revolutionary stocks. The last two years of the Internet boom were Kool Aid drinking of the finest financial kind, in my opinion.

When I shorted shares of Krispy Kreme earlier this decade, I was told repeatedly how much money I was going to lose. The company made the best donuts in the world, and the growth opportunities were virtually unlimited. I agree that Krispy Kreme makes some fine donuts, but there was nothing that made the company worth the multiples the market was assigning at $40-plus a share back then.

I was also short Starbucks at the time, and was considered to be the highest manner of idiot for shorting something as basic as coffee and donuts. I considered Starbucks to be cult-like in nature as well. The coffee is okay, but I can get a 24-ounce cup of joe at 7/11 for less than two bucks, so the economics never made sense to me. I ended up losing on Starbucks — but the donuts eventually collapsed.

We see cult stocks in every market all the time. The current market is no different than any other. Right now, the ultimate cult stock, in my opinion, is still Sirius XM.

We did a focus on this stock last year on RealMoney. None of those of us who wrote liked the stock. By the mail we all got, you would think we had insulted baseball, apple pie and motherhood. I get that some people think Howard Stern is funny. I understand the appeal of having a wide selection of music and that programming is attractive to some folks.

I also get that for many of us, the free radio works just fine for tooling around town in our car. I also get that the company is unprofitable and has a $3 billion debt load that requires large annual outlays for interest expense.

Green Mountain Coffee also strikes me as a cult stock. Although I have always thought the stock was overpriced, I was pretty excited last Christmas to get one of the Keurig one-shot coffee machines.

After a few months, I found myself at Target, buying a new Mr. Coffee.

The thing was just a pain to use when you drink a lot of coffee. When all the kids are here, there are four coffee drinkers in the house, and a cup at a time is just not practical. The coffee is expensive, and unless you are single and live alone, I don't think the machines make a lot of sense. Sixty times earnings for what is basically a coffee fad has very little margin of safety, in my opinion.

The real problem with cult stocks is that the investors who get caught up in the hoopla do not take the time to do the work. Who cares what the balance sheet looks like or how much stock the insiders are selling? The bear can TALK! The P/E ratio does not matter, the donuts are hot out of the oven! Howard Stern is funny and everyone wants to pay to hear him talk dirty, on their way to work. It is a new paradigm and valuations do not matter for such world-changing companies.

(Paradigm, by the way, is another word for stop-loss for me. If I ever hear the word associated with a stock I own, I sell it.)

The way to avoid cult stocks and the inevitable bad ending is to always do the work. Investing, as Ben Graham pointed out, works best when most business-like. Avoid the hype and the promotion, and focus on the value of the business, and you will never find yourself with a glass of Kool Aid in one hand and worthless stock certificate in the other.

Tim Melvin is a contributor to RealMoney.

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