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Greenberg: When to Ignore the Shorts

For years Green Mountain Coffee has been every short-seller’s nightmare – a classic example of a stock that for years steamrolls every skeptic in its path.

AP

No doubt the shorts were stunned yesterday, as the stock posted an astonishing one-day gain of 40%, after the company struck a strategic partnership with Starbucks.

It’s foolhardy to ignore warnings of short-sellers; good investors use each nugget to double-up on their own research — just in case! As was the case with for-profit schools, subprime lenders and much of the financial system, not to mention the likes of Enron, Worldcom, Sunbeam and Tyco, they’re often the best early warning system of possible trouble. That’s something which gets lost in the translation of momentum-driven hysteria.

But there are times to put the short story on "ignore." With the caveat that there are exceptions to every rule, among the short arguments that get me least excited:

1. It’s just a fad. Sometimes it is blindsiding the true believers. The trick is figuring out when a fad turns into something disruptive, whether it’s premium-priced coffee (Starbucks), single-serve coffee (Green Mountain), the concept of renting DVDs by mail (Netflix ) or a new type of data warehouse appliance (Netezza, recently bought by IBM ).

2. There’s something wrong with the accounting. Maybe there is, but worrying about accounting is so 1990s. Even after accounting issues are discovered, the resulting restatement — no matter how big — is usually spun away as something in the past, not in the future.

3. There’s an SEC investigation. SEC investigations, from a stock perspective, stopped meaning something years ago. (Sad but true.) Even when a company is found having engaged in wrongdoing, the result is usually a slap-on-the-wrist. Big yawn, if you ask me.

4. Class action lawsuits – or any lawsuit. Anybody can file a lawsuit and make any kind of outrageous claims. People even lie in sworn depositions. An exception is when a class action lawsuit has been amended, with allegations by multiple former employees, as has been the case with Green Mountain. Even those, however, are usually meaningless because those suits tend to be settled out of court.

5. Who would do a deal with them? Famous last words — and always the killer to any short story. With Green Mountain, the general feeling among analysts with close ties to Starbucks was that Starbucks would never acquire or align itself with Green Mountain. Starbucks even issued a well-leaked memo two weeks ago suggesting that it would go single-serve alone. (For the memo click here ). As it turns out, the memo, which referred to Green Mountain, was likely a negotiating tactic with the kind of words the company would never put in a press release. From the Starbucks perspective, the deal is brilliant. As Starbucks CEO Howard Schultz told CNBC’s Maria Bartiromo yesterday: Starbucks gets broad distribution without having to put up any cash.

6. The established competition will crush them. Well, Starbucks didn’t crush Green Mountain with its single-serve through Kraft and Tassimo. And neither Coca-Cola nor Pepsi crushed Hansen Natural , the energy drink maker.

7. The valuation is crazy. Indeed — and it can get crazier.

Again, there are exceptions, but what ultimately matters is slowing growth, growing competition (great example: GPS maker Garmin , the Green Mountain of its day) and an addiction to aggressive accounting in hopes from getting from here to there (eventually it does catch up — but it can take years.) Ditto for strategic deals where one side gets the best economics.

The tell-tale signs will still always first show up on the balance sheet and in the cash flow statements, not that the market will care.

Even fads that become disruptive have a dark side: That period when consumers are finally all-in on their original purchases, at which point new purchases don’t drive supercharged growth. Think Crox , The LeapPad from Leapfrog and the George Foreman Grill , which led to the demise of Salton's run as a public company. There are those who believe that may very well be the eventual fate of Green Mountain, as well, the timing of which would depend on the economics of the Starbucks deal.

My bottom line: Investors should always be on the lookout for fads, fakes and frauds. There are plenty. (Seen some of those Chinese reverse mergers lately?) And some businesses are just, well, bad, with second rate concepts poorly executed by third-rate executives. But business models that power through win all. Always have, always will — warts and all. (Until, of course, they don’t.)

Questions? Comments? Write to HerbOnTheStreet@cnbc.com

Follow Herb on Twitter: @herbgreenberg

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