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Finding the Next Great Growth Stock

Last year one of the market’s biggest winners was Crocs (CROX). Most people just call them plastic, but we made a lot of money in the stock, and therein lies an excellent opportunity for a lesson in Romance, Transition and Reality.

Last year one of the market’s biggest winners was Crocs (CROX), the maker of funny-looking but comfortable shoes made of a thermoplastic resin. Most people just call them plastic. Many people still ridicule them.

But we made a lot of money in the stock, and therein lies an excellent opportunity for a lesson in Romance, Transition and Reality. If you’re a long-time reader, consider this a refresher course in the concept. If this is your first exposure to these three terms, I promise it won’t be your last.

CROX’s first appearance in a Cabot newsletter was October 2, 2006, when it appeared in Cabot Top Ten Report, earning that spot solely on the basis of its momentum.

Here’s what editor Michael Cintolo wrote.

“Specialty retail stocks often provide fertile ground for finding market leaders; Deckers was a big winner in recent years, and Coach was a true leader in 2003 and 2004. Now we see Crocs, a company that just came public in February, selling thousands of pairs of its proprietary, patented footwear ... The company’s growth is the stuff dreams are made of, and by effectively creating a whole new category of footwear, we believe Crocs has big, big potential.”

Mike liked it so much, in fact, that he made it Editor’s Choice. And a week later, we added it to the Model Portfolio of Cabot Market Letter! (Our buying price was about 16, adjusted for a later 2-for-1 split.) We had no idea at the time it would turn into a major winner for us ... but we knew it had the right stuff.

At the time, revenues were growing at a 232% rate, while earnings were growing at 280%. We love triple-digit growth rates!

Furthermore, profit margins in recent quarters had grown from 12.4% to 14.4% to 18.3%. We love fat and expanding profit margins!

Perception: Romance Phase

Equally important, but less well appreciated by most investors was the matter of perception. Remember, it’s not the growing sales and earnings that make a stock go up; it’s the improving perception of a company in the minds of investors.

In the case of Crocs, we noted that because the shoes were so “ugly” and the product category so new and unproven, there was a lot of skepticism about the stock. Yet the shoes were obviously satisfying a need for cheap, comfortable footwear. We reasoned that as more and people bought the shoes, investors would slowly shift their attitude from scorn to mild skepticism to acceptance and then, finally, to love.

We wrote, “Fact is, most revolutionary developments are misunderstood-even laughed at-before they’re embraced. And Crocs are now being embraced rapidly!”

Well, in the months after our buy recommendations, the stock soared! It certainly helped that we were in a healthy bull market. But what helped more was the improving perception of the stock by investors, who learned to appreciate the rapid growth numbers being posted by the funny-looking shoe company.

In short, CROX became a market darling. Investors fell in love with the stock, in part because it was going up, and in part because they came to believe that the company was capable of rapid growth over the long term.

That was the Romance Phase of the stock’s life cycle ... and it was fun while it lasted.

In the end, we held the stock for a little more than a year. At its peak, on the day before earnings were released in November 2007, it traded as high as 75.

Perception: Transition Phase

And then the “bad news” hit. Revenues were up 130% and earnings were up 144%, but that wasn’t good enough. Furthermore, there was a troubling buildup of inventory. Management attempted to explain it away, referring to the transition to new styles, but Wall Street would hear none of it. The next day, the stock plunged 36%, on 10 times normal volume. We issued a sell signal, saying, “The bottom line is that CROX is totally broken and it will take months (at least) before the stock is ready to make a serious sustained advance.”

And we walked away with a profit of 194%.

Now, I bring this up today because I recently read a glowing fundamental recommendation for CROX. The author was claiming that CROX is now a good growth stock selling at a value price. So I took a look at it, and here’s what I saw.

Pricewise, the stock is now selling at 17, a hair above its low of two weeks ago. It’s now more than 60% below our sell point of last November.

And fundamentally? In the fourth quarter, revenues grew 99%. That’s good, but there’s a steady trend of deceleration. Earnings per share grew just 73%, reflecting the firm’s now-shrinking profit margins, down from 22.1% to 17.0%. And the stock’s price/earnings ratio today is just 9 ... which might well be a bargain price.

Trouble is, there’s no way of knowing if the stock’s downtrend is done, because since November this stock has been in the Transition Phase. Remember: Romance, Transition and Reality

Reality Phase Will Kick In

Most of the red-hot lovers who romanced CROX on the way up have left the stock, and it’s their selling pressures, driven by reduced perceptions, that have been pushing the stock down. (The bear market hasn’t helped, either.) Every time a diehard who had sworn to hold the stock forever gives up in disgust, the stock is pushed a little lower.

It’s not the company’s fault. If stocks truly traded rationally, based on earnings, this stock would have been nowhere near as high as 75 last November, and it would be higher now than it was then.

But stock prices are determined by people. People who fall in and out of love. People who buy with visions of profits and sell in disgust when their dreams are dashed. People who drive stocks to irrational heights and sell them to irrational depths. That’s what makes investing a challenge ... and very profitable, if you know what you’re doing.

Eventually, CROX will bottom, the Transition Phase will be over, and the Reality Phase will kick in, and that’s when analysis of the stock should become a little easier for investors who base their decisions on fundamentals. If the company’s sales and earnings are growing, as I expect them to, the stock will rise, too. But it will do it in a far more rational manner, reflecting the reality of the company’s sales and earnings growth.

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What you want to be doing, therefore, is hunting for the next CROX, the next stock on which to make your fortune.

Ideally, it will have rapid growth of revenues and earnings, and fat profit margins. And, if you want a stock that gives you a very profitable Romance Phase ascent, it has to enchant a rapidly growing group of investors who can fall in love with it and bid its price up rapidly.

It might be Visa (V), which came public two weeks ago and could become a darling of institutional investors who hope it can duplicate the performance of MasterCard (MA)

It might be Gafisa (GFA), the Brazilian homebuilder that’s expanding rapidly across the country, and which I and other editors have mentioned previously.

Gushan Environmental: Chinese Biodiesel

And it might be little Gushan Environmental (GU), China’s largest producer of biodiesel fuel and related products, and thus a key element of the country’s plan to reduce air pollution while reducing reliance on fossil fuels.

Gushan was recommended recently in Cabot Green Investor and here’s what editor Brendan Coffey had to say.

“Biodiesel is derived from natural oils by a chemical process that splits the oil (usually soybean) into the biodiesel and glycerin, which is then often used in soap manufacturing. Compared to traditional diesel, biodiesel results in almost complete elimination of acid rain emissions. Since trucking fleets are nearly completely diesel-based, it can provide a tremendous benefit to the environment as well as some freedom from oil imports.

Nowhere is the combination of pollution and reliance on petroleum imports a more pressing need than in China. The booming economy there has brought with it a surge in diesel use, up 200% in the past decade to 116 million tons a year. Pollution from automobiles has gotten so bad in parts of China that some running events have been threatened to be moved from Beijing for this summer’s Olympics. That has led the Chinese government to get behind biodiesel in a significant way this past year. The country is now aiming to use 20 million tons by 2020 up from an estimated 200,000 tons in 2007.

The bulk of 2007 biofuel production came from Gushan Environmental, a Fujian Province company that made 190,000 tons of biodiesel in 2007. By the end of this year, Gushan will have annual capacity of 400,000 tons thanks to new plants slated to open in Beijing, Shanghai, Hunan and Chongqing provinces.

The company has focused on making its product not from soybean oil but from waste sources including vegetable oil, used cooking oil and methanol. Sales exploded from $5.3 million in 2002 to $115 million in 2006 (2007 sales are estimated to come in at $130 million), with net profit margins over 40% each year.

The price Gushan fetches for biodiesel varies in tandem with traditional diesel. Traditional diesel prices in China hit $1,000 a ton in late 2007, and have recently dipped because of seasonal factors to $800 a ton. Based on past years, that implies Gushan is now making somewhere around $720 a ton for its biodiesel.

There are only so many restaurants from which to collect discarded cooking oil in China, so the government has announced an effort to plant 7,000 hectares of forest this year in Hebei province (where Gushan has a factory) to produce material for biodiesel. Plantings like the Chinese pistachio tree and others are seen as beneficial because they can be grown on mountainsides that can’t be used for other agriculture and provide jobs for people in remote villages, and the nuts have high natural oil content that provides a strong yield for producers. Hebei and other provinces also have stated they will plant another 1.27 million hectares of biodiesel forest by 2010, with government plans calling for 13 million hectares by 2020. It’s all part of an effort by the government to grow national renewable fuel use to 10% of total fuel use in two years (from about 8% now) and to 15% by 2020.

For Gushan, all of that should power sales growth of 65% in 2008 to $214 million, presuming China’s diesel doesn’t fall too far below $800 a ton, which isn’t expected. If prices climb closer to the $1,000 a ton mark for the year, Gushan could blow past that $214 million estimate quite easily. Since 110,000 tons of Gushan’s annual production isn’t scheduled to come online until the fourth quarter of 2008, sales should rise significantly again in 2009. We also like that Gushan has a low debt-to-equity ratio of 7%, compared to 29% for the typical fuel producer.

Gushan holds a Chinese patent through 2020 on technology it developed to efficiently process waste products into biodiesel, something it says allows it to operate more profitably in the sector. Competitors, which relied mostly on food crops for their biodiesel efforts, have to play catch-up in light of new regulations. In the meantime, Gushan has filed for six more patents on various biofuels processes. It’s also worth noting that Jianqiu Yu, Gushan’s founder, chairman and owner of 42% of the stock, is a member of the political committees of two provinces, giving the firm a stronger voice in policy.”

In short, Gushan has a great growth story, and because it’s still little-known by U.S. investors, there’s tremendous upside potential for a big Romance Phase uptrend.

Short-term, however, you need to be careful. Last Thursday and Friday, the stock jumped from 10 to 15 on big volume, for no obvious reason, taking the stock to its highest close of the year. Today, the stock took a breather. Aggressive investors will try to buy low and keep close stops.


Editor’s Note: Gushan Environmental may never be mentioned here again, but you can get regular updates on the stock, as well as a comprehensive overview of the Green investment sector, by reading Cabot Green Investor. The newsletter has no track record, because it’s young; the first issue was published in January. But it uses the same time-tested investing system used by Cabot Market Letter, so we expect results to be excellent, not least because the whole world is now pushing earth-friendly living. If you want to make money in earth-friendly stocks, Cabot Green Investor is what you need. To get started with a no-risk trial subscription, simply click the link below.

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Cabot Wealth Advisory

Timothy Lutts is Chairman Emeritus of Cabot Wealth Network, leading a dedicated team of professionals who serve individual investors with high-quality investment advice based on time-tested Cabot systems.