CASH: Sure, that’s easy. For the record, we’re going deeper into this than I intended — as I said, I’d rather save this stuff for a smaller, more select group of readers — but since we’re pals I can give you a historical example.

JL: Mighty kind of you. (I think.)

CASH: So the stock is Vonage.

JL: Vonage, Vonage… Right, I remember them. Symbol VG, I believe. They do the telephone calls over the computer, right? They were going to revolutionize long distance or something. And they had a big “people do stupid things” marketing campaign.

CASH: You got it. That campaign turned out to be perfect for the Vonage IPO, as some people did the “stupid thing” of buying that dog of a stock. Vonage was one of those offerings that had “stinkeroo” written all over it.

JL: Fascinating. I don’t think the public had any idea. I remember reading in The Wall Street Journal, back before it happened, how there was a lot of optimism before the IPO came out…

CASH: Yep, that’s how it works with this stuff. Behind the scenes, the red lights were flashing big time. I had at least three different contacts tell me they could get me a ton of shares — always a big warning sign.

JL: So then what happened?

CASH: When the Vonage deal priced, I got every single share I requested — fortunately, that wasn’t too many — and the stock never once closed above its IPO price. The funny thing is, I even had friends outside the business asking me if they should take stock in the deal, because they were Vonage customers and had been offered a chance to participate. When you get non-trading friends asking whether they should take shares, that’s another red flag.

JL: I can see how this is an important area to keep tabs on. But I can understand how you’d want to keep those kinds of trades to a smaller audience. So what’s the other “dark side” category you make money with?

CASH: Well, there’s another way to approach the short side that might appeal to a broader cross section of readers. I’ll use another well-known example to tell the story. Then, we can fast-forward and look at a name that’s setting up in real time.

JL: Do tell…

CASH: The example is a shoe company that created chaos in what used to be a very mundane industry. If you haven’t already guessed it, I’m going to tell you about Crocs Inc. (CROX).

JL: They make those ugly Swiss-cheese-looking sandals, right?

CASH: Those are the ones — although, ugly depends on who you ask. I’m no fashionista or anything, but I think they’re pretty cool.

JL: I rest my case.

CASH: Hey! But anyway, regardless what you think about the shoes, you have to be impressed with the growth of the company. After coming public in early 2006, CROX traded in a range for a few months… and then broke out from $15 or so and ran all the way up to a high above $75. That’s more than a 400% gain!

JL: Now that’s a stylish move.

CASH: Yes, indeed. We made our share of profits on the way up, but got out when things started looking a bit “frothy.” See, names like this will oftentimes create too much excitement. That makes them destined to come back to earth in a big way.

JL: Wow. Just pulling up a CROX chart here. The stock fell off a cliff.

CASH: Yup. And there was good money to be made on the way down, just as there was on the way up.

JL: What happened? Was there an outbreak of athlete’s foot tied to the shoes or something?

CASH: No, nothing that dramatic. Once the company started running into growth problems — the typical headaches that plague small companies when they start to get big — investors started heading toward the exits. Soon the selling touched off a stampede, and anyone who stood in the way got trampled.

JL: What was that great old quote? “Men go mad in crowds, and regain their sanity one by one.”

CASH: Right, except the madness cuts both ways. While excitement and hype can drive a stock price much higher than it should really go, fear can do the same thing in reverse — knocking a stock price much lower than one might expect.

JL: So much for an efficient market.

CASH: Ha! If these markets were efficient, you and I would be shining shoes. Anyway, CROX now trades at $10 or so, even though the company is expected to earn $1.60 per share this year. Management has lost credibility due to the growth missteps, and the shorts have cleaned up handsomely.

JL: Sounds like a fun way to make money… raking in the bucks while everyone else is moaning and groaning about a “tough market.”

CASH: That’s my favorite part.

JL: So you promised a real time example. Anything on your plate with CROX-like characteristics?

CASH: How about a big, hot, tasty opportunity that’s both fundamentally and technically flawed.

JL: Was that a pun? Because I didn’t really get it.

CASH: Yeah, actually it was — or maybe it was just my stomach growling. The stock is Chipotle Mexican Grill (CMG:NYSE). Just talking about this stock makes me hungry. This southwestern quick service restaurant has grown from a local concept, incubated by McDonalds, to a thriving business spanning the United States.

JL: Sure, the made-fresh-to-order burrito guys. We don’t have those in northern Nevada, but I eat there sometimes in Baltimore. (Dang it, now I’m hungry, too.)

CASH: Those are the guys. With a strong reputation for healthy, organic ingredients, CMG built an incredible track record. They won the trust and admiration of investors everywhere. The IPO was a huge success… and I may have mentioned in the past that I got shut out of the deal. That was one of the angriest moments of my career.

JL: Oh yeah, I remember the story. And I recall you wound up making some sweet profits in CMG anyway. But we’ll save that recollection for another day. Let’s get back to the here and now.

CASH: Good idea. After running to a high of over $150, CMG has finally begun to roll over. It’s given up a third of its market value, but it looks like the fun could be just beginning… fun for the shorts, that is. After all, remember what happened to CROX — a company that is still robustly profitable.

JL: So what’s driving CMG down? Not moving as many burritos? Paying too much for their ingredients? People trading back down to McDonalds to save money?

CASH: Not yet. Sales are still relatively strong. But you did hit on one aspect: Agricultural pressures are weighing on margins. These guys are increasing the number of restaurants that sell naturally raised beef and chicken, which “naturally” costs more to produce. At the same time, inflation in everything from avocados to tortillas to cheese means food costs are trending higher.

JL: Sounds like they need to raise prices.

CASH: That’s harder to do than one might think. One of the reasons sales are strong is that the food is a relative value to customers. Management has committed to only raising prices in stores that are converting from traditional beef and poultry to naturally raised alternatives. While the decision is noble, it will likely cause margins to trend lower. Investors are beginning to price in a bit of this bad news… but it’ll take another earnings report or two before they realize the full effect of higher costs.

JL: Is the stock still pricey compared to earnings?

CASH: Yes. CMG is trading at nearly 40 times next year’s earnings, and nearly 30 times 2009 expectations. That sounds a bit high, but it wouldn’t be a huge concern if not for the problem I have with those expectations. See, analysts have been programmed to expect high numbers from CMG like clockwork. They’ve been spoiled by the way the company has consistently beaten its own goals, coming in on the upside quarter after quarter. Now that we’re transitioning to a tougher environment, those upside surprises are less likely to happen.

JL: So you think expectations are going to come in lower.

CASH: Exactly. And imagine what happens when the stock multiple declines at the same time that earnings numbers are being revised lower.

JL: Doubly low prices?

CASH: I’m not sure you can grammatically phrase it like that, but yeah, you’ve got the idea. The potential is for a drastically lower stock price

JL: I see. Well, short ideas like this could help our readers do a better job of protecting their other investments. We’ll have to keep an eye on CMG and turn up a few more short candidates soon.

CASH: I’m hungry. Let’s get a taco.

JL: I think you mean burrito. Unless that’s a Reservoir Dogs reference.

CASH: Very sharp, my friend. Catch you next week.

by Justice Litle, Editorial Director, Taipan Publishing Group

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