On Sept. 25, the Fool is celebrating Worldwide Invest Better Day, but in the meantime, we Fools are sharing some of our best advice, tips, and, yes, cautionary horror stories. Sometimes, learning from someone else's mistakes is better than studying their successes, and in that spirit, I offer my own tale of woe.
The story on the stock
The stock that burned me was Aeropostale (NYSE: ARO ) . Aero shone during the recession. While competitors like Abercrombie and Fitch (NYSE: ANF ) and American Eagle Outfitters (NYSE: AEO ) were seeing their profits get crushed, Aero was snatching up market share and heading toward record sales.
The main reason was that Aeropostale's products are cheap. Even in a recession, stylish teens still need new clothes every 10 minutes. Customers who could no longer afford to continually refresh their wardrobe at higher-priced rivals began flocking to Aero's $20 jeans and 70%-off sales. That helped push Aero's revenues up nearly 60% and helped it double net income.
But somehow, the company was trading at just 10 times earnings. Abercrombie and American Eagle were both trading at multiples three times higher, despite struggling to keep customers. With the recession dragging on, the choice seemed obvious, and I bet big.
What went wrong
My first red flag should have been when co-CEO Mindy Meads resigned. In January 2010, the company promoted Meads and Thomas Johnson to serve as co-CEOs. Johnson had been the chief operating officer for many years, but Meads had previously served as the chief merchandising officer.
Meads resigned as co-CEO right around the time I invested, barely a year after taking the job, which should have scared me off immediately. The loss of Meads and her merchandising expertise was followed by a decline in the fashionability of Aero's products, at precisely the worst time. Abercrombie had finally relented and began lowering prices and holding promotions until it was competitive with Aeropostale, and the economy had finally recovered enough for customers to start thinking about trading back up.
Meanwhile, cotton prices were soaring to record levels. This hurt the company badly because it can't just eat the costs the way premium-priced rivals can, and risks damaging its low-price brand if it passes on the costs to customers. As a result, since 2010, Aero has seen its profit margin drop from about 10% to just about 2%.
The lessons to be learned
There's a lot that can be gleaned from this story, but I made three big mistakes.
First, if a new CEO quits the job after one year, that should scare off any reasonable investor immediately. The official reason given was that Meads just wanted to pursue other interests, but if she did, any well-managed company should have known she wanted to leave before they promoted her, and if she didn't, a cautious investor should have taken her swift departure as a sign of trouble.
Second, as philosophers from Robert Frost to pop-punk band New Found Glory have noted, nothing gold can stay. Aeropostale's sales took off because customers were trading down to save money. As soon as brands with more status appeal lowered prices to staunch the market-share bleed, I should have known that Aeropostale would start to see its sales growth slow.
And finally, I should have realized that a deep-discount business model suffers when input costs start rising. Aero is not likely to recover until cotton prices fall or until it finds some way to pass costs on to customers. This is likely the reason for the 15% fall in shares of Dollar Tree (NYSE: DLTR ) since June. Food prices are soaring, and it's not easy to pass on those costs to cash-strapped customers.
You can't always anticipate these kinds of changes, but the key takeaway is that a good investor should know what makes a company tick. The factors that let Aeropostale flourish no longer held true, and ignoring that cost me a lot of money. Don't let that happen to you. Stay tuned to the Fool to hear more stories like these and head over to InvestBetterDay.com to celebrate the art of investing on Sept. 25.