Monitoring the Trend

In Chapter 8, we corralled and assembled a smorgasbord of economic, demographic, and psychographic data alongside developing technologies and regulatory mandates to formulate our thematic trends. The beauty of doing all this up-front work is you've already identified the key pieces of data and other critical items to monitor. You've also uncovered the sources for those information nuggets, and hopefully the frequency in which they are reported.

That takes a lot of the bite out of monitoring the trend, but not all of it. Aside from formal data, we also keep our eyes open for news stories, like those you may find in a variety of magazines and newspapers like Bloomberg BusinessWeek, Economist, Wired, Fast Company, Successful Farming, Time, Money, Scientific American, Popular Science, Wall Street Journal, New York Times, and Investor's Business Daily. Increasingly, there are more and more resources online, like TechCrunch, MentalFloss, DroughtMonitor, and dozens of others.

You may be tempted to drop them all into your browser bookmarks, but we'd recommend using an aggregator service like Feedly and an online storage and clipping service, like Evernote, which saves and categorizes articles and other news items for later use. These services will cost you a little bit, but from a time management and information flow perspective, we find them very worthwhile.

One other important trend tracker source comes from the companies themselves. At industry events and conferences, a key member of a company's management team may make a presentation that is filled with data that we can use to monitor a thematic trend or two. We had two such great examples that pertain to the Connected Society in September 2015.

At Apple's annual new product reveal event in September 2015, ahead of introducing the all-new Apple TV, CEO Tim Cook shared the following—“We believe the future of TV is apps.” Not surprising, given the moves by Netflix, HBO, Hulu, and others to offer apps that allow customers to stream video programming on almost any connected device. Thanks to its leading position in global video streaming across multiple categories, combined with the ubiquitous iPhone and iPad (according to Adobe Digital Index¹), Apple has some unique perspectives on the direction of video consumption and viewer habits.

A few days after Apple's presentation, Lowell McAdam, the chairman and CEO of Verizon Communications, announced at an investment conference that “40 percent of Millennials do not and have never had a TV in their home and another 20 percent have said they have got it, but they don't use it that much and they are considering cutting it. But what you see in the data volumes of our networks, which have experienced 20× growth, is they are watching it over mobile and they are watching it in digital media versus broadcast kind of media.”²

On the one hand, these nuggets confirm the slow death of the broadcast industry at the hands of the connected society, which is not all that different than what happened to the newspaper industry, as we discussed in Chapter 7, when it ran headlong into the Internet. On the other hand, it shows the insights we can gather by listening to company or subject-matter-expert presentations. Sometimes you may walk away with a bag full of nuggets, sometimes just a few, but in our view, they are worth it.

In monitoring a thematic trend, you want to be mindful if it's accelerating, running at a pretty steady state, cooling off, or starting to fade. Some of this can be determined from the data you're tracking, but another useful trick is to keep tabs on how often it's being mentioned across the various media outlets, from other companies (as well as its customers and suppliers), among your friends, colleagues, and co-workers, and in some cases our daily language.

For example, somewhere between 2009 and 2010, the “selfie” explosion started, and by the end of 2012, Time magazine considered selfie one of the “top 10 buzzwords” of that year; although selfies had existed long before, it was in 2012 that the term “really hit the big time.” That was huge for Facebook, Instagram, and other social media and photo-sharing platforms. Today, the word selfie is pervasive as is the act of sharing it. Think of the impact that had on mobile phones, the primary tool for the selfie, and the need for high-resolution cameras for both the front- and back-facing cameras.

If your monitoring shows the thematic trend is accelerating, generally speaking, that is a good sign. If it's tracking or hitting a bump in the road, we'd say that's good to normal, but be sure to check the long-term opportunity to make sure the thematic tailwind remains intact. If, however, signs are pointing to a pronounced slowdown in a thematic trend or signal that it may be becoming a headwind, it could be time to consider alternative investments in a different theme, assuming there are well-positioned companies that meet the net upside requirements we discussed in Chapter 10.

That offers us a nice transition to…

Monitoring the Company

Much like monitoring a thematic tailwind, the work in Chapter 10 helped you uncover most, if not all, of the key levers that drive a company's business, from key industry data points to understanding which business units or products really drive a company's overall revenue and profit stream to what are the key ingredients or cost drivers. Just like with monitoring the trend, monitoring the company means maintenance reading, which consists of reading company and competitor, and even key supplier, press releases, financial filings, and presentations that can be found on the Investor Relations section of corporate websites; industry reports; overviews (those nuggets can be very insightful!); and trade magazines and various other publications that touch on a company and its business. These are the usual suspects we outlined earlier in the chapter as well as the growing list of online media.

Don't forget those organizations that track industry data as well as forecast what they expect to happen in the coming quarters and the next few years. For example, when examining shares of firearms manufacturer Smith & Wesson (SWHC), you would be taking a hard look at firearm background check data published by the Federal Bureau of Investigation monthly. Are background checks accelerating compared to the last few months? Is the number of checks up year-over-year or not? If so, for how many months? And so on.

If we wanted to monitor how rail companies were doing, we'd look to the weekly railcar loading data published by the American Association of Railroads. To get a bead on heavy truck demand, we'd be keeping tabs on the manufacturing economy through monthly industrial production figures published by the Federal Reserve, truck tonnage data published by the American Trucking Associations, and industry order, production, and backlog data that is collected and published by ACT Research.

If you were drilling down on apparel companies, you should be checking on cotton prices and the condition of the cotton crop, which is published by the National Cotton Council of America and other organizations.

All that may sound like a lot, but once you know where to look, if you just jot down what you need to track and where to look it up, much of this can be something you do quickly and efficiently over your morning coffee or on the subway or bus during your morning commute.

Pretty much each industry and company has recurring metrics that will clue you into the tone of the business as well as its vector and velocity. This also means watching for new developments—remember, in many ways a company is like a shark that needs to swim in order to force water over its gills so it can survive. A company that rests on its laurels could fall victim to the changing landscape around it because of economic, demographic, technology, or regulatory shifts and changes. In conducting your ongoing company monitoring, here are a few questions that you should be asking; this is by no means a complete list, but more of a starter kit. As you dig deeper into the inner workings of a company, its supply chain, and competitive landscape you'll find yourself adding to these:

Has the company introduced new products and services? Is it leading the pack and breaking new ground with a new technology, or is it following behind a competitor and responding with a “me-too” product or service? Will this new product help improve the company's profitability?

As we've noted more than few times in this book, Apple has been an innovator with its iProducts (iTunes, iPod, iPhone, iPad) that have fostered much creative destruction across several industries, but these products have forced product responses from the company's smartphone competitors, like Samsung, LG, HTC, Motorola, and others. Another example is Tesla Motors, which sent Ford, General Motors, Honda, and other automotive manufacturers back to the drawing board after its Tesla Roadster and then its Model S, a fully electric luxury sedan, were hits with consumers.

Have any of a company's key suppliers developed a new technology that can be incorporated into an existing product or help the customer company bring a new one to market?

There are all sorts of examples one can think of, but again, perhaps the most recognizable is the iPhone, which thanks to the Apple supplier base introduced all sorts of breakthroughs when it announced its various iProducts. Think about how Apply Pay can impact the way consumers shop and interact with businesses.

Has the company altered its product or service portfolio in any way? Does this open up a new demographic or target audience that has never used the company's products or services before?

Seeing the growing demand for apartments by Millennials and other Cash Strapped Consumers rather than single-family homes at a time when vacancy rates were falling, traditional high-end single-family homebuilder Toll Brothers (TOL) moved into this market in 2014.

Has a competitor decided to target market share gains and introduced disruptive pricing at the expense of margins and profits in the short to medium term to succeed?

While this can be disruptive in the short-term, world-class companies with strong brands that offer products and services that consumers and other companies want tend to weather such storms. In the short run, competitor moves like this can pressure margins and profits in the short term and potentially decrease revenue if your company needs to respond.

We've seen such disruptive pricing from the likes of T-Mobile USA and Sprint, both of which have been aggressively trying to win wireless consumers from AT&T and Verizon Communications.³

Case Study: Starbucks Corp

Have changes in input costs resulted in the company having to boost prices for its products and services, or have input costs fallen, which could help boost a company's profits and earnings?

In Chapter 10, we put Starbucks through the valuation wringer. We know Starbucks has been a coffee company, but increasingly it is becoming a coffee, tea, and food company. Key ingredients therefore include primarily coffee (Figure 11.1), but also milk (Figure 11.2), wheat (Figure 11.3), and cocoa (Figure 11.4). In the company's 10-K filing for its fiscal year ending September 2015 with the Securities and Exchange Commission, which you can find at www.sec.gov, we find that Starbucks purchases, roasts, and sells high-quality whole-bean Arabica coffee beans and related coffee products. So let's look at the price of Arabica beans.

Looking across the charts of these commodities, the prices of coffee, milk, and wheat have fallen over the past year, with both coffee and milk down over 30 percent while cocoa prices actually trended up over the year. An investor in Starbucks would need to know how changes in the prices of these commodities could affect Starbucks margins. A great way to understand what is most impactful to the company is to look at the “Risk Factors” section in the company's 10-K.

In the company's 2015 10-K, one of the main risks itemized is “Increases in the cost of high-quality Arabica coffee beans or other commodities or decreases in the availability of high-quality Arabica coffee beans or other commodities could have an adverse impact on our business and financial results.” The 10-K also tells us, “We also purchase significant amounts of dairy products, particularly fluid milk…”

The 10-K goes on to say, “Because of the significance of coffee beans to our operations, combined with our ability to only partially mitigate future price risk through purchasing practices and hedging activities, increases in the cost of high-quality coffee beans could have an adverse impact on our profitability.” This tells us that changes in the spot price of coffee will impact the company's bottom line more than if it were to lock in purchase prices for Arabica beans well in advance.

Earlier in this chapter, we saw that coffee and milk prices had fallen over 30 percent during the prior year. If we take a further step back with coffee, we can see that by September 2015, prices had fallen about 37 percent over the prior 5 years. Milk prices, by comparison, had fallen about 9 percent over the prior 5 years, ending in October 2015. Looking at past performance, we would expect to see Starbucks' margins benefit from these falling prices and would want to confirm that was the case. If not, further investigation would be in order to determine why that was the case.

Looking forward, we would want to look at research reports concerning where the price of coffee in particular is expected to go. Prices would be affected by weather patterns and any changes in crop plantings. Falling prices could very well mean that many farmers, over the years, would have chosen to switch from coffee to some other type of crop. Over time, this would mean a decrease in the available supply, which would then push prices up, which would hurt Starbucks' margins if they were not able to then raise prices sufficiently to cover the higher costs. This is the kind of thought process Cocktail Investing is all about.

Have there been any regulatory mandates or other changes that will impact a company's costs structure?

Starbucks also mentions in its 10-K that its financial conditions might be adversely affected by “increases in labor costs such as increased health care costs, general market and minimum wage levels and workers' compensation insurance costs.” If we look at just wage costs for the majority of Starbucks employees, the lifesaving baristas, we can see that labor costs have been steadily moving up over the five years from 2010 through 2015. See Figure 11.5.

But what about any larger future changes? As of September 2015, the federal minimum wage stood at $7.25 per hour; however, there were a growing number of states boosting their minimum wage in increments, with some like New York City and Seattle and the California cities of Oakland, Los Angeles, San Francisco, and Berkeley approving phased-in increases that would eventually take their minimum wage to $15 an hour.

To understand the impact of these changes, we looked at the city of Seattle because in June 2014, the Seattle city council passed a $15 minimum wage law to be phased in over time, with the first increase to $11 an hour starting on April 1, 2015. By the later part of 2015, evidence was already emerging that the minimum wage increases were having a negative effect on restaurant jobs in the Seattle area.

According to data assembled from the American Enterprise Institute, the Emerald City Metropolitan Statistic Area started experiencing a decline in restaurant employment around the beginning of 2015 (when the state minimum wage increased to $9.47 per hour, the highest state minimum wage in the country at that time), and the 1,300 jobs lost between January and June of 2015 represented the largest decline during that period since 2009 during the Great Recession.⁴ The loss of 1,000 jobs in May 2015 following the minimum wage increase in April 2015 was the largest one-month job decline since a 1,300 drop in January 2009, again during the Great Recession.⁵ Odds are high that similar results were likely to be seen as these higher minimum wages took effect in other cities and states.

Comments from the September 2015 U.S. Federal Reserve's Beige Book (a qualitative assessment of the U.S. economy, compiling findings from each of the 12 Federal Reserve districts) pointed out that concerns about upcoming minimum wage hike increases, as well as higher costs associated with the Affordable Care Act, were in fact relatively widespread.

Getting back to our Starbucks example, the line item on the company's income statement that would reflect these pending minimum wage hikes, as well as any changes in healthcare costs, would be “store operating expense.” As seen in Figures 11.6 and 11.7, Starbucks had done a good job keeping its store operating expenses in check relative to revenue growth for most of 2015. Given what we suspected would be coming, this would be a line item to watch, as it could pressure profits and potentially result in the company needing to boost prices to maintain, if not add to, profits. Boosting prices can create a tricky situation, because past a certain point, it can turn a guilty pleasure, such as the pumpkin spice latte or peppermint mocha latte, into an expensive beverage that turns off consumers.

STARBUCKS CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS (in millions, except per share data) (unaudited)

	Quarter Ended		Three Quarters Ended
	Jun 28,	Jun 29,	Jun 28,	Jun 29,
	2015	2014	2015	2014
Net revenues:
Company-operated stores	$3,915.0	$3,290.5	$11,310.7	$9,702.3
Licensed stores	475.2	408.1	1,380.5	1,166.1
CPG, foodservice and other	491.0	455.1	1,556.7	1,398.7
Total net revenues	4,881.2	4,153.7	14,247.9	12,267.1
Cost of sales including occupancy costs	1,953.9	1,711.5	5,804.9	5,135.7
Store operating expenses	1,392.4	1,176.5	4,032.5	3,486.1
Other operating expenses	131.6	120.6	394.5	346.3
Depreciation and amortization expenses	236.5	180.1	659.6	524.2
General and administrative expenses	288.5	269.4	892.8	752.6
Litigation credit	—	—	—	(20.2)
Total operating expenses	4,002.9	3,458.1	11,784.3	10,224.7
Income from equity investees	60.3	72.9	168.0	183.9
Operating income	938.6	768.5	2,631.6	2,226.3
Gain resulting from acquisition of joint venture	—	—	390.6	—
Interest income and other, net	25.5	19.4	36.6	57.0
Interest expense	(19.1)	(16.4)	(52.3)	(47.7)
Earnings before income taxes	945.0	771.5	3,006.5	2,235.6
Income tax expense	318.5	259.0	899.7	755.4
Net earnings including noncontrolling interests	626.5	512.5	2,106.8	1,480.2
Net earnings/(loss) attributable to noncontrolling interests	(0.2)	(0.1)	1.9	(0.1)
Net earnings attributable to Starbucks	$ 626.7	$512.6	$2,104.9	$1,480.3
Earnings per share - basic	$ 0.42	$ 0.34	$ 1.40	$ 0.98
Earnings per share - diluted	$ 0.41	$ 0.34	$ 1.39	$ 0.97
Weighted average shares outstanding:
Basic	1,498.5	1,503.5	1,499.3	1,507.9
Diluted	1,515.7	1,522.0	1,516.3	1,527.8
Cash dividends declared per share	$ 0.16	$ 0.13	$ 0.48	$ 0.39

Starbucks Corporation (USD in millions)

	Quarter Ended		Three Quarters Ended
	28-Jun-15	29-Jun-14	28-Jun-15	29-Jun-14
Company Operated Store Revenue	$3,915.0	$3,290.5	$11,310.7	$9,702.3
Increase	19.0%		16.6%
Store Operating Expenses	$1,392.4	$1,176.5	$4,032.5	$3,486.1
Increase	18.4%		15.7%
Source: Company reports.

One of the final questions we ask after we've completed 90 percent of our monitoring homework is:

Have Wall Street analyst expectations changed over the last few weeks to reflect any of the answers to the above questions as well as any others that materially impact a company's business?

Before we start to answer that question, perhaps like Bob or Sophia, you've never heard the term “Wall Street analyst expectations” before. They're the consensus estimates for revenue, profits, or earnings per share that are obtained by averaging expectations from all of the investment professionals that publish their forecast for a particular company.

That's not as straightforward as it sounded inside our heads. Since we've been sticking with Starbucks, we can turn to Yahoo Finance! (or any other financial resource that publishes analyst expectations like Nasdaq.com or Bloomberg), and we find the average of the 25 analysts that publish earnings-per-share estimates for Starbucks was $0.43 for the quarter ending September 2015. You'll notice the “low estimate” and “high estimate” for that three-month time period—0.43 and 0.45, respectively—which gives us the expected earnings range for that quarter.

For the same three-month period, as Figure 11.8 shows, only 22 analysts have shared their revenue expectations and that average is $4.90 billion, up 17.1 percent year over year. Unlike the relatively narrow expected earnings range, the expected revenue range is much wider at $4.78 billion on the low side and $5.14 billion on the high side. As you can see, depending on the period of time, more or fewer analysts publish their forecasted figures.

As we saw in the commodity input price charts, the cost side of the equation for a company can swing based on supply, demand, and other factors, like weather, for example, affecting coffee bean production.

What we needed to determine was if Wall Street's expectations had caught up with what had been going on in reality. In the case of Starbucks, as seen in Figure 11.8, per the EPS Trends box, there had been little change in earnings expectations for the September 2015 and December 2015 quarters as well as the year ending September 2016 [Note: Starbucks is what we call a “funny fiscal” because its fiscal year ends at the close of September, not December like the vast majority of companies].

Looking at that lack of change over the prior 90 days, and comparing it to the changes in coffee, dairy, wheat, and cocoa prices, there may be a reason to think those Wall Street expectations could be a bit conservative.

Viewing the earnings history box, however, we find that Starbucks seems to be one of those companies that tends to deliver exactly what's expected when it comes to its bottom-line earnings—note all the zeroes between EPS estimated, EPS actual, difference, and surprise percentage. This tells us that Starbucks is pretty adept at managing expectations for its revenues and earnings in upcoming quarters.

Now, why did we point all of that out?

In addition to knowing what's expected, we want to determine if there has been an upward or downward move in those expectations over the last week, month, or longer. If we see key input costs are moving in a direction that is favorable for a company—as we saw with coffee, milk, and wheat prices for Starbucks—or signs that revenues may be picking up because industry demand is improving or better yet both, but we don't see revenue or earnings expectations being changed to reflect those moves, it could be mean the group of analysts following the company are asleep at the switch. This could spell opportunity, as upside surprises tend to lead to pops in stock prices, particularly if the company issues a rosier than expected outlook.

Similarly, if costs are moving in the wrong direction and/or revenue looks to be hitting a serious headwind, and the analyst group hasn't updated its expectations to account for this, it could signal that a revenue or earnings shortfall could be had.

A few final thoughts on what it means to monitor a company and its business…

Aside from all the data you're collecting, we encourage you to note your own observations as you move around in your day-to-day life. Are you seeing more of one product than another? What stores are experiencing long lines? Is there a new service that your friends are talking about, or one their kids can't stop using? Are once-busy stores now far less occupied with customers? All good fodder to track in your investing notebook!

When you see things like this, always, ask yourself, “What does that mean?” The answer will help cut to what is really going on. The last thing you want to do is get all excited about a long line in front of a new fast-food restaurant only to find out it's because there was a fire in the kitchen and customers are stacked up waiting for their orders.

Between those kickstarter questions, examples, and answers that was quite a bit to chew on. Here's a quick recap:

By looking at the developments in and around the companies that are at the heart of your investments (“We buy companies, not pieces of paper called stock certificates”), you can put noise into context and wind up with either confirming or warnings signals. You have to pay attention to the continuum of companies that surround the one you've invested in as well as any new ones that may enter the industry (Tesla and automobiles, for example).

Announcements such as better than expected revenues and new product instructions from customers could be bullish for your company, but if a competitor announces a new customer win or new product offering that ups the ante for your company, it could spell trouble. As you collect all of these data points—industry, company, supplier, competitor, and customer—the big question is, how does all of this impact the business of the company you've invested in? Asked another way (as we said, shifting one's perspective is helpful and insightful!), is the data tracking as expected, falling short, or stronger than anticipated?

Depending on the answer, it could mean that expectations for a company's revenues, profits, and bottom-line earnings need to be updated. If such adjustments are called for, that could mean the shares need to be revalued, so you will want to take another look at the numbers you came up with using the tools in Chapter 10's Question 12. This could alter the upside versus downside potential to be had, which may change your opinion on whether to continue to own the shares.

All of this ties to the final section, which is…

Monitoring the Stock Price

This is where the rubber hits the road.

If you've never owned any stocks before, you might think that opening up your monthly brokerage statement and quickly reviewing your holdings is what we mean when we talk about monitoring a stock. To the almost 52 percent of Americans who do not own stocks, according to the most recent 2013 Survey of Consumer Finance published by the Federal Reserve⁶ in 2014, this probably sounds rather logical.

Unfortunately, there's more to it than that. While reviewing your monthly statements should be part of your overall financial review, just like shoring up your checking and savings accounts, when we talk about monitoring a stock's price we have something else in mind.

Monitoring a stock's price centers not only on the movement of the actual share price—up, down, or essentially flat—from where you bought it, but also on how the valuation figures you put together toward the end of Chapter 10 have changed in response to the move in the share price and updated Wall Street expectations for your company's revenues, profits, and earnings per share. Don't get us wrong: We like to jump up and down when a stock that we own soars higher and get seriously frustrated when one drops more than expected, but to us it's primarily all about today's price relative to future revenues, profits, earnings, and cash generation that could fuel future dividend increases that drive tomorrow's price.

Think of the historical valuations you put together as you answered Question 12 in Chapter 10 as the historical framework, or what we like to call bumper guards, for the stock price. These bumpers help you understand the valuation multiples where your stock has peaked and bottomed in the past.

As a stock moves higher, we want to keep in mind the distance to its upper valuation bumper. As it climbs, the distance between the current valuation and that upper valuation bumper will shrink. In Wall Street speak, this means the valuation multiple is rising and the shares are more expensive relative to the company's earnings than they were before.

For example, let's say you bought shares in Company PDQ at $10 and it was expected to generate $1 in earnings per share over the coming 12 months. Pretty simply, PDQ shares would be trading at 10× those expected earnings. Based on your historical valuation work, you know that PDQ shares have peaked at 14× expected earnings and bottomed at 8× expected earnings, which gives rise to your net upside target of 20 percent in the shares —40 percent up to $14 () and down 20 percent to $8 (). Don't you love how all of this from the last few chapters comes together?

Now after a few months, PDQ shares have climbed to $13, which means you are up 30 percent from your $10 purchase price. This means PDQ shares are trading at 13× the expected $1 per share in earnings, which is far closer to the upper bumper of 14×, and in Wall Street speak they are more expensive than the 10× earnings you paid for the shares a few months prior. At the $13 mark, you have upside of just under 8 percent to your $14 price target and potential downside of 38.5 percent to that lower bumper of $8. To us, situations like that, which have a negative net upside (+7.7% – 38.5% = –30.8%), do not have a desirable risk-to-reward trade-off.

What to do, what to do?

The good news is you have some options:

1. You could certainly continue to hold the shares if you were so inclined.
2. You could sell all of your PDQ shares, book a nice win, and use the returned capital and profits to buy another promising-looking contender, park the cash in your account until another well-priced opportunity came along, or you could do something fun with your gains.
3. A third option would be to sell a portion of your PDQ position, ringing the register and locking in profits on your sold shares while keeping some of the PDG position intact to potentially capture further upside. In Wall Street lingo, this is known as “taking some chips off the table” or “trimming the position.”

In this case, of those three options, we would opt for option B for the following reasons:

• The shares have climbed 30 percent in a few months, which is a fantastic return considering the average annual return for the S&P 500 since its inception in 1928 through 2014 was approximately 10 percent.⁷
• The incredibly unfavorable risk-to-reward trade-off is –30.8 percent. Need we say more?

Generally speaking, we are fans of “taking some chips off the table” after the first 20 percent upside move. In the PDQ case, at the $13 level there was simply far more potential downside than upside to be had for our liking. Instead, we would recommend more risk-averse investors trim back their PDQ position after the shares hit $12, a 20 percent return from the initial $10 purchase price, by selling half their shares while keeping the rest in play. Even after booking that 20 percent profit, you would still have “skin in the game,” meaning you have to continue your active monitoring duty.

Now what if during your initial monitoring activity of PDQ shares, earnings expectations for the company were revised higher to $1.20 per share from the $1.00 at the time you purchased your PDQ shares? It would mean you would adjust your upward price bumpers to $16.80 (14 × $1.20) and the lower bumper to $9.60 (8 × 1.20).

Of course, we would want to double-check that these P/E ratio derived bumpers still mesh with the other valuation metric bumpers you calculated back when you first were contemplating buying PDQ shares. If this sounds a bit fuzzy to you, review Question 12, “Is today's price right?” in Chapter 10. Should those other updated metrics confirm the revised bumper levels, your confidence level in them should be much higher. If, however, those other metrics do not confirm the revised bumper levels, then your confidence and comfort level should be low.

Even though we would still be inclined to trim PDQ shares back once they were up 20 percent from the initial purchase price (our rule of thumb!), the increased earnings expectation points to more potential upside to be had for the remaining portion of the shares you would continue to own if you only trimmed back half your original position. At that $12 level with expected earnings now sitting at $1.20 per share, PDQ shares have potential upside of 40 percent (from $12 to $16) and potential downside of 20 percent (from $12 to $9.60), or net upside of 20 percent. Because you continue to own those remaining PDQ shares, they are part of your regular stock monitoring efforts.

As we hinted at above, upward earnings revisions are “fun” because more often than not, they drive stock prices higher. Negative revisions, also known as “cutting earnings” or “slashing the outlook,” as you can imagine, have quite the opposite effect on stock prices—they tend to drive stock prices lower. In some cases, they go much lower. Under some market conditions, even a small miss for reported earnings versus the consensus expectations has led to sharp drops—in the range of 10 to 20 percent—for a company's stock price.

Sell or Buy More?

This is one of the most common questions we get from both individual and seasoned investors and is almost as important as when to buy. As you've come to appreciate through the above examples, there is no hard-and-fast rule. There are rules of thumb to follow for sure, but because all of this is unfolding (just like a movie plot!), it requires the constant monitoring that we've been yammering on about in this chapter.

As we mentioned earlier, we like to trim back a position (meaning, sell some portion) after the shares climb 20 percent above our purchase price, provided the theme as well as data and company monitoring turn up reaffirming signals. If the signals are mixed, we may wait for some additional data to get a clearer picture. If the signals are turning negative, we may sell all the shares. As we do this, we are mindful of our upper and lower valuation bumpers, making sure to update them as new data and expectations—good or bad—become available, so that we always know where today's price fits in.

After trimming the position and making any adjustments to our valuation bumpers, we not only continue to monitor the trend and the company, we also continue to track the distance between current valuations and the valuation bumpers. As the distance between those two narrows, we are more inclined to trim back more of the stock position.

Let's get back to the PDQ share example from a few pages ago. Remember, in that example, you bought shares at $10 and the share climbed to $12 and based on revised expectations you boosted your price target to $16. If the shares continued to climb, reaching $13 and then $14, we would recalculate our net upside, and in doing so, we would find at $14 that there was now 14 percent upside to $16, but more than 28 percent downside to our lower price bumper near $10. Seeing this, we would complete another round of monitoring for PDQ, revising our valuation bumper calculations along the way. If the upper valuation bumper did not move higher and the net upside remained at –14 percent (+14% – 28%), we would likely close out our PDQ position, meaning sell all the shares, at $14.

What's the advantage to selling in that staged way?

That staged selling booked an initial 20 percent profit when we trimmed back at $12 and also freed up capital that we could have invested in another well-positioned stock at the right price, assuming there was one. By holding onto the remaining shares and exiting them at $14, we booked an additional 17 percent profit ($14/$12) on those PDQ shares. Averaging those two sell orders, our average return on PDQ shares was 30 percent, as shown in Figure 11.9.

Transaction Summary

There's nothing like making money along the way as a stock moves higher, but what about when a stock falls, like with the DSW shares? It depends.

What was the reason for the drop in the shares? How does it match up against any revisions to your upper and lower bumpers based on new data for the theme or the company? What was happening in the overall stock market that day or last few? What about the company's sector? What's happening with the stock prices of its competitors? Did a major competitor come out with some news that surprised the markets? Did a supplier hint to the markets that the company might have reduced its orders, indicating slowing sales? You need to look around to see what is driving the moves in the share price.

The answers to these types of questions as well as the magnitude of the pullback will dictate whether you should sell the shares, or use the pullback to buy more. Buying additional shares when the price falls to scale into or maintain your target portfolio weighting is a time-tested strategy that reduces your average cost as you build out your position size in a particular stock or ETF.

Figure 11.10 is an example of how scaling into a position works. You decide that you want to have 2 percent of your $100,000 portfolio invested in PDQ, but rather than buying it all at once, you decide to stage it in two steps. This is often a wise decision, as there is no way to know that in a week, shares won't be priced lower than today. We often scale into a position in three or more steps, unless there is a compelling reason to think the shares are likely to have bottomed out for a particular set of reasons. We are showing just two steps here, for the sake of brevity.

You purchase the first half, $1,000 at $10.00, which translates to 100 shares. After a few weeks, the share price falls to $8.89 and you decide to purchase the remaining portion. However, at this point your initial PDQ investment is no longer worth $1,000; it is now worth $889. Other investments in your portfolio have actually gone up in value, so your total portfolio today is still $100,000. Today, to have 2 percent of your portfolio allocated to PDQ you need to purchase $2,000 – $889 = $1,111 worth of shares, which at $8.89 is about 125 shares. The total you have invested in the shares is the original $1,000 plus the second purchase of $1,111. Notice how you've purchased even more shares at the lower price, which helps lower your average cost on the shares to $9.38. When you sell all the shares at $12 per share, your total return will be 28 percent.

If the share price continued to fall further, but you were still convinced of the fundamentals of the business, you could purchase even more shares to maintain a 2 percent position in PDQ in your portfolio. This would only be reasonable, however, if you have good reason to believe that the market is simply mispricing the shares.

For more risk-averse investors, there are trading tools like stop-loss orders and stop-limit orders that can help minimize your losses. Much has been written on them and their differences, which you can read more about at Investopedia. Our rule of thumb for using those tools kicks in only after we have built out our entire stock position over the course of several buys, generally between two and four transactions. We tend not to go “all in” on a stock in one fell swoop, but instead prefer to use pullbacks in share price to build out the position at lower prices. Once we've reached a targeted position size relative to our overall portfolio, then we may utilize a stop-loss or stop-limit order on that position. As this particular stock climbs higher, we would revisit those stop-loss and stop-limit orders, boosting them as needed; we see that as part of our regular stock-monitoring program.

We must give you a word of caution here on stop-loss or stop-limit orders, as they do have their dangers. If you set a stop-loss at say 10 percent below today's price and in a week the stock drops 10.2 percent, the order will be triggered and your shares will automatically be sold. The problem is, the stock could have just experienced a wacky quick dip (technical term) to that level for mere minutes and within a week be up higher than where it was when you set the stop-loss. This is the challenge with using an automated trigger. Then again, if you are on vacation and shares of the stock go on a rapid descent, a trigger could be a lifesaver. Automatic triggers can be particularly dangerous during periods of heightened market volatility, when everything is moving up and down more dramatically, so carefully consider the pros and cons.

A happy medium for some may be to set up alerts that send you an email or a text if the stock price drops by, say, 8 percent if you think you might want to sell after a 10 percent decline. This way you'll know you need to pay very close attention and figure out what is causing the stock price decline, so if it does fall 10 percent, you'll have determined if you want to trim back or sell the entire position, use the drop to build your position size at more attractive prices, or do nothing and keep your position size intact as is. Most online brokerage services have this alert capability.

We also like to decide ahead of time just how much we are willing to let the price fall before we sell completely out of the stock or fund. Stock prices can occasionally fall despite the fundamentals remaining strong—for example, when there is a major market correction after a prolonged bull run. When that happens, it is better to just get out as quickly as possible and then buy back in at a lower price once things have settled down and you've had time to double-check your other indicators and key data to make sure the fundamentals are still intact. The challenge is that we only know after the fact that it was a major correction.

During such a time, many will argue, “Today, it is all going to turn around,” and sometimes they are right. As a general rule of thumb, we don't like to let a position drop much more than 15 percent before we get out, unless there is some compelling reason to stay in. Occasionally, if we are dealing with something that we know will be unusually volatile, we'll expand that to 15 to 20 percent. It is important to have these rules set up beforehand so that if/when the time comes, we don't find ourselves double-thinking and getting all tied up in emotional knots about not wanting to give up.

In our view, it is far better to take the emotion out of the equation as much as possible. Establish the price at which you will get all out and stick with it. As the price of a stock moves up, we typically also move our “floor” price up. One of the best ways to make money over the long run is to minimize how much money you lose. That sounds pretty obvious, but it is really easy to follow a company's shares further and further down, every day thinking, “Tomorrow it'll turn around, I just know it!” Any seasoned investor will tell you that mentally wishing a stock higher rarely works.

Here are some helpful reminder questions to summarize what we've been talking about:

• Are the valuation metrics you looked at in Question 12 in Chapter 10 getting too high relative to your company's peer and/or historic multiples? This means the stock price may be getting to a point where you consider selling at least some.
• Have you uncovered something in the theme or in your company monitoring that has either raised or lowered revenue, profit, and/or earnings expectations? Is it a short-term blip or has something fundamentally changed?
• Are the shares trading at even more attractive valuation multiples than before? If you are still convinced of the fundamentals, you could consider adding more to maintain your target allocation for your portfolio (e.g., a stock that has fallen in price now represents 2 percent or your portfolio instead of your initial target of 3 percent).
• Has the upside-to-downside trade-off shifted enough to warrant buying the shares, or despite the changes to the valuation metrics, the potential upside-to-downside trade-off remains the same? If the metrics have not improved, you'd likely not want to purchase even more.
• Have expectations been revised higher by the Wall Street community over the last few days or weeks, or have they moved lower? How does this affect your “bumper” price points?

Just like with exercise, the more you do this, the easier it will become. Along the way, you'll put pieces together quicker, draw conclusions easier, and be more comfortable in “all the math” that comes with valuing and revaluing a stock.

What will help you get in fighting shape is the fact that you need to do all of this monitoring for each individual company stock that you own. So, the more stocks you own, the more time you should be spending on monitoring. That's why we recommended you think about how much time you can regularly devote to this kind of recurring “homework” because you'll also want to update your portfolio contender list along the way as well. If you own 10 stocks, we think you should have somewhere between 3 and 5 on the bench.

Taking stock, pun intended, of the answers to these questions and the others we've shown you along the way is all part of the regular maintenance you need to perform on your investments. To us, it's a lot like taking care of your car. Once you buy a new car, or a used car as we're seeing more and more with the cash-strapped consumer, you drive it home, and before too long you've racked up a few thousand miles. At that point, you have some regular maintenance on the vehicle—changing the oil, brake pads, tires—all the things that will keep it humming for you. From time to time, there could be damage, maybe from an accident, a rock putting a crack in your windshield, or something else unforeseen that is beyond repair and forces you to get a new car. If you forget to change the oil, past a certain point it will start to affect performance of your vehicle; forget too long, and it could lead to even bigger problems.

Where this comparison breaks down is that most people have one or maybe two cars, but in a portfolio you may have several stocks to as many as two dozen. There is no simple rule that says if you spend X minutes a week per stock then you will be fine. There may be some weeks when you spend a lot of time reading up on one particular company, and because of the frequency of the data and other information you should be tracking, others may take only a fraction of that.

We can tell you first hand that the first few weeks of quarterly corporate earning season (January, April, July, and October) can be more time-consuming as hundreds and hundreds of companies issue press releases, hold conference calls, and submit filings to the SEC. During this time, it helps to stay focused on just those companies you want to track, and luckily websites such as Seeking Alpha and several others furnish transcripts of corporate earnings conference calls. In our experience, reading several of them side-by-side can prove far more insightful than listening in real time to just one. If you plan ahead and stay focused, it need not be overwhelming. You can do this!

Cocktail Investing Bottom Line

Just as you take care of your health with regular medical and dental checkups, mixed with eating right and regular exercise, so, too, does your investment portfolio need regular care and monitoring. Conditions in the global economy change over time, as does the political landscape and the prevailing narrative, particularly if a new disruptive or enabling technology is poised to unleash creative destruction on a particular industry or three. Just keep paying attention the way we've discussed throughout this book and you'll find it all becomes like riding a bike.

• In addition to monitoring government supplied data, to stay up to date and informed, be sure to track other indicators such as customer, supplier, and competitor press releases, financial filings, and other commentary such as conference presentations to help you put all the investing puzzle pieces together to determine if a Cocktail Investing trend is heating up or cooling off.
• Be diligent in your reading of various business periodicals, financial news websites, and industry trade publications to stay abreast of the prevailing narrative, all the while looking for confirmation as well as potential changes in the vector and velocity for both your Cocktail Investing Thematic and your corresponding investment(s).
• Monitor movements in your investments against the Cocktail Investing Thematic data points you are tracking (obesity levels, average household income levels etc.) as well as the valuation framework to determine if you should be holding steady, scaling into the security position, or trimming back.
• When monitoring your investments, do not fall in love with them, as emotional attachments to stocks tend to hinder investment returns rather than help.

Cocktail Investing Final Thoughts

• You will make mistakes. Even the greatest investors in the world experience surprise losses. It happens and you should treat them as learning experiences, rather than beating yourself up over them and fearing trying again. Figure out what you did that didn't work, know that the best of the pros have had whopping mistakes as well, and move on.
• Not all your investment decisions will work out the way you think. Investing is all about probabilities. There are no guarantees. Know when to cut your losses and move on.
• Do not fall in love with your holdings. We have seen this happen time and time again, with people hoping, believing, and in some cases trying to wish their stocks higher. Stick to what the data tell you.
• Do not buy your entire stock position at once. Ease into it and build it out across two to three transactions, depending on the net upside to be had. We like to use pullbacks to scale into or build out our position size because it helps improve our average cost basis.
• Do not put all your eggs in one basket. For every thematic tailwind, there are a few ways to invest in it; you just might have to wait for the right net upside to emerge.
• Try to focus on areas that really draw your interest, and don't forget to have fun along the way. Investing can be frustrating when you are searching for data that you think are available but can't locate. The more interested you are in the particular investing theme, the less annoyed you'll be by the bumps along the way. That's why we recommend you begin with one of the Cocktail Investing Themes you find most interesting.
• Visit us for more tips and information at CocktailInvesting.com!

Cheers, and here's to a successful investing life!