Portfolio Cocktails

I have accumulated, over the years, a small collection of books devoted to vintage, or retro, cocktail recipes. They make for interesting reading and look nice on the coffee table--and who knows when Don Draper and the boys from Sterling-Cooper might show up, so I need to be ready to shake up some Manhattans and Whiskey Sours for breakfast. One of the volumes is a collection of signature cocktails from famous hotel bars: the Tonga Room Mai Tai from San Francisco's Fairmont; the Bel-Air Bellini from the Hotel Bel-Air in Los Angeles; the Vieux Carre Cocktail from the Monteleone in New Orleans; the Emerald Martini from the Breakers in Palm Beach. Yummy. I'll have one of each! Given my affinity for the nostalgia of cocktail culture, it probably comes as no surprise that I would, sooner or later, get around to drawing a comparison between the art of mixology and the practice of portfolio management. In both cases a successful outcome depends on keeping the ingredients in their prescribed proportions, at times tweaking the recipes depending on individual tastes and what you are seeking to accomplish. So, today we'll take a look at what investors might learn from bartenders.

For our purposes we'll avoid the complex alchemy of the more esoteric concoctions and use as our example the basic vodka and tonic. (The vodka should be Grey Goose, that Nectar of the Gods with which Arthur's keeps me well-supplied.) The first thing we'll point out is the role here of the alcohol--without it this liquid is not a libation. The vodka (Grey Goose, remember) is the key ingredient, but not the main ingredient by volume. That distinction is held by the tonic water, as most civilized versions of this drink would be about one part vodka to two or three parts tonic. The more aggressive growth stocks in our portfolios serve the purpose of the vodka in our portfolio cocktail, as they have the potential to give us outsized returns. Stocks of more established companies, which we also expect to have growth potential but may pay dividends and are likely to be less volatile, stand in for the tonic water, a sort of ballast that gives us some grounding. Now, you may be thinking that, if the aggressive, smaller stocks are the ones with the juice, why not invest solely in them? If the vodka is so special, why not leave out the tonic entirely? Well, that is called a martini. If you drink three martinis, you will end up consuming more alcohol than if you had sipped your way through three traditional vodka and tonics. Where you land between these opposite ends of the spectrum depends on a host of factors, including your risk tolerance, other resources, need for liquid funds, etc. There is no "one size fits all" answer. The risk, in one case, is that you will end up doing pilates demonstrations on the bar at Interim while wearing your underwear on your head, or in the other case that you will suffer a hangover of losses that lingers well beyond the next morning. Invest responsibly.

Like all analogies, this one has its limits, so now we'll look at a few sober examples.We cannot always say precisely what constitutes an aggressive growth stock versus a more stable growth stock, but we can offer some general guidelines. We are not talking about the most speculative stocks that typically trade for less than $10 and are prone to being "all hat and no cattle"--all promise but no profits. They may have a place in some portfolios, but they are analogous to the lime twist in your vodka and tonic or the olive in your martini--use sparingly, in other words. The stocks at issue here tend to be classified as small- to mid-cap, typically defined as a market capitalization less than about $3 billion for small cap, $3 billion to about $12 billion for mid cap. Sourcefire (FIRE, $57), the Internet and database security firm, is clearly a small-cap stock ($1.6 billion), while Disney (DIS, $45) is definitely a large-cap ($80 billion) company. That's clear enough, and we can say that the former is probably a riskier investment than the latter, but that FIRE has more upside potential (as it should, because the potential for reward should increase with risk).

We don't want to make the mistake of assuming, though, that larger always means safer. By definition, a company's market capitalization rises as its stock price increases. The tremendous return in shares of Intuitive Surgical (ISRG, $528), for example, has catapulted the stock into large-cap territory, at $20 billion. It would be foolish to think that ISRG is automatically safer merely because it is more valuable--in fact, its high valuation may make it more vulnerable to earnings growth disappointments and to sell-offs in the overall market. The point is just that successful smaller companies have the potential to become bigger companies and, in the process, reward us with market-beating returns. These companies, in their early years, typically are not covered by very many Wall Street analysts. As Wall Street catches on to their success, the stocks pick up more analyst coverage, and more institutional investors start buying them. This drives their prices higher and gives the investors who bought in early the shot at incredible returns. Small may be beautiful, but it is also risky.

Before investing in any stock, we should perform our due diligence to assess the company's potential and risk. We need to know about the company's debt level, sales trends, margins, potential competitors, and the size of the market for its products. In other words, we need to read the analyst reports so that we understand where we are putting our money. That is true for any individual stock, but what about the task of putting it all together, the portfolio recipe? I find it extremely helpful to consider the dividend characteristics of stocks, and to make this a key part of my diversification strategy. Consider, for example, that if you had just started a business and saw tremendous potential for growth, you would want to take any profits and plow those back into the business. You might even lead a rather austere lifestyle so that you wouldn't have to take any more money than absolutely necessary out of your company. At some point, though, if your company realizes its growth potential, that growth will start to level off, and you might be able to dine on steaks from Lobel's instead of tomato sandwiches. Publicly traded companies that we might invest in also go through life cycles, typically not paying dividends during their earlier years of highest growth. At some point these companies will likely start to reward their shareholders with dividends, and those dividend payments--and especially dividend increases--are a signal of greater stability and confidence in the company's prospects. So, one way to mix the portfolio cocktail is with a civilized shot of high-growth stocks that are not yet in a position to pay dividends, topped off with a stabilizing mixer of more established companies with dividends. The proportions we choose will be determined by a host of factors, generally the risk level that is appropriate for our particular circumstances.

A word of caution is in order here when looking at dividend-paying stocks. Pitney Bowes (PBI, $14), the maker of postage meters and other document-handling and mail-management equipment for businesses, has a current dividend yield of about 11%. Before you start licking your chops over a free lunch, remember that there is no such thing in the market as a free lunch (and certainly not a free cocktail). A stock's dividend yield is the annual dollar amount of the dividend divided by the stock's current price. There are two ways for this yield to go up: an increase in the dividend itself, or a decline in the stock price. Technology is consistently chipping away at PBI's core business, and the company is a candidate for "value trap" or "bear trap" status. The dividend payout ratio is a high 75%. The better approach to dividend stocks, in my view, is to seek out companies with good growth prospects that offer a modest dividend yield with a reasonable dividend  payout ratio, especially those that have a strong history of dividend increases. The fact that a company pays a dividend at all may be more important, when mixing the cocktail, than the dividend yield itself.

Here is a list of growth stocks chosen from our Radar Screen, in descending order of market capitalization:

Growth Stocks with Dividends


Coca Cola (KO, $75); 2.70% yield; $170 billion market cap
McDonald's (MCD, $91); 3.06% yield; $93 billion market cap
Walt Disney (DIS, $45); 1.35% yield; $80 billion market cap
CVS/ Caremark (CVS, $45); 1.44% yield; $57 billion market cap
Starbucks (SBUX, $55); 1.25% yield; $42 billion market cap
Nike (NKE, $111); 1.34% yield; $40 billion market cap
Costco (COST, $86); 1.30% yield; $36 billion market cap
TJX (TJX, $41); 1.12% yield; $30 billion market cap
Whole Foods Market (WFM, $89); .65% yield; $16 billion market cap
Ross Stores (ROST, $63); .90% yield; $14 billion market cap

Growth Stocks without Dividends


Cerner (CERN, $80); $13.5 billion market cap
Monster Beverage (MNST, $73); $12.6 billion market cap
Dollar Tree (DLTR, $102); $11.8 billion market cap
Watson Pharmaceuticals (WPI, $74); $9.3 billion market cap
Lululemon Athletica (LULU, $74); $8 billion market cap
Verisk Analytics (VRSK, $48); $7.9 billion market cap
Hain Celestial (HAIN, $57); $2.5 billion market cap
Ultimate Software (ULTI, $82); $2.2 billion market cap
Liquidity Services (LQDT, $63); $2 billion market cap
Sourcefire (FIRE, $57); $1.6 billion market cap

Cheers!

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of DIS, FIRE, ISRG, MCD, KO, NKE, CVS, SBUX, WFM, ROST, TJX, COST, HAIN, ULTI, VRSK, LULU, DLTR, WPI, CERN, MNST, and LQDT. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing staed here should be construed as investment advice or the recommendation to buy or sell any security.

Tomorrowland

Most parents who have ever taken their children to Disney World would probably agree with my observation that it is one of those experiences where when the vacation is over, you feel like you need a vacation. Any adult relaxation on such a trip may just be exhaustion by another name, but I still wouldn't trade my times there with my children for anything. The long lines and multiple excursions on the It's a Small World ride were worth every minute (and the indelible tune weeks later), just for the memory of my kids' joy and excitement. And even though the adult beverages are served in EPCOT, my favorite part of it all remains The Magic Kingdom. It was there in Tomorrowland that a different sort of memory became lodged in my mind. Tomorrowland is supposed to show visitors what life will be like in the future, but it came off as more retro than futuristic--something right out of The Jetsons cartoon. I am sure this area has been re-imagined and redone at least once since the late 1980s, but at that time it looked to be exactly what it was: a representation of how imaginative minds of the 1960s and 1970s had conceived of a technological future. Why is it that conceptions of the future, especially where technology is concerned, so often miss the mark?

First, the most obvious part of the answer is that imagining the future involves predicting what tomorrow will be like, and even the most logical projections of a technological path are prone to major errors. The other part of that answer, which concerns us as investors because investing does involve assessments of the future, is that people who design exhibits, write books, and make movies about the future typically are not concerned with matters of economics. (This is a good thing, because the Star Trek saga would be far less compelling if the story were all about how investment bankers put together the financing to build the first U.S.S. Enterprise.) The most exciting visions of the future are not likely to materialize if they don't make the economic sense needed to lure investment capital. This is why we are not all driving around with solar panels strapped to the roofs of our cars. A world of green energy would be nice, but the price of gasoline would have to be much higher--probably high enough to wreck the economy first--for any major shift to occur. The increased supply of natural gas attributable to new drilling technologies (fracking) has caused the price of natural gas to plummet, and that has made this fuel source more appealing economically than other alternative energy solutions. Our cars are probably going to be running on stuff that comes out of the ground for a very long time.

Thirty years ago a popular notion of future communications involved all of us having video phones on our desks. Instead we have smartphones that are more advanced than Captain Kirk's communicator. What used to travel over the airwaves (television) now predominantly comes through a wire (cable), and what once came through a wire (telephone service) now just as commonly comes over the airwaves. It's not just a matter of the proverbial "better mousetrap," but also a question of an innovation that works commercially. As investors, we need to take a hard look at what ideas and visions are attracting investment capital. In other words, we always need to follow the money.

Companies have always sought to find more effective ways to pitch their products and services to potential consumers. Budweiser, for example, may spend millions of dollars on a Super Bowl ad, and that's probably a good investment because lots of football viewers are also beer drinkers. One of the early examples of more targeted marketing and advertising was born when household products companies like Proctor and Gamble realized that many women were home during the day, and the soap opera was born, first on radio and then television. Companies love to reach that narrower, more well-defined audience of people who actually are the most inclined to purchase their products. Now, the goal of reaching that narrower audience is abetted by technology. Every time we swipe our debit card or conduct a Google search, we leave permanent footprints in cyberspace. These data trails contain patterns and correlations that can by identified and interpreted by computer software and used as a predictor of future behavior. Vivek Ranadive, the CEO of TIBCO Software (TIBX, $29), was on CNBC recently explaining how the firm's software is used in a casino to identify when gamblers have had a losing streak. This alerts someone on the staff to give that gambler some reward, such as free tickets to a show, to keep that person from leaving the casino. So, the capability here is not just about analyzing data after the fact, but also in real time. This is what is known as data analytics.

An article in The New York Times Sunday Magazine detailed how Target has discovered that women who are in the very early stages of pregnancy tend to purchase certain items--not diapers or strollers as you might assume, but something seemingly unrelated like coca butter skin lotion. This information allows the company to send these future mothers promotions for things like diapers and other newborn-related products, with the idea of getting them in the habit early of shopping for all of their baby needs at Target. The story relates how a man called Target irate because his teenage daughter had been receiving promotions from the retailer for various baby products. The manager who took the call apologized, only to have the man call back weeks later to apologize himself, as he had just found out that his teenager was, indeed, pregnant. All of this may have you squirming with the realization that Big Brother has you under his watchful, ubiquitous eye (think twice before you post those bachelor party pictures on Facebook). For our purposes, though, the simple lesson is that companies will spend money on products and services that either reduce their costs or increase their revenues. The precise nature of the future may be cloudy, but the contours are taking shape around the collection, storage, and analysis of "Big Data." Companies have been collecting such data for years, but what is new is the ability to make smarter and faster use of such information to make better decisions.

The business of Teradata (TDC, $69) is all about data warehousing and enterprise analytic technologies. Earlier in May the company reported earnings of  $.60 per share compared with a consensus estimate of $.56, with revenues coming in at $613 million versus an expected $587.52 million. The company also raised revenue growth forecasts to the 12%--14% range from a previous 10%--12%. Several investment firms raised their prices targets, which now range from $87 to $91.

The other part of the larger trend here involves the migration of computing power and storage to what is commonly known as "The Cloud." As we have noted before, just as computer power moved from the central mainframe to the desktop, that is now tending to move towards a network of servers, so that what once was installed and stored on your personal computer is now moving "out there" to the cloud. Ultimate Software (ULTI, $79) is involved with what is known as Software as a Service, or Saas. They offer businesses online payroll processing services, so that this business function can now be handled over the Internet rather than with software on the company's computers.

Another technological development that seems firmly based in reality is the emerging trend in mobile payments. As we have noted before, Visa (V, $118) acts as a toll collector in processing transactions; the company does not take credit risks. Of course, when there is less traffic on the highway, not as much money will be collected in toll fees. So, the one thing we need to remember about Visa and other "toll collectors" is that their business will rise and fall with the level of economic activity. Another interesting company in this space is PayPal, which is now part of eBay (EBAY, $40). According to Argus Research, PayPal will be coming out with new features that will allow shoppers to store coupons, gift cards, and loyalty points on their mobile devices for use at the point-of-sale. The company will be able to integrate customer purchase data with its geo-location service, Where, to target customized offers to people based on their location. And, you will soon be able to pay for your purchases before you arrive at the store. Also worth noting here is that Verifone (PAY, $45) makes the in-store terminals for processing transactions.

No matter how compelling or attractive the vision, no one can will or dream a successful enterprise into being. To acknowledge the key role of investment capital and economic calculations is not meant to throw cold water on utopian dreams of the future, but such realistic thinking can serve as a means of separating what sounds appealing from what actually works. You may not have a robot to cook your dinner, but you may be able to preheat your oven using your iPhone. More important, the latest technological innovation and application may not be a gadget you hold in your hand, but instead something lurking in the background that is keeping tabs on your shopping patterns--and ringing the cash register for businesses.

Checking the Radar Screen

All of these collections of data need to be protected, and that is the business of Sourcefire (FIRE, $54), which specializes in Internet security. The company reported earnings of $.11 per share versus an estimate of $.08, and the stock has been holding up relatively well in a very challenging market environment.

Disney (DIS, $44) reported earnings of $.58 per share, ahead of the $.55 estimate, and this is another stock that is holding its own in this tricky market. The Avengers is a blockbuster hit for the company's Marvel unit.

As of mid-day Wednesday, the yield on the 30-year Treasury stands at 2.83%, with the yield on the 10-year at 1.74%.

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of TIBX, TDC, ULTI, V, EBAY, PAY, FIRE, and DIS. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.

Facebook: Where Narcissism Meets Voyeurism

My wife and I have, hanging on our living room wall, a framed, limited edition serigraph of Thomas McKnight's Narcissus (pictured above). McKnight, in his unique, colorful, and whimsical way, depicts his version of Narcissus in the process of falling in love with himself. As legend has it, of course, Narcissus became so enamored of his own reflection in the water that he went after it and drowned. With Narcissus so close at hand, I have been thinking about Facebook--not just the stock, which we'll get to in a moment, but really the cultural phenomenon--and how it appeals to two aspects of the human psyche, the narcissistic impulse and the voyeuristic impulse. We love to have people pay attention to us, so we tell our Facebook friends the various minutia of our lives, from how we brushed our teeth that morning to the cutest phrase our child has just uttered. And we love to peer in on the lives of others, fascinated to know (if not particularly enthralled by) the details of their comings and goings ("Joe just checked in at Hooters!"). We get to be both performer and spy at the same time. This is the genius of Facebook, that the company has tapped into these two undeniable and immutable parts of human nature. This nexus of narcissism and voyeurism is a marriage made in heaven--or at least made in Menlo Park, California, where Mr. Zuckerberg stood to ring the NASDAQ's opening bell Friday to herald FB's first day of trading.

Another part of human nature is our attempt to understand something new by comparing it to something more familiar, and here the investment commentators and prognosticators have been falling all over themselves and gushing forth analogies. Is Facebook like Amazon? I have made the point here before that Amazon is a technology company only in the sense that FedEx is an airplane company. Both Amazon and FedEx made innovative use of existing technologies to redefine their respective businesses, the former in retail and the latter in delivery services. I don't know about you (although I might, thanks to Mr. Zuckerberg), but I don't go to Amazon's Website unless I am shopping or intent on purchasing something, such as all past seasons of Mad Men. The same could be said of Google, although you are reading this as part of their services. What about more traditional advertising media? My wife and I contribute to CBS's blockbuster ratings with our loyal viewing of Hawaii Five-0, NCIS, and CSI, but with those shows going into summer reruns, my lovely bride and I will more likely be spending our evening hours sipping beers on our Buzz-Free patio. Broadcast television, of course, is not interactive, although my parents used to get me to be quiet and sit still by telling me that the people on television could actually see me (I caught on to that by the time I was six, and it is too late to call Child Services). The problem with comparing Facebook to anything else is that the comparisons at hand, at least when it comes to where our eyeballs are focused, are all purpose-driven. No purpose, no eyeballs. I think that the proper analogy for Facebook is with (are you ready, drum roll).....the telephone!

Think back to the early days of widespread telephone usage, and imagine Grandma picking up the receiver to dial (yes, youngsters, people actually had to dial the numbers on a rotary device) her friend's number, maybe to discuss FDR's latest Fireside Chat. Now, what if, once Grandma had placed the call, she had to listen to an audio advertisement before connecting with her friend? It might be a voice telling her that a new Cadillac would be her smoothest ride, or that Tide detergent would get her clothes the cleanest, or that "Winston tastes good, like a cigarette should." Had the business model developed that way, the trust-busters would have gone after Ma Bell much sooner, as AT&T would have been printing money faster than you could say, "Facebook Timeline." Now we are getting to a more meaningful comparison. The telephone, leavened here with a little imaginary advertising, was the essential interactive technology of the last century. You may say that phone conversations are also purpose-driven (apologies to Rick Warren), but they are so in a different way. We don't have to be in the mood to shop, search, or watch a crime show to engage Facebook. All we have to do is what comes as second (or maybe first) nature, which is to connect with other human beings. Facebook is just the evolution of this connectivity, from smoke signals to letter-writing to phone calls to friending. YouTube is not "broadcasting yourself." Facebook is.

As for the investment side of this, we go back to one of our fundamental rules, namely that a great company does not necessarily make for a great stock. In this case, we are not even sure we have a great company on our hands, but we do have--and this is not hyperbole--the greatest idea in the history of the modern world. Yes, it is that big. Nine hundred million active users disclosing their like and dislikes--an advertiser's orgy. Don Draper, what would you have done with this? As for value, any asset's worth is determined by its ability to generate a profit. Mr. Zuckerberg's company--now our company if we are shareholders--will not only have to prove itself by generating massive revenue, it will also have to bring that revenue to the bottom line. Execution is key, and that is the challenge of all great ideas. We'll look at that notion more in the next post.

As Mr. Zuckerberg was ringing the opening bell Friday, CNBC's Jim Cramer asked whether most people would be proud of him or jealous of him. I am proud of him, and I am proud of what an individual with a powerful idea and investment capital can accomplish in this country. This is a textbook case of wealth creation, the stuff of dreams and jobs and prosperity and economic and cultural progress. Another commentator complained that Facebook would not create jobs the way a company like General Motors once did. Nonsense. Give that man a rotary phone and some vinyl records. And then tell him to shut the hell up.

Life is short. Get busy.

Jim


Disclosure/Disclaimer: My family members and/or I own shares of FB and CBS. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.

Can You Say, "Monster"?

Last week (Monday, April 30th) The Wall Street Journal reported a story on the wires that Coca Cola (KO, $77) was in talks to acquire Monster Beverage (MNST, $66.74). Shares of MNST shot up from about $65 to $83 as the news circulated, but before the close of trading KO said that they were not in such talks. MNST fell right back to about where it had started the trading day. A fundamental rule of investing is that we should never buy a stock on takeover speculation alone, and I will always adhere to that. This case, though, offers us some insights about what happens when a company is bought out, and we can draw some conclusions about why MNST might be a logical takeover candidate.

The first point of interest is that more than one research analyst responded to the story by saying that Monster could go out (be bought) at somewhere between $84 and $100 per share. That is not surprising, really, because when one company wants to take over another one, the acquirer has to pay the shareholders of the target company a premium price. This takeout price is typically going to be substantially higher than the target prices analysts place on stocks, because such target prices are based on the company's projected worth as a going concern, not on the price another company might pay. Also, MNST is no beaten up stock that a bigger company might opportunistically pounce on to buy it on the cheap. MNST is up some 41% year to date and up more than 100% over the past year. Even with this move in the stock and its current price-to-earnings multiple of 43, the analyst community still considers that the company is worth even more to a suitor such as Coca Cola.

Why would Coke want to buy Monster? For one thing, the traditional soft drink business is mature, and even with the potential of growth internationally, this is just not a high growth business. One part--maybe the only part--of the beverage sector that is growing impressively is the energy drink category. Remember what was going on with Diamond Foods last year, before the accounting fiasco that caused the stock to implode? The stock soared at the prospect of the Pringle's acquisition. Investors love the steadiness of the food and beverage sector (consumer staples), but it just doesn't offer tremendous growth. So, when a business combination comes along that could ignite much higher growth, investors get all excited and knock themselves out buying the stock. This is by no means a suggestion that MNST will ultimately be bought by one of the big players, but that possibility is certainly not hurting the stock price. One lesson here is that growth is worth a premium, just an even higher premium if a company is bought out. If--a big IF, now--Coke or some other company were to buy Monster for $90 per share, that would be about 58 times current earnings.

Monster Beverage was once known as Hansen Natural, a company started by Hubert Hansen in the 1930s to sell fresh, non-pasteurized juices to film studios and retailers in Southern California. The company went through several names changes, and their natural sodas have been available in health food stores such as Whole Foods Market for years (I have always liked their Black Cherry flavor). When energy drinks became such a major part of their business, they changed the name of the company to Monster Beverage. You ought to see my wife whiz through the Dollar Tree after she's knocked back a couple of cans of this stuff. I am especially fond of their Rehab drink, which combines the energy formula with two of my favorite (non-alcoholic) beverages, iced tea and lemonade.

Elsewhere in the food and beverage sector, Hain Celestial Group (HAIN, $50.27) reported great earnings last week of $.54 per share versus an estimate of $.50; their full year earnings view is now $1.76 to $1.80 per share, with the consensus at $1.73. The stock rose $2.96 Friday to close at $50.27, bucking the market sell-off. Hain is a manufacturer and marketer of  natural and organic food products, with brands including Earth's Best, Celestial Seasonings, Garden of Eatin' (love that name), and Arrowhead Mills. Here again we have a company that is thriving in a higher-growth niche of a larger sector that is showing much slower growth. The projected growth in earnings for Hain is about twice that of Kraft, for example, and Kraft is splitting into two companies to unlock value for its shareholders, with the higher-growth snack business trading as a stand-alone company. Hain's products are a mainstay on the shelves of health food stores, and we don't want to forget who owns a lot of those shelves, Whole Foods Market (WFM, $89.96). WFM reported earnings last week of $.64 per share; the estimate was $.59. They raised their full year earnings view to $2.44--$2.47 from $2.28--$2.32, and the stock responded by surging about 8%. I think that the trend of healthier eating will be in place for a long time, and it is one that I expect to thrive alongside the success of Taco Bell, Kentucky Fried Chicken, and Pizza Hut, which are all owned by Yum! Brands (YUM, $71.15). That's just another variation of our "Tale of Two Cities" economy investment thesis.

Speaking of monsters, the big monster earnings surprise of the past week was from Liquidity Services (LQDT, $64.17), which clocked in at $.52 per share, blowing away the $.37 estimate. The company raised its full year earnings view to $1.64--$$1.70 from $1.32--$1.38. The stock responded by surging 13% on Thursday and bucked the downtrend on Friday by adding another $1.93. LQDT operates online auctions for the sale of salvage and surplus inventory. They are, in effect, an eBay for the wholesale sector.

Finally, there seems to be a monster of a mess at Chesapeake Energy (CHK, $17.39), and here we have another cautionary tale of the cockroach theory of bad news. I owned CHK during part of last year, until I read the Sell recommendation from Argus Research in November. Any other shareholders who heeded that report would have been spared the 35% decline in the stock since then. The Argus report pointed to the convoluted nature of some of the company's accounting, with particular concerns about its arrangements with its Chairman and CEO. Until all of this is resolved, I have to assume that there may be more cockroaches lurking in the walls.

My advice? Drink some Monster to get your feet moving fast enough to stomp on those cockroaches.

Life is short. Get busy.

Jim

(Wikipedia was the source of the historical information about Hansen.)

Disclaimer/Disclosure: My family members and/or I own shares of MNST, HAIN, WFM, LQDT, YUM, and KO. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as a recommendation to buy or sell any security.

The Trifecta

There are some investors who will contend that the market obsesses and frets way too much over quarterly earnings reports, and that true investors should pay less attention to the parade of financial results every three months and focus instead on a company's fundamentals and long-term prospects. I strongly disagree with that view, for two basic reasons. First, investors should pay attention to anything that moves a stock's price. If we were to discover a meaningful correlation between a stock's price and lunar eclipses, hemlines, or the performance of the Ole Miss Rebels football team, we should pay attention to those things, too. Second, the two approaches are not by any means mutually exclusive. Investing is all about what is going to happen in the future, and stock prices represent a particular assessment of that future. The quarterly reports cards are a vital source of feedback for whether those assessments are too optimistic or too pessimistic. If a company's sales, earnings, and margins are growing faster than expected, the stock is likely to move up--and vice-versa. While we do not want to make immediate buy or sell decisions based only on the earnings report, we do need to factor that information into our overall investment thesis for the company, at least as a way of squaring our own assessments with reality. Remember that hubris can be an investor's worst enemy, so don't start thinking that you are smarter and cuter than everybody else, or that you are right and the market is wrong. That's a sure way to get your head handed to you.

As we will see in the examples that follow, a company has to hit a virtual trifecta with its earnings report in order for its stock to react favorably. First, the so-called "headline number," or the actual earnings per share result, needs to exceed expectations. Second, the sales and margin results need to strike the right balance. If too much of earnings growth is coming from profit margin expansion, that can be a red flag because the company can reduce costs only so far--true growth companies need impressive top-line growth. If margins are slipping, though, that can be a sign that the company cannot pass along higher input costs or that it is not being managed efficiently. Third, and back to the future, what a company has to say about its prospects going forward, what is known as "guidance," needs to reflect a positive outlook. Here are some recent results from companies on our Radar Screen.

Tempur Pedic (TPX, $57) reported earnings of $.86 versus an estimate of $.84, but first quarter revenue was below forecasts. The stock has fallen more than 25% since the report. Furthermore, the company committed the unpardonable sin of forecasting a full fiscal year outlook of $3.80 to $3.95 per share compared with a consensus view of $3.97, with the report lacking any upward revision to guidance. Why such a dramatic decline in the stock? Well, TPX, like many other high-growth stocks, has been on a tear since the beginning of the year, rising more than 60%. As we have noted before, an expectation develops that such stocks will exceed the earnings estimates by a wide margin, and this is known as the "whisper number" of expected earnings. The stock advances strongly as this true expectation is built into the price of the stock, and even the slightest disappointment can send shares tumbling. Also, we need to consider the nature of the company's business. If your son or daughter has just graduated from college and you are being the proud and generous parent who is going to help him or her furnish that first apartment, a Tempur Pedic mattress is probably not on your shopping list. No, you are likely to shop for that first mattress at one of the discount warehouses. Such high-end bedding is usually purchased by people who are upgrading from their old box-spring product. This is why TPX is not as dependent on the housing cycle as would be the case for a maker of mass market appliances or furniture. That distinction is what has allowed TPX to be a growth, rather than a cyclical, stock. TPX, though, is not the only maker of nicer mattresses (Select Comfort is another), so the modest outlook that the company offered just fed those fears about competition. TPX is also bringing out a new line of lower-priced mattresses, and that has some investors concerned about cannibalization of the company's signature offerings.

Stanley Black and Decker (SWK,$72) reported first quarter earnings of $1.09 per share, shy of the $1.13 estimate; revenues actually came in ahead of estimates. The stock began the year at around $67, rallied up to around $81 in March, and was trading at $78.49 going into the earnings report. The earnings miss sent the shares down to the $72 range. The decline in the share price was less severe than what we saw with TPX, which is more of a momentum stock that had shown major gains prior to its report. The investment thesis for SWK appears to be essentially intact, with the company noting that it now sees annualized cost synergies at $485 million versus the previous forecast of $350 million.

QUALCOMM (QCOM, $62) reported earnings per share of $1.01, ahead of the $.96 estimate, and revenues were also above forecasts. The company noted, however, that it is having some issues with supply constraints, as its foundry partners are having trouble manufacturing enough chips to meet demand. That is actually one of those "good" problems to have, and it reflects the continuing strong demand for smartphones. However, this may mean some weakness in results for the current quarter, although the company actually raised its full-year earnings outlook to $3.61 to $3.76 from $3.55 to $3.75. Goldman maintains its Conviction Buy rating and price target of $76.

Yum! Brands (YUM, $71) reported earnings per share of $.76, beating the consensus of $.73, with revenues also exceeding expectations. Investors have been focusing on the company's growth in China, which has been making up for weakness in its domestic Taco Bell segment. Now there are concerns that China growth may be moderating, but that is being offset now by a rebound in the U.S.

Cerner (CERN, $81), whose products and services bring technological integration to the healthcare sector, reported earnings of  $.54 per share, compared with an estimate of $.50; revenues came in at $641.2 million versus an estimate of $578. 39 million. The company also raised their full-year view for earnings.

GNC Holdings (GNC, $38), the retailer of nutritional supplements once known as General Nutrition Centers, reported eps of $.60 versus an estimate of $.52; revenues were $624 million compared with the forecast of $589 million. The company raised their full-year earnings projection to $2.05, compared with a consensus of $1.93. The stock pulled back when the FDA issued a safety warning about dietary supplements containing dimethylamylamine (DMAA). GNC contends that the product is safe, but even in a worst case scenario where the product is removed from shelves, consumers are likely to substitute another performance-enhancing offering. The supplement in question does not make up a meaningful amount of the company's sales.

Titan International (TWI, $28), a maker of wheels and tires for the agricultural, earthmoving/construction, and consumer sectors reported earnings of $.78 per share versus an estimate of $.52; revenues were $463 million versus a forecast of $429 million.

Chipotle Mexican Grill (CMG, $409) reported quarterly earnings of $1.97 per share, versus an estimate of $1.92; revenues were $640.6 million compared with a forecast of  $630.92 million.

Las Vegas Sands (LVS, $55) reported earnings of $.70 per share versus an estimate of $.60; revenues came in at $2.76 billion versus the $2.62 billion forecast. The story here is all about the continuing strong growth in the Macau market, plus the company's other planned expansions internationally.

What are some "take-aways" from these earnings reports? First of all, stocks have had an incredible run since the end of last year, and those gains have left shares especially vulnerable to profit-taking. When there is the slightest whiff of something even remotely negative--when an earnings report does not hit a perfect trifecta--we can expect a sell-off. Companies that are best positioned to bounce back are those with exposure to solid long-term growth trends that may be suffering through some sort of temporary challenge or setback. QUALCOMM would be an example here. Of course, the company has to demonstrate that it is growing sales and managing that growth effectively. As for valuations, a company that is growing at 25% per year can trade at a price/earnings ratio of 50 (Chipotle, for example; a good rule of thumb is that the p/e ratio should not be more than twice the growth rate), but if anything is perceived to put that growth in jeopardy, look out below.

Investors are conditioned to "buy low and sell high," so it is tempting to think that a dramatic decline in a stock's price is an automatic buying opportunity. That is not always the case, so we have to evaluate stocks on a case-by-case basis to understand what exactly is causing the stock to go lower. Of the stocks mentioned above, I would have the most concern about Tempur Pedic. Yes, the stock has fallen significantly since the earnings report, but the issue here may have more to do with investor perceptions. Investors became accustomed to the company reporting exceptional results, and expectations of this pattern were built into the stock. If any of that is indeed broken, the stock may not return to its glory days. We see a very different case with Cerner, which did hit the trifecta with its report. The stock had been trading around $78, rallied to $84 following the earnings report, and is down to around $80 in Friday's broad market sell-off. The investment thesis for Cerner is still very much intact, so the stock's decline in a bad market is a case of the "baby being thrown out with the bathwater"--good stocks get taken down along with the not-so-good ones, and that makes for one of my favorite buying opportunities. The important distinction to make is between a decline that is company-specific, which can constitute a red flag, and a decline that is just the result of an overall market sell-off.

Finally, all of this serves to underscore the importance of diversification. If we do our homework and apply a disciplined investment methodology, we can find stocks that have the potential to outperform the market over long periods of time. Those stocks can compensate for the occasional disappointments and negative surprises, but in order for that to hold true we have to own stocks in a variety of companies across different sectors. In other words, never bet the farm on your favorite horse.

We'll look at more earnings reports next time as part of our ongoing reality check.

Life is short. Get busy.

Jim

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The photo at the top of this post is from A Day At The Races, my favorite Marx Brothers movie that is still one of the funniest films I have ever seen. If you want a good laugh, give it another viewing.

Disclosure/Disclaimer: My family members and/or I own shares of SWK, QCOM, YUM, CERN, GNC, TWI, CMG, and LVS. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.