What Can Go Wrong? Everything, Part 2

Editor's note: In this multipart series, Jim Cramer will tell you everything that can go wrong with a stock. The trader believes that the post-April market has brought about new soberness and investors need to change their approach. Be sure to check out Part 1, which ran Tuesday.

The worst problem is when a stock stops trading and a company announces that it cannot meet Wall Street estimates. When this happens, you invariably are going to take a beating, but you may not have to, and in some cases, it may mean that the worst is over.

Take a recent preannouncement or "blowup" by Solutia(SOI Quote), a heavily leveraged and cyclical chemical company. The stock was about $12 when it "blew up." The only problem was that analysts had been slashing estimates for weeks on this name. So when the bad news hit, the stock went down a bit and then held. It has since rallied about 20%. How can that be? Because the warning was in the stock.

That's why we pay such close attention when analysts trim numbers. If an analyst trims numbers dramatically, it is usually a sign that a company has signaled at real problems.

Not all blowups are created equally. We care tremendously at Cramer Berkowitz about number bumps that involve even the slightest hint of chicanery or accounting problems. Any time we get one of these, we sell. We sell no matter where and no matter what. We sell because nine times out of 10, that stock will be lower a few weeks from now. As my yellow Post-It says on my quote machine: "Accounting Irregularities =Sell."

A Question of Demand

The second most damaging are blowups where demand is in question. We freak out and usually sell when a company signals that demand has slackened. That's one of the reasons we worry so about the semis. If demand ever slackens and all of the plants of the semi manufacturers are running full out, you are going to have inventory build up. When inventory builds up, companies have to cut the cost of goods to get rid of them. That's how you get giant estimate cuts as companies are now selling fewer chips at lower prices! That's why when a semiconductor analyst cuts an estimate it is often the first of many estimate cuts to come.

The third most damaging is when supply is the problem. Throughout the spring and summer, analysts cut numbers and companies preannounced lower-than-expected earnings because they could not get all of the parts they needed to build the products that they could have sold if they had them. This kind of shortfall can be bought. Eventually those supplies will ease up and the stocks will rally back. This is one of the reasons we still like Nokia(NOK Quote). We think it could do even more business if it could get all of the parts it needs.

Specific Industries

But there are other kinds of earnings blowups for specific industries that are quite serious. Recently Wachovia Bank(WB Quote) preannounced that it could not make the Street's estimates and it was from a sickening combination of loan losses and lack of demand. Financial companies, in particular, have a whole host of problems that can go wrong.

They may have to spend too much money to attract deposits. They may have invested poorly. They may have to pay out more in interest than they get in interest because the short rates are higher than the long rates and mortgages are based on long rates while depositors get paid on short rates. They may have made bad loans that now have to be written off. Because so many of these things can go wrong at banks, these companies tend to sell far more cheaply than other stocks. They sell cheaply because they can miss their numbers because of more than just simple supply and demand.

Retailers blow up fairly regularly in a slowdown. That's because they have anticipated robust times and taken down a lot of merchandise that is now not moving. Again it has to be cut in price to move so earnings go still lower. That's what has happened in a succession of Gap(GPS Quote) quarters and explains its meager stock price.

Be sure to check back tomorrow for more on specific industries in Part 3.

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