Stock-Picking, Week 2: How to Pick Contrarian Stocks

Editor's note: The Stock-Picking Training Program is a series of six weekly assignments. Each assignment is based on one of Jim Cramer's lessons in his book, Jim Cramer's Mad Money: Watch TV, Get Rich. To learn how to get a copy of the book for free, click here.

Your second week of stock-picking is the antithesis to your first week. While a good trader likes to go with the flow, long-term investors often score their biggest wins by betting against the conventional wisdom. However, this is easier said than done, because there are many value traps out there (see "Should You Buy It? Ingram Micro a Value Trap"), and it can sometimes be a long, painful battle to be a contrarian . That's why more than just knowing a company's fundamentals , you need to have a feel for the market's sentiment toward the stock and its industry.

Here is a recent example of how Jim Cramer used this methodology: Fannie Mae(FNM) is a government-sponsored entity that keeps the secondary mortgage market liquid, by purchasing loans and providing payment guarantees. In 2004, the Office of Federal Housing Enterprise Oversight (OFHEO) accused the company of accounting errors, leading to $6.3 billion of earnings restatements and the ouster of CEO Franklin Raines and other executives.

When Cramer bought the stock for his charitable trust in April 2007, the most recent financial statements the company issued were from 2004. OFHEO had also placed several restrictions on the company, limiting its growth potential. But Cramer did his homework and believed that analyst estimates for Fannie Mae to earn $5 or $6 a share in 2007 were achievable. And with the stock trading at $59, or just 10 times expected earnings (see P/E ), when the average S&P 500 company trades for 16 times expected earnings.

(To learn more about the Fannie Mae story, check out "Jim Cramer's Stop Trading! Buy Fannie Mae" and "Fannie Mae Completes Restatement.")

So far, this contrarian bet has paid off. Fannie Mae shares are now trading around $65. The company filed its 2005 financials in early May and said it plans to have its government filing up to date by early 2008. Once this happens, the potential increases that the new Democratic-controlled Congress could loosen the lending reins on Fannie Mae. Finally, the company is a potential beneficiary of any future interest rate cuts, which would reduce Fannie Mae's borrowing costs and boost profits.