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Rule No. 10: Bad Buys Won't Become Takeovers

Editor's note: Jim Cramer's new book, Real Money: Sane Investing in an Insane World , is available in selected bookstores now. As a special bonus to RealMoney readers, we will be running Cramer's "Twenty-Five Rules of Investing." For more about the new book and to order it, click here . Today, we present Cramer's tenth rule of investing. To read about his first rule, click here ; for his second, click here ; for his third, click here ; for his fourth, click here ; for his fifth, click here ; for his sixth, click here ; for his seventh, click here ; for his eighth, click here ; for his ninth, click here .


Nothing's more exciting than a takeover. Nothing's as lucrative. You can put on a lifetime's worth of moves in a day from a takeover. So people go to great extents to try to get them, including buying a lot of bad companies in the hope of catching one takeover.

Funny thing about bad companies: They rarely get bids. In fact, the companies that get bids are great companies with cheap stocks, not crummy companies with expensive stocks. Yet that's what people buy, all the time.

Here's my rule:

Never speculate on companies with bad fundamentals.

The odds are that you will end up owning something that could go down much more than you thought, but that has very limited upside. You can make much more money buying a Neiman Marcus (NMGA), which is doing well and can still get a bid, than you can buying, say, a Rite Aid (RAD), which is doing poorly and is unlikely to get a bid.

Any time I deviate from this rule I get burned, particularly when I approach a stock as a nontakeover story and then the fundamentals go awry and I try to shoehorn it into a takeover story. Take Nortel (NT). After the accounting fiasco, I consoled myself that perhaps the company would be acquired because it was so cheap. That proved to be a sucker's game, because the company simply couldn't put out financials. Maybe one day Nortel will get a bid, but I have a feeling that it won't happen soon enough to make up for the time value of money.

Some people stay in stocks like Sun Microsystems (SUNW), Novell (NOVL) and Gateway (GTW), always thinking that lightning could strike. Meanwhile, if they had moved on, they could have bought high-quality companies that moved up over time and could have done much better.

Where are the fundamentals cheap and the takeovers likely right now? I have to tell you that I would think that the oil and gas plays with the big reserves -- both Canadian and American -- are the place to be. No company is too big to be acquired in the patch with ExxonMobil (XOM) walking around with $28 billion in the bank. I own EnCana (ECA) for my Action Alerts PLUS portfolio, and I bet that one won't be independent two years from now. Or Cimarex Energy (XEC) either, for that matter. These companies are valued too cheaply vs. what they have in the ground.

Remember, though, unlike companies with bad fundamentals that you speculate on, if these go down you don't need to cut and run. If they don't get a bid, you still can win.

And you need multiple ways to win, at all times.

1. Pigs Get Slaughtered 2. It's OK to Pay the Taxes
3. Don't Buy All at Once 4. Buy Damaged Stocks
5. Diversify to Control Risk 6. Do Your Homework
7. Don't Panic 8. Buy Best-of-Breed
9. Defend Some Stocks 10. Don't Bet on Bad Stocks
Check back for more of Cramer's Rules

At the time of publication, Cramer was long EnCana and Cimarex Energy.

James J. Cramer is a director and co-founder of TheStreet.com. He contributes daily market commentary for TheStreet.com's sites and serves as an adviser to the company's CEO. Outside contributing columnists for TheStreet.com and RealMoney.com, including Cramer, may, from time to time, write about stocks in which they have a position. In such cases, appropriate disclosure is made. To see his personal portfolio and find out what trades Cramer will make before he makes them, sign up for Action Alerts PLUS. While he cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to jjcletters@thestreet.com. Listen to Cramer's RealMoney Radio show on your computer; just click here. Watch Cramer on "Mad Money" at 6 p.m. EST weeknights on CNBC. Click here to order Cramer's latest book, "Real Money: Sane Investing in an Insane World," click here to get his second book, "You Got Screwed!" and click here to order Cramer's autobiography, "Confessions of a Street Addict."

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