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This show last aired on May 2.
NEW YORK (
TheStreet) -- "Investing isn't easy, but it doesn't have to be mystifying," Jim Cramer told
"Mad Money" viewers Friday. He dedicated the entire show to helping translate Wall Street gibberish into plain English for individual investors.
"Secular" and "cyclical" are two important ideas that go hand in hand. Cramer explained that cyclical companies need a strong economy to grow. Think steel, machinery and chemical stocks.
Secular growers, on the other hand, keep growing regardless of the economy. Cramer said these are companies that make anything you eat, drink, smoke, brush your teeth with, or use as medication.
Why are these distinctions important? Cramer said it's because they help determine how much a company will earn in a given environment. He said the hedge fund playbook was written on buying and selling these powerful trends.
This is why the philosophy of buy and hold is silly, he said. Why would anyone want to hold onto a stock that's out of favor? During times of recession investors need to sell the cyclicals and buy into the secular names. When the economy is recovering, it's time to sell the seculars and jump back into the high-growth cyclicals.
An Important Metric
Cramer's next took on the different metrics used to value a stock. He explained that when you buy a stock, you're actually buying a small sliver of that company's earnings. By owning a stock, he said, you're betting those earnings, or the multiple the market is willing to pay for those earnings, is going up.
Cramer said there's no magic to price earnings, or P/E, multiples. The price of stock is equal to its earnings times the multiple. That's it. Of course, both the earnings and the market's multiple on those earnings are always changing, but the formula remains the same.
The market is always drawn to growth, said Cramer, and that's why faster-growing stocks often fetch higher multiples than slower-growing ones. To determine how fast a company can grow, investors need to dig for clues in its quarterly reports.
Cramer said he's always interested in a company's top-line growth, or how much revenue it generates, as well as its bottom-line profits. He said the markets always pay up for accelerating growth, growth that is speeding up quarter after quarter. Gross margins, the amount of every dollar a company turns into profits, is also another key metric to consider.
Cramer said the only way to truly compare stocks is to look at the multiple, the earnings, the growth rates and how well the top line, bottom line and gross margins are doing.
Next on Cramer's agenda, "risk-reward," a term that permeates much of Wall Street. Cramer said this term is nothing more than comparing the possible upside gains of owning a stock against the possible downside risk.
To determine the risk-reward of a stock, Cramer said you need to understand two types of investors -- the growth investors who are willing to pay up for the stock, and the value investors who will swoop in as a stock falls and gets cheaper.
Cramer said the reward is determined by the growth investors, while the downside risk is determined by the value investors. He said one quick and dirty rule is that a stock is cheap if it falls below one times its growth rate, but is too expansive over two times its growth rate.
For example, if a stock trades at 20 times its earnings and it has a 10% growth rate, it probably won't go much higher. But if the same stock falls to a multiple of 10 times earnings, then it probably won't fall much lower.
Cramer said pegging a stock's multiple to its growth rate is a quick and effective tool in determining its risk-reward. You must know what you own, he said, and know what others will pay for it.
Trade vs. Investment
Next, the difference between a trade and an investment. Cramer said that on the surface these terms might seem identical, but in fact they're very distinct.
Cramer explained that when you buy a stock as a trade, you're buying it for a specific short-term catalyst, some anticipated future event that will drive the stock higher. This event may be a company's quarterly earnings, or it may be news driven, like a regulator approving a drug.
In either case, the plan is to buy a stock ahead of the catalyst, and sell it afterward. Once that window closes, however, Cramer said investors must sell their trades, good or bad.