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Editor's note: This show first aired on Aug. 20, 2010.
NEW YORK (
) -- "Investing isn't easy, but it doesn't have to be mystifying," Jim Cramer told the viewers of his "Mad Money" TV show Friday, as he dedicated the entire show to helping translate Wall Street gibberish into plain English for individual investors.
Cramer's first words in the Wall Street dictionary were "secular" and "cyclical," two important ideas that go hand in hand. He said cyclical companies need a strong economy in order 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 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, said Cramer. Why would anyone want to hold onto a stock that's out of favor? During times of recession, said Cramer, investors need to sell the cyclicals and buy into the secular names. And 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 page in the Wall Street dictionary was all about 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 that either 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, that's why faster growing stocks often fetch higher multiples than slower growing ones. To determine how fast a company can grow, Cramer said investors need to dig for clues in its quarterly reports.
Cramer said he's always interested in a company's top-line growth, 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, the term "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 cohorts of investors, the growth investors, who are willing to pay up for the stock, and the value investors, those who will swoop in as a stock falls and gets cheaper.
Cramer said the reward is determines 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 time 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
Cramer's next gibberish item focused on the difference between a trade and an investment. He said 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 news driven, like an FDA drug approval. In either case, the plan is to buy a stock ahead of the catalyst, and sell it afterwards. Once that window passes however, Cramer said investors must sell their trades, good or bad.
An investment on the other hand, is a long-term trading thesis that is not event driven. Cramer said investments are not an excuse to buy and forget however because they can still go wrong. That's why he recommends one hour of homework a week for each stock in your portfolio. As long as your investment thesis is still intact, he said, investors can continue to own their investments.
"Never turn a trade into an investment," Cramer reminded viewers, even if that trade is a successful one.
Cramer's next item in the Wall Street dictionary, the dreaded "correction." Cramer said a correction is nothing more than a roaring market turning around and retreating, sometimes as much as 10%. He said corrections may feel like the end of the world, but panicking is always the wrong reaction.
Cramer explained that corrections are simply what happens when stocks go up too far, too fast. Investors should expect corrections, he said, and not beat themselves up if they fail to see one coming. "We don't have to like them," said Cramer, "but we do need to acknowledge that they happen."
Cramer's final word for the day: execution. He said this is a tough one since it's largely subjective, but execution usually refers to management's ability to follow through on its plans. When you own a stocks, he said, you always run the risk of management screwing up, and not producing what they promised.
Cramer said this is why its always worth paying up for what he calls "best of breed" companies, those with proven track records, and a management that consistently delivers what it says. "You want companies with proven, seasoned management teams," he said, as they're less likely to drop the ball.
-- Written by Scott Rutt in Washington D.C.
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Jim Cramer, host of the CNBC television program "Mad Money," is a Markets Commentator for TheStreet.com, Inc., and CNBC, and a director and co-founder of TheStreet.com. All opinions expressed by Mr. Cramer on "Mad Money" are his own and do not reflect the opinions of TheStreet.com or its affiliates, or CNBC, NBC UNIVERSAL or their parent company or affiliates. Mr. Cramer's opinions are based upon information he considers to be reliable, but neither TheStreet.com, nor CNBC, nor either of their affiliates and/or subsidiaries warrant its completeness or accuracy, and it should not be relied upon as such. Mr. Cramer's statements are based on his opinions at the time statements are made, and are subject to change without notice. No part of Mr. Cramer's compensation from CNBC or TheStreet.com is related to the specific opinions expressed by him on "Mad Money."
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