Investing isn't easy, but it doesn't have to be mystifying, Jim Cramer told his Mad Money viewers Thursday. Once you learn the language of Wall Street, knowing the difference between a cyclical and a secular stock, and how to spot a sector rotation, will come naturally. In fact, anyone can manage their own money if they're willing to do a little homework.
The entire financial industry was designed to convince you that investing is best left to the professionals. But the truth is, the pros just want to charge you fees to manage your money. That's why the lingo of Wall Street is so confusing. It's designed to be.
Fortunately, Cramer offered up his financial "Gibberish-to-English" dictionary to help.
The first definition investors need to understand is the difference between a cyclical and secular stock.
Put simply, cyclical stocks do better when the economy is growing. Stocks like Dow Chemical (DOW) - Get Report and PPG (PPG) - Get Report fall into this category. Secular stocks don't need the economy to make money. When you think about secular stocks, think about things you eat, drink or use as medicine. Procter & Gamble (PG) - Get Report and Pfizer (PFE) - Get Report are secular stocks.
As a general rule, when the economy is growing, you can own more cyclical stocks. But when things are slowing, it's best to own more secular names. This is why the buy-and-hold strategy that many financial advisers recommend doesn't always make a lot of sense. You don't have to endure losses, because economic trends can be determined, and you can invest accordingly.
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Plain English, Please
Cramer's second Wall Street gibberish term that every investor must know was the price-to-earnings multiple, also known as the P/E ratio, or just "the multiple." This is a gauge of how cheap or expensive a stock is. Every time you buy a share of stock, you're buying a slice of that company's future earnings. How much those earnings are worth depending largely on one thing -- its growth.
A faster-growing stock, like Chipotle Mexican Grill (CMG) - Get Report, trades for 40 times earnings, while a slower growing stock like PepsiCo (PEP) - Get Report, typically trades for just 22 times earnings.
The thing with multiples, however, is that they're not static. Investors are willing to pay different amounts for a company's earnings depending on market conditions. When they're willing to pay more, we call that a multiple expansion. When they're willing to pay less, you guessed it -- a multiple contraction.
How can you determine what a company's earnings are likely to be in the future? Just look at their earnings report. Look for the top-line revenue, bottom-line earnings and their gross margins for clues. In some industries, like oil, the margins can vary wildly, making it easy to spot the biggest winners.
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Risk vs. Reward
The next definition that needs to be in investors' Wall Street dictionary is the concept of risk and reward. Risk/reward analysis is a staple of short-term stock picking and it simply weighs the potential downside, the risk, against the potential upside, or the reward. Too many people only consider the upside, but according to Cramer, knowing the downside risks are far more important.
What's a good rule of thumb for determining a risk/reward? Cramer said if a stock's multiple is less than its growth rate, it's probably cheap. But if its multiple is more than twice its growth rate, that's too expensive and should be sold.
There's another metric that can help with this calculation and that's the PEG ratio, which is the measure of price to earnings to growth. If a stock's PEG is less than one, it's cheap. More than two, and it's expensive.
If you know what you own and what others will pay for it, you'll be well on your way to investing success, Cramer said.
A Trade or an Investment?
What's the difference between a trade and an investment? Are they the same thing?
Cramer weighed in with his thoughts. He said a trade involves a specific catalyst, or reason, for making the trade. You expect something to happen, or something already has happened, and you expect to respond accordingly. When it does, the catalyst is over and the stock must be sold. Sometimes trades will work, sometimes they won't. Either way, there's only a brief window when you should own it.
Investments are a different animal. They don't have a limited shelf life like a trade. With investments, you're buying for the long term. But that doesn't mean you can buy and forget about it. Investments go bad, too, Cramer reminded viewers, which is why regular homework is always needed to see if the facts have changed.
A Correction and an Execution
Cramer's last lessons for viewers were around the terms correction and execution.
A correction is when a market that's heading higher suddenly reverses course and drops, say 10%, over the course of a few days or weeks. Corrections feel like the sky is falling and the world is ending, but in fact, they're a natural part of a healthy market. Don't get flustered, don't panic and never sell everything, Cramer advised. The bulls always return.
Finally, Cramer reminded viewers that when it comes to picking great stocks, nothing matters more than execution. This may be a subjective term, but a best-of-breed company with a management team that has proven it can deliver results is the best predictor of future results you're ever going to find on Wall Street.
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