Sneak Preview: Commodities Are Special Cases

Making substitutions here is a recipe for disaster, from Cramer's new book.
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6. Not all companies that produce commodities are as interchangeable as their products.

When you look over a group of oil producers, or copper producers, or nickel producers, or rock producers, you should have a natural tendency to think that all of the stocks are pretty much the same. They all do the same thing, and the product they produce is totally undifferentiated. After all, what's the difference between a ton of iron ore from one company and a ton of iron ore from another company?

This kind of thinking is wrong. It's gotten me hurt in the past, and it could get you hurt in the future. Companies aren't just boxes that turn inputs into outputs and generate profits. Even commodity companies don't work that way. There are just too many ways for an oil company or a mineral company to screw up what should be an easy, profitable process.

That's why you can't treat commodity companies like the commodities they produce, as interchangeable products. You have to differentiate between the good, the bad, and the ugly, even in business where you'd expect all companies to look pretty much the same. If you make the assumption that all oil and gas companies or all mineral companies are essentially the same, then you'll end up holding the worst ones and losing money hand over fist.

I had to set down this commandment after I got

Energy Partners

(EPL)

dead wrong. I got behind Energy Partners on April 13, 2006, when it was trading at $24.35. Energy Partners is an oil and natural-gas exploration and production company, but it's tilted heavily toward exploring for new oil in the Gulf of Mexico.

I said that Energy Partners was one of the cheapest exploration and production stocks out there. Because of its heavy exposure to the Gulf, Energy Partners had been beaten up by Hurricanes Katrina and Rita, which had hurt their business in the last quarter of 2005 and the first quarter of 2006. But Energy Partners had put the hurricanes behind them, or so I thought, and they were ready practically to print money finding new oil. Boy was I ever wrong.

By June 13, just two months after I'd recommended the stock, it was bottoming at $17.67 a share, down well over 25 percent from where I'd initially backed the stock. Ultimately, if you hung out long enough, you made your money back when EPL got a takeover bid. But that's all you got. The bid came in right where I recommended it, so you got all the angst and none of the upside.

***

When a stock is cheap, it's usually cheap for a reason. Energy Partners wasn't cheap just because Hurricane Katrina had done a lot of one-time damage to the company. It was cheap because it was a poorly run company that couldn't execute.

***

Bad management teams can hurt you by making bad decisions. Just because Energy Partners produced a totally undifferentiated product didn't make it the same as every other oil and gas company. If I had been more willing to believe that these companies were all different, and that there was a lot a bad management team could do to screw things up, I never would have recommended this stock.

I made the same mistake on July 21, 2006, although without the same disastrous results. I recommended both

Vulcan Materials

(VMC) - Get Report

and

Martin Marietta Materials

(MLM) - Get Report

as plays on highway spending because both companies make aggregate, the rocks you use to build roads. What could be more interchangeable than rocks, right?

Once again, I was wrong. Although both stocks went up a lot within the next three weeks, Vulcan Materials went up 12 percent, Martin Marietta up 9 percent as of August 7. Vulcan went up more because it was a different company. It had rocks in California, and California was where most of the big highway spending was coming from. Even though these companies looked the same because they made the exact same product, they were still different, and that difference would have made or cost you money.

When a company producers a commodity, its stock should not be traded or valued like a commodity. Even rocks can be different. Remember, sector analysis is 50 percent of performance, not 100 percent. You need to look at more information about the specifics of a company before you equate it with its similar-looking competitors or you could get burned just as I did in Energy Partners.

Editor's note: This is one of Jim Cramer's 10 Rules from New Mistakes, New Rules: Ten Lessons From My Bad Calls, a special excerpt from his newest book,

Jim Cramer's Mad Money: Watch TV, Get Rich

, in stores now. Check back tomorrow for a new excerpt.

From Jim Cramer's Mad Money by Jim Cramer. Copyright

2006 by Jim Cramer. Reprinted by permission of Simon & Schuster, Inc.

At the time of publication of this excerpt, Cramer had no positions in any of the stocks mentioned.

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