Editor's note: This is a special excerpt from Jim Cramer's book,
Jim Cramer's Mad Money: Watch TV, Get Rich
. To order your copy and read all the rules, click here.
So let's get to business. To make step one easy for you, I'll tell you how I would break up the market into sectors and then I'll identify industries within each sector. Here's a quick and easy breakup of the economy into sectors, and sectors into subsectors. This should make your job a lot easier. I'm not going to pretend that this is a thorough and canonical way to slice and dice the market, but as long as you're flexible and careful about grouping companies into their respective industries, I'm sure you'll be able to take care of step one easily.
- Consumer goods
- Defense contractors
- Food and beverage
- Health care
- Metals and minerals
- Oil and gas
- Paper and chemicals
These are the big-picture sectors that people usually talk about. Some of them are self-contained and make a lot of sense internally, but some make no sense whatsoever. Tech, for example, isn't really a sector. Tech stocks do trade together -- there's no question about that -- but "tech" is really a twentieth-century designation. There used to be a lot less software, a lot fewer gadgets, and no good way to make money from the Internet. Now all of that's changed. I defy anyone to tell me what
, which makes the vast majority of its money from selling advertising on its searches, and
, a company that makes the machines that make semiconductors, have in common.
On the other hand, autos, aerospace, and defense contractors are much more sensible groupings. There are only a handful of big defense contractors. There are only a handful of big automakers. These companies can be compared easily, and that makes your life easier if you're trying to play your own Lightning Round.
But don't be fooled by this list of sectors. If you know just one great stock for each of the seventeen sectors on that list, you're not ready. Take the financial sector. This includes banks, investment banks, and discount online brokerages -- not to mention savings and loans and credit card companies. Being able to do a Lightning Round means having a feel for each of these subsectors. You should be able to look at the sectors, which represent only so much, and cut them up into smaller industries that are more meaningful.
Transports is another good example. Transports could include trucking companies, railroads, airlines, and any company that services those businesses. These things don't all trade together. ... So when I talk about sector analysis, what I'm really talking about is industry analysis. If you just look at the sector, you won't do enough work, and you won't be able to do a good Lightning Round. Knowing the subsector a company actually is in, and not just the sector that it's a part of, can also help you stay diversified.
I suggest you start with what you know. The odds are good that you're already familiar with at least a handful of industries or subsectors. Unless you're a professional, you're never going to have a handle on even a majority of subsectors, but that's fine because most of the subsectors are too small to matter. This is a situation where you can actually go with your gut for once. You can rely on your intuition, but the best thing you can do is watch the show. You should watch the "Lightning Round." The stocks people call about most frequently will belong to the industries that matter most. Watch and keep track of which industries seem important and large and which ones are rarely asked about. When you notice that an industry is talked about a lot, that's one you ought to rank. Keep watching the show. Once you have at least forty different industries in your head, you know what you think of them, and you know which stocks are best within these industries, then you're ready to do a Lightning Round. ...
Once you have a handle on which industries are out there, you have to figure out what you like and what you don't like. This is actually surprisingly easy -- except with tech. Tech is never easy. It can't be gamed because there's always some new product coming along to wreck all your preconceptions about the sector. But for every other sector, step two is pretty simple. You must form an opinion about each sector.
Virtually every sector is levered to some kind of cycle. Most are levered to the business cycle, by which I mean the business cycle in America, since most of the stocks I deal with are American. ... Not everything is levered to the business cycle. There is an aerospace cycle, and it's virtually independent from the business cycle. With aerospace, you can expect seven good years and seven bad years. When this book comes out, there should be about two more good years left in the latest aerospace cycle. Why does it work this way? Because the aerospace cycle is really a cycle of airplane replacement, and seven years is just how that happens to work out. Defense contractors are levered entirely to government spending. That's not really cyclical, but it is easily observed. If the Pentagon is cutting defense spending, you'll probably go negative on the defense contractors. If we're going to war, you probably want to tell people to buy them. And the farm equipment cycle is levered to grain prices, not interest rates.
I could go through every single industry and tell you what it's levered to and how best to play it, but that's another book. It would also be impossible to write that book because everything in it would quickly become outdated. That's why I continue to prize flexibility above all else. If you're preparing for your own Lightning Round Home Game, you need to be willing to change your mind about each of these sectors. Revise your opinion -- if not every week, at least every other week -- or you won't be able to do a decent Lightning Round.
The point here is to keep you watching sectors, to keep you watching the whole market, and to give you a fun way to hold a lot of information in your head. The real prize here is that if you can have a solid opinion about every sector and most of the subsectors or industries, then you'll really have a good feel for the market. Once you have a good feel for the market, you'll be able to make a lot more money. It's just a matter of experience. Experience is what lets me be so good at what I do, and experience will make you good at it too.
Once you've broken down the market into different sectors and industries, and only after you've come up with an opinion about each industry, then you shop for best-of-breed stocks in the industries you like. ... Now if you really want to be a pro, if you, for some psychotic reason, aspire to be me, then you won't be lazy. You'll pick out best-of-breed stocks even in sectors you hate. And you'll do it in the name of flexibility. Suppose one week the autos are terrible, but the next week they turn out to be great. If you were a money manager, you'd want to know which automaker to buy as soon as you went positive on autos. ...
So how do you go about picking best of breed? Or, if we don't want to use that term, how do you pick your favorite stock in each industry? ... Look at how stocks are priced relative to their competitors. Compare them based on their P/E multiples and their growth rates. Take into account their future prospects; which is most consistent and least prone to earnings misses? Once you've done that, you can declare one stock your favorite. Now be warned, this could take a lot of time. You might have to study a lot of stocks before you decide on a favorite, and that's just in one industry. The payoff, however, is that you'll get really good at comparing stocks, and you'll also develop an in-depth understanding of the sector you're looking at. Plus, if you want to impress your friends, you'll be able to do your own Lightning Round right in front of them.
Once you've come up with a favorite stock in each industry, you'll need to reevaluate that opinion at least weekly, just as you reevaluate your opinion of each sector. The stock market is dynamic. Your favorite stock might implode, or it might go up so much that it becomes too expensive and you prefer to recommend a different company in the same sector. As long as you keep monitoring the situation and you keep practicing, you should be able to pull off a Lightning Round as well as I do.
I know that all of this seems incredibly labor-intensive and time-consuming. As I said before, doing the homework to be able to pull off a Lightning Round is not for everyone. But doing all this extra work can save you a lot of time in the future, because you'll have an amazingly thorough understanding of what kind of stocks you want, when you want them, and why you own them. Doing the homework for a Lightning Round, long term, means you need to do less homework to prepare to buy individual stocks because you'll already understand what affects their sector and industry, and you'll already know how those stocks rank within their peer group.
Just remember that the Lightning Round is all about sector analysis. After that it's an easy game of stock picking within sectors. If you want to do your own Lightning Round to broaden your knowledge of the market, just make sure you understand what all the sectors and industries are, know which industries you like and which ones you don't, know your favorite stock in each of your favored industries, and always, always, always update your opinions.
Editor's note: This is Part 2 of a special excerpt from Jim Cramer's newest book,
Jim Cramer's Mad Money: Watch TV, Get Rich
, due in stores Dec. 5. Click here to read Part 1. Check back Monday for a new sneak preview. To preorder your copy on Amazon, click here. Can't wait? Attend the special book signing, 7:30 p.m. Monday, Dec. 4, at the Barnes & Noble in Clifton, N.J. (395 Route 3 East). Or get your copy signed at Borders Books and Music (290 Commons Way) of Bridgewater, N.J., on Wednesday, Dec. 6, at 7 p.m.
At the time of publication, Cramer had no positions in any of the stocks mentioned.
Jim 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
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