Sneak Preview: How to Be Contrarian

Find out how to go against the flow in this special excerpt from Jim Cramer's upcoming book.
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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.

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2. How to be a contrarian and still make money.

I just told you to go with the flow, but there are times where you make a lot of money by going against the conventional wisdom and buying a stock that's totally out of favor.

That said, you have to know what you're doing. Not every hated stock becomes a winner. Most of them keep being hated and keep going down. If you're going to buy a stock that you think the big institutions are wrong about, you have to do more than just your regular homework. You still must understand the fundamentals of the company; you need to know how the market treats the sector; you have to know that the stock you're buying is good.

But you must add one more thing if it's a stock that's seemingly out of favor: you must understand why the big institutional money managers and/or the analysts will change their minds about the stock. If they don't change their minds then no matter how good the company is, no matter how great the fundamentals, you know that stock is not going higher.

The way to make good, contrarian calls is by understanding what will make a stock move from the out-of-favor column into the in-favor column. You need to know how the money managers think, and for that, you should watch me think out loud on Mad Money. There are some easy ways to tell what the institutional investors are thinking about a stock. If the earnings estimates for a stock are all low, and you think that the company is going to blow those earnings away, then you have a good thesis.

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Two of my best contrarian calls were

Amylin Pharmaceuticals

(AMLN)

and

Google

(GOOG) - Get Report

at the very beginning of the show. People might not think of Google as an out-of-favor stock at this point, but from its IPO in August 2004 until about a year later, this stock was unloved. It was being valued at a huge discount to competitors like

Yahoo!

(YHOO)

.

Investors were wary of the stock, and even some of the analysts who were giving Google high earnings estimates were telling their clients to stay away. Amylin is a small drug company that specializes in treatments for diabetes. When I got behind it in June 2005, it was one of the most heavily shorted, most despised stocks out there. When I recommended both of these companies, I stressed not just the good fundamental story, but also what would cause the institutional investors to stop hating them and start buying them.

Even though it already had a drug on the market, Amylin was basically a one-drug story for me when I recommended it on June 13, 2005, at $17.63 a share. That drug was Byetta, and it hit the market the day I told people to buy the stock. Most of the analysts covering the company, and most of the Street, which was either ignoring or shorting the company, thought Byetta would be a nothing drug. It treated type 2 diabetes, and even though the clinical trials had shown it was very effective, the Street didn't think it would sell because it had to be injected.

I disagreed. The stock broke through $30 on August 26, $40 on Dec. 20, and touched $50 on July 5, 2006. This stock did not go up because I was right about Byetta sales and the Street was wrong. The stock went up because the Street changed its mind. It came around to Cramer's view. When I recommended the stock, I knew that the big institutions would start to like it if Byetta sales exceeded the low expectations that the Street had set for them, or if new applications or new versions of the drug were introduced.

Why would this change their minds? The Street hated Amylin because they thought its drug wouldn't sell; they thought it was hype. I know this because Amylin was practically a one-drug stock: if you liked Byetta, you liked Amylin, and if you hated Byetta, you hated Amylin. I'd done my homework and thought the drug would work -- the Street's objections were silly. Most diabetics already inject insulin, so having to inject Byetta, a more effective drug than others on the market, didn't seem to me like much of a drawback. I was right, but again, what mattered was that the Street was willing to repudiate its old position and agree with mine.

The story behind Google was similar. Everyone knew that Google had tremendous growth and earnings power, but people were hesitant to buy it, and most of the analysts were telling people to sell it all the way up. The big institutions were staying away from Google, which was priced at $178.61 on the first day Mad Money aired, March 15, 2005, but which I'd been recommending from the IPO in August 2004 at $100.

The big institutions that run the market disliked Google for irrational reasons, but irrationally can rule the market. Most of the money managers on the Street had gotten incredibly burned by big internet IPOs in the late 1990s and 2000. They still felt like anything that made its money from a Web site had to be all hype. When it came to Google they were wrong, because Google was making boatloads of money, and it had steroidal growth.

But how did I know they would change their minds? I saw what all the high-growth mutual funds were paying for Yahoo!, Google's closest competitor. It was a whole lot more than what they were paying for Google, based on P/E (price/earnings) or PEG (price/earnings to growth). They weren't paying as much for Google because it was a newly public company and they didn't have faith it could deliver the earnings or the growth the Street was predicting. I knew that once Google had reported enough good quarters, the big growth mutual funds and the negative analysts would forget about the dot--com stigma attached to Google and just buy the stock. But they needed reassurance before they bought; they needed good quarter after good quarter to get rid of their lack of conviction. Once these guys started to change their minds, the stock couldn't stop going higher.

How is this any different from another company reporting lots of good quarters and going up? The point here is that Google was undervalued because the big institutions were approaching it irrationally. The hedge funds and the mutual funds are usually pretty rational when they approach stocks, at least where earnings are concerned. If a company reports a bunch of good quarters, its stock might not do anything. It might even go down.

But when a stock is out of favor because the institutions don't have any faith it will hit the estimates -- not for any real reason, but because they've gotten burned by similar stocks in the past -- when that stock reports good quarters and good earnings, that really matters. Good earnings make a difference when they change minds. If you look for situations where the big institutions all essentially agree, are all negative, and you think they're wrong, you have to be able to point to some catalyst that will cause the institutions to change their minds. Otherwise you won't make much money.

Always remember that the big institutions out there have to own stocks. That forces them to value stocks. When the portfolio managers took a hard look at GOOG, they recognized that it was going to have to get the highest multiple on its earnings because it was growing faster than every other large-cap company. Once they attached the highest multiple and solved for P, or price, that got them to $400, which is where I pegged the stock even when it was in the $200s.

Editor's note: This is one of Jim Cramer's 10 Lessons From Success: Some Buy and Sell Rules, a special excerpt from his newest book,

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

, due in stores Dec. 5. Learn how to hold your own Lightning Round, Part 1 and Part 2, and read Lesson 1. Check back tomorrow for a new lesson. 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.

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, Cramer was long Yahoo!.

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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