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Editor's note: The following is a recap of a "Mad Money" episode that first aired on Oct. 4. It was rebroadcast on Tuesday.
Do Your Homework
Good investing isn't a game. You have to make plans and stick to them to be successful, said Jim Cramer on his "Mad Money" TV show Tuesday night. "Good investing isn't a game, it's not random, it's not all touch and go." You need to understand what you are buying and why you are buying it. Without that understanding, you will lose money, said Cramer. Additionally, don't lie to yourself when you're wrong, he said. That only compounds the problem. When you're wrong, you need to recognize it quickly. Don't let hope creep in or give yourself the benefit of the doubt. If you're wrong, sell the stock and find something new. "Don't lie to yourself as the evidence comes in. You need to coldly evaluate the evidence and act on it rationally ... Hope has no place," said Cramer. "If you can't be honest with yourself, you can't make a dime." Cramer recommends only buying stocks you have the time and the inclination to research and follow. "Buy and homework," says Cramer. For a diversified portfolio, he recommends a minimum of five stocks and maximum of 10. Cramer's rule for diversification also includes having no more than 20% of your portfolio in a particular sector. That means if you have five stocks, you should own, for example, no more than one tech stock, one oil stock, one health care stock, one defense stock, etc. Cramer's method of managing his portfolio involves trading around investment positions. He likes to sell some of an investment if it goes up too much and buy it back lower, always keeping a core position in the stock. Cramer will only make pure trades if he has a clear entrance strategy, a clear exit strategy, a defined time frame and catalysts to propel the stock. How should one decide when to sell? "No one is good enough to be able to call a top or a bottom," he said. Cramer follows this mantra: Bulls make money, bears make money, pigs get slaughtered. If you have a stock that has a good gain, take some off the table so that you're playing with the house's money, and let the rest run.
Ground Those Airlines
So, how does one decide which companies are good and which companies are bad? It takes having a rubric and rigor, said Cramer. The first step is to be sure you're investing in companies that make money and do not have a lot of debt, said Cramer. Debt is often overlooked, he said, but you have to pay attention to it to accurately value a stock. The reason is, he said, a company with too much debt may not be able to pay its bills if its business gets into trouble. And your stock is collateral for the company's debt. "Debt matters," said Cramer. "Lots of debt can strangle a healthy business." If the company goes bankrupt, the shareholders usually wind up with nothing. People who own the debt, "get first dibs to cannibalize the company," he said. All debt isn't necessarily bad, said Cramer, but you need to be careful with it. For example, retailers often take on debt in the fourth quarter to buy merchandise for the holiday season. That's acceptable, said Cramer, as long as sales turn out to be good. Cable companies might need to take on debt to finance building their networks. That's understandable, said Cramer. Airlines take on debt to buy expensive planes. That too is understandable, he said, adding, however, that he would never recommend investing in an airline. Cramer said it is only wise to invest in companies emerging from bankruptcy if you've read the bankruptcy trustee's report to find out if the common stock is worth anything. Cramer says he's rarely done well investing in such a situation, however.
Heed the Conference Call
There's a lot more homework involved in judging a company than just looking at debt, said Cramer. He recommends budgeting an hour a week per stock for homework. By homework, Cramer means reading the company's SEC filings, available at www.sec.gov . Pay special attention to the quarterly and annual reports, he said. Cramer also recommends reading analysts' reports. Most are also available via the Internet. Although sometimes you have to pay for the reports, most of the time, it's worth it, said Cramer. Finally, the "holy grail" of homework, said Cramer, is the quarterly earnings conference call held in conjunction with the company's release of its quarterly earnings report. Conference calls can be listened to via the Web, and transcripts are often available after the call. Regulation FD has gone a long way toward leveling the playing field for individual investors, said Cramer. Whereas the best information used to only be available to the wealthiest and the most well-connected investors, Regulation FD dictates that all investors should have equal and simultaneous access to information. Thus, it's possible, if you have the time and the inclination, said Cramer, to do work that is equal to or better than that of Wall Street analysts. However, if you don't have the time and inclination, you should have a professional do that work for you.
Tons of Metrics
In order to tell how a company is doing, you need to know how fast a company is growing, which is measured by revenue growth (sometimes called sales growth), and how profitable a company is, which is measured by earnings, said Cramer.
For a young company, revenue growth should be rapid, he said. An older company should have healthy profits, some of which can be turned into dividends. A really mature company should maximize cash flow and return that cash in some way to shareholders. Also pay attention to gross margin, which is a measure of how much of a company's sales are available to be turned into earnings. Things that give clues about gross margin are how much competition a company has, how expensive the company's products are to make and the cost of doing business in general. Companies that have little competition will have a higher gross margin. Companies experiencing an increase in demand for their products should see gross margin going up. Companies whose costs for raw material are going up should see gross margin go down. Know which industry-specific metric is important to be able to judge a company, said Cramer. For a cable company, the key metric is enterprise value (market cap plus debt) divided by the number of subscribers. For a hotel, the key metric is average revenue per room. For airlines, it's average revenue per seat. For retailers and restaurants, the key metric is same-store sales. For tech stocks, it's gross margin per product sold. For financial stocks, it's net interest margin, i.e., how much money was made on each dollar the financial institution had in assets. Once you know the key metric, compare it with the company's peers. The retailer with the best same-store sales, for example, is the one you want to own, said Cramer. Similarly, you want to own the tech stock with the best gross margin, he said. As for leading economic indicators, Cramer said the conventional wisdom is to pay attention to GDP, retail sales and employment growth. However, Cramer likes to pay attention to companies on the front lines of the economy. If those companies are saying that inventories are up and gross margin is down, for example, Cramer would expect a slowdown in the economy even though the more conventional, leading economic indicators might not yet be signaling one. Want more Cramer? Check out Jim's rules and commandments for investing from his popular book by clicking here.