Cramer: The Fundamentals and How They Really Impact Stocks

Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC

When I started investing I cared only about the fundamentals. And for the longest time that really was about all you should have focused on, be­yond some traditional sector analysis. Think about it: we didn't have index funds or sector ETFs; our companies hadn't grown as global as they are now; the government hasn't been this interventionist since FDR and the New Deal; and interest rates didn't affect stocks as instantaneously as they do now. But what a company does and where it fits into the vast economic scheme of things still matters tremendously, even after all of these other influences are gamed. And that means we need to be as shrewd as ever about how to examine fundamental inputs.

The first and most important fundamental influence? The company's growth rate. While a company's past-how much revenue and earnings it has booked historically-can be very important, it's not the most signifi­cant factor when we are determining how much to pay for an individual stock at any given moment. What matters is how fast a company's sales and earnings are growing, especially in the context of what is expected of the company. The expectations are set by the analyst community, which is why we have to pay so much attention to the consensus of those expecta­tions. Fortunately, you can find these analysts' aggregate expectations for sales and earnings at a whole host of websites, including CNBC.com, Yahoo! Finance and TheStreet. While I have stated my case that the invis­ible forces outlined above now tend to dominate the day-to-day pricing of stocks, the ability of an individual company to generate earnings and sales in excess of those expectations remains the biggest factor in trying to figure out if the stock is going to go up or down over both the near and longer term.

At all times we are trying to figure out how fast a company can grow, compared to both all other stocks and the stocks in its sector. We need to know how to assess how a company performs in times of not just domestic but worldwide economic acceleration and deceleration.

Earlier I detailed the notion of cyclical versus secular growth, the growth that is hostage to economic forces and the growth that is depen­dent upon longer-term themes that don't revolve around the increase or contraction of the gross domestic product. We are always on the lookout for companies that can better both their sector's growth and the econo­my's growth as a whole. If we can profit from secular-growth companies, that's terrific, but we may have to pay a too-high-to-sleep-at-night price for it. In other words, the price-to-earnings multiple, what we will pay for that stream of future earnings, is higher or more expensive than what we might be willing to pay for a stock with a far more variable, economically dependent earnings stream. That's nothing new. But since the Great Re­cession, there has been a big change in the price tag of stocks with this kind of consistent growth, because worldwide economic activity has slowed and is now so sporadic that it can't be counted on to produce ex­cessive earnings gains from cyclical stocks. The world has become a much more difficult place for companies to grow earnings consistently. So many economies are now experiencing sluggish, intermittent growth that we treasure any company that can maintain any constant level of growth. Who's got that? Many companies, but the ones I regard as classic growth stocks include Kimberly-Clark, Procter & Gamble, Johnson & Johnson, General Mills, Coca-Cola, PepsiCo, Hershey, Kellogg and Clorox. These stocks are trading at historically high levels because they can deliver con­sistent, albeit slow, earnings growth in a tepid economy.

On the other hand, if your company's fortunes are linked to the slings and arrows of global or domestic growth, then you have a classic cyclical on your hands, and you need to anticipate any reacceleration or decelera­tion or both, something that's become exceedingly difficult to monitor. That's why if you own Caterpillar, Ford, General Motors, General Electric or Cummins, the engine company, to name some examples, you have to be on top of world events, particularly in China, pretty much every day.

Some stocks, like 3M, Honeywell and Emerson, are what we call growth cyclicals, hybrids that have the characteristics of both kinds of stocks. They hold up at times of mild acceleration and stability.

Of course, some companies are levered to individual cycles. Deere, Monsanto and Potash are all about the farm cycle, chiefly whether or not the farmers are flush. Boeing and Precision Castparts and to some degree United Technologies hug the aerospace building cycles and track world­wide aircraft demand.

Others have their own secular-growth themes, such as the renaissance of oil and gas, the desire to look and feel well, and the aging population. Those themes are myriad and pervasive, and I spend the next chapters describing the best ones to profit from over the long term and which stocks best fit the long-term winning theses.

But all stocks, whether they be cyclicals, growths or hybrids, get graded the same way by analysts: Are the underlying fundamentals of the enterprise better or worse than expected, as expressed by the consensus of the analysts' estimates? Consider this whole investment process as an Olympic diving match. The analysts are the judges, and they grade on many different inputs. The ones we care about are sales expectations, or the top line, and the earnings expectations, or the bottom line. Many people are fixated just on the top line, the revenues, as a way to judge whether a company is growing faster than the global economy or its own cohort.

I agree that the top line is a very important input. A company's stock will be walloped if it "misses" on the revenues. However, I think the bot­tom line is more important, and here's why: the earnings-what a com­pany has left after it takes out the costs of all of those goods sold, expenses, taxes and depreciation-certainly need to please the analysts, but on top of that, bigger earnings can lead to bigger dividends, which are such a huge part of a stock's upside over time and can be traced to about 40 per­cent of a stock's long-term performance, dating back to the 1920s. Profits matter even in this new, crazy world, because profits can put dividend checks in your hand and help propel stocks higher over time due to those ever-increasing dividends. Thank heavens something remains true to the old days!

As part of our judgment process, we have to compare the numbers in the earnings and sales reports to the expectations set by Wall Street analysts. Perhaps more important, though, we care about the company's outlook for the future, and how that jibes with the expectations. This out­look is typically given cursorily in the company's quarterly earnings re­lease, but is much more in-depth on the conference call, at the end of management's discussion of the earnings and right before the question­and-answer session. That outlook is the single most important consider­ation when you are trying to decide whether to buy or sell a stock at the time it reports. That's why I always laugh-with scorn, mind you-when I see people trading stocks after hours without listening to the conference call. If the largest determinant of the future price move comes usually about ten minutes into the call, what the heck are these bozos trading off of? It's shameless and stupid, and I sure hope I don't catch you doing it.

What are we listening for in that outlook? We want to hear forecasts, particularly for the rate of change of sales and earnings growth. But the portion of the forecasting I care the most about is the direction given on future gross margins, because that can be a true indicator of what the business can earn in the future. The gross margin guidance is what will be used to try to figure out next quarter's earnings estimates. That will set the benchmark that has to be beaten next time. When you hear "Such and such company beat the estimates," I say, "That's nice." It can help a stock and won't hurt it, for certain. But when you hear "Such and such a com­pany beat estimates and raised guidance," then I know the stock is going higher. That's because a raising of the guidance by the company in that one little moment on the conference call before the Q&A means that analysts have to change their views to be more positive about the stock, which means more upgrades, more price target increases and more promo­tion. Those are the fundaments of immediate increases in stock prices. That's the only earnings "surprise" you should really care about, not the "better than expectations" stuff that you are normally told should matter. "Beat estimates" can matter. "Beat and raise," shorthand for "beat the estimates and raised guidance for future quarters," is what matters most. That's the crucial phrase you need to hear to bet with a stock instead of against it. That's when you know you have a winner, even if the unseen forces are playing havoc with the stock that day. If you keep a file of the "beat and raise" stocks and you buy them on down days, you are going to be investing carefully and making a boatload of money despite the noise that seems to weigh on stocks on a daily basis.

Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC

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