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Rule 4: Buy Damaged Stocks, Not Damaged Companies

Let's say Wall Street is holding a sale of solid merchandise that it has to move.

And let's say you take that merchandise home only to find it doesn't work, has a hole in it or is missing a key part.

If we were on Main Street, of course, it wouldn't matter.

There are guarantees and warranties galore on Main Street. You can take anything back.

But you can't return merchandise on Wall Street and get your money back.

Nope, no way.

Which is why I always say: You have to buy damaged stocks, not damaged companies.

Sometimes these buys are easy to discern.

In 1998, when Cendant was defrauded by the management of CUC International through a series of bogus financials,

the stock went from $36 to $12 in pretty much a straight line.

Was that a one-day sale that should be bought?

No! that was a damaged company.

It took years for Cendant to work its way back into the hearts of investors.

Some say it has never recovered.

If you have any doubt what damaged merchandise is, I urge you to buy a copy of my autobiography, Confessions of a Street Addict.

The Cendant story is all in there, including how Chris Christie who -- soon after the book came out--
had me testify against an officer of the company who was instrumental in the fraud.

There was no merchandise worth owning in much of that company.  

Sometimes, the sales on Wall Street aren't as obvious.

I got snookered in 2004 thinking that Nortel's accounting problems were a simple sell-off of a damaged stock, and that the company was fine.

In fact, the company was gravely damaged by an accounting fraud, and it has looked doubtful it would ever recover.

And sometimes the sale is so steep that it looks as if something's dreadfully wrong, when really the problem is something that -- over the longer term -- will go away.

Same thing happened with some of the oils the trust owned in 2016;

I figured there was no way a stock like Marathon Oil could be cut in half without bouncing back.

I was wrong.

It got cut almost in half AGAIN and has barely recovered

because in the end, it was just a mirror of a commodity that hasn't been able to recover.

So how do we know if there is something wrong with the company instead of just the stock?

I think that's too complicated a question.

What I like to do is develop a list of stocks I like very much,

I call this the bullpen in my Action Alerts Plus portfolio,

and when Wall Street holds an en masse sale, I like to step up to the plate.

I particularly like to be ready when we have multiple selloffs in the stock market --because of events unrelated to the stocks 'Äì

Because then I want to buy,

whether its a major shortfall of an important bellwether stock, or perhaps some macro event that doesn't affect my micro-driven story.

Of course, sometimes you just have to deduce that the company's fortunes haven't really changed,
and the fundamentals that triggered the selloff -- either in the market or in the company 'Äì
will be something that will reverse themselves shortly.

But you never know.

Which is 'Äì again -- why I think that rule number. 3 must be obeyed.

If you don't buy all the stock at once, and if you take your time,

it is more likely that you won't be left holding a huge chunk of merchandise when more bad news comes around the corner.

Action Alerts Plus portfolio manager and TheStreet's founder Jim Cramer has learned a lot over his 30+ years of investing. So he created a list of 25 Rules for Investing that can help you avoid the novice pitfalls that even he fell into on occasion.

In the video above, he harkens back to the some of the mistakes he made. 

"I got snookered in 2004 thinking that Nortel's accounting problems were a simple sell-off of a damaged stock," he laments.  (Those issues were a part of a much larger issue with the company and the stock eventually was delisted in December, 2008)

He even got burned as recently as 2016, with Marathon Oil (MRO - Get Report) , thinking the tanking stock would quickly recover and it did not.

 

Rule 4: Buy Damaged Stocks, Not Damaged Companies

But how do you know if there is something endemic wrong with the company and not just the stock?  

Watch the video to find out!

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