Deconstructing Purpose

Jim Cramer

Jim Cramer’s Mad Money: Watch TV, Get Rich, Jim Cramer’s wildly popular accompaniment to his similarly titled TV show on CNBC was a slow read. However mixed in between historical case studies from his hedge fund past, is a splattering of educated opinion and a number good nuggets of information. For me, the most valuable section was his chapter on research.

Cramer says there are five steps to doing homework on a stock before you can make a decision to purchase.

1. Learn in very precise terms how a company makes its money.
2. List and understand all the possible things that can affect the performance of the sector the stock is in.
3. Examine the recent performance and behavior of both the stock and the company it represents.
4. Compare the stock to its competitors and make sure its competition doesn’t pose a serious thret.
5. Take a look at the company’s income statement, balance sheet, and cash flow statement.

Step 1. Figure Out How a Company Makes Money.

Review the 10-K (annual report), and/or 10-Q (quarterly report). Make sure that a company is actually earning its revenue the way it says it does.

Cramer brings up case study’s:

Boston Market - At first look seems like it makes money by selling food, when it actually made money by lending to its franchisees, and ripping them off. (NOT GOOD FOR THE COMPANY)

IMAX - Supposed to make money by selling tickets to movei, was instead posting large gains by selling off parts of the company and getting deposits back on leases they were backing out of.

“You cannot own a stock unless you can explain to a friend who knows nothing about business precisely how the company makes money.”

Step 2 Check out the performance of the sector the company is in, and how the company stacks up against the competition.

Once you have figured out exactly how a company makes money, it is then easy to determine what sector it belongs to. Now that you know the sector you should determine how the sector has been performing, and form an opinion on its future. You should know what economic factors effect the sector for instance, High interest rates means a slowing economy and will hurt banks, homebuilders and tech and retail, cramer says get defensive, buy “secular growth stocks” or food and beverage companys drug stocks, anything that will still produce a solid profit in a slowing economy.

Invariably a company like PEP will grow at 11% year after year, bad economy or a good one. So when the economy slows, PEP will go up, simply because it is less effected by a slow economy and large institutions will pull out of stocks that are hurt more by a slowing economy and buy up these secular growth stocks.

“Half of what a stock does is totally dependent on its sector.”
“There are events that help and hurt a company, and events that help and hurt a stock.”

Review the Performance of the stock, and the Company represented by the stock.

Review past filings, earnings, and reports, check the balance sheet, and look for any warning signs. You are also looking to see if the company consistently meets expectations, or has let the market down.

Review the Performance of the Company’s Peer and Competition.

When doing this step you are looking to see if a company actually has any competition and if so what kind of threat it poses to the company. Another large part of comparing the stock to its competition is to see what it is really worth or its valuation.

Aside from speculative companies, the market favors companies based on their earnings, future estimated earnings and growth.

The P/E Ratio

P/E or Price to Earnings ratio is a simplistic form of evaluating a company. The P/E is calculated by dividing the stock price divided by the earnings per share. It is how many more times than earnings the market is willing to pay for a stock.

I.E. a stock price is 67.50 and its earnings per share is 5.50 then divid 67.50 by 5.50 and you get a 12.27 multiple, or you can say the stock is trading at 12 times its earnings.

The multiple is the common denominator for all stocks, allowing you to compare a stock on even ground.

PEG and Growth
Check the growth rates, and never pay more than two times the growth rate. You can find the Growth rate by looking towards the anaylists.
Peg is your Price to Earnings divided by growth a company with 12% growth and 18x earnings would be trading at 1.5 times growth.

Checking the Company’s income statement, balance sheet, and cashflow

Look for a company with a healthy balance sheet, with a small amount of debt (red or negatives) or at least enough cash on hand to cover it.

Amazon Readers Tips
A stock is only worth what the big institutions are willing to pay for it (p3).

· You can’t be sure about research from this or that brokerage house. They’ve all been tarnished… for colluding with their clients (p3).

· Tips are for waiters (p23).

· Learn in very precise terms how a company makes its money (p25).

· Nothing is more important than the sector a stock lives in…half of what a stock does is totally dependent on the its sector (p27).

· The actual stock price means nothing without context (p32).

· You can’t make money until you sell (p55)

· If the stock is growing faster than its competitors but has a lower P/E, then it’s a slam-dunk. I’d give it a triple buy - we’re done, next caller. (p69)

· I don’t like inside information, both because it’s illegal, and because it makes you sloppy (p75)

· Almost all analysts have been trained exactly the same way, so they think in lockstep (p75).

· We don’t love stocks -they’re just pieces of paper (p81).

· Whenever a CFO is cautious, I’m cautious. If a CFO is negative, I’m negative. You can take that as gospel (p114).

· It’s these institutions that set prices, because they do most of the buying and selling (p121).

· Resisting the business cycle is futile…. if you buy a secular growth stock when we’re in a cyclical upturn, or a supposedly cyclical stock when we’re in an economic slowdown, you will lose (p121)

· You can’t trust companies that are coming out of a leveraged buyout. The investment banks favor the LBO firms because they do a lot more business with them than with the average investor (p127).

· Latin America is always a trade. If you hold onto Latin American stocks for long enough, your gains will evaporate (p130).

· Not everything is worth betting on. Don’t be afraid to say it’s too hard (p133).
· When a stock is cheap, it’s usually cheap for a reason (p137).

· Past performance is not an indicator of future success…. it’s like black jack; the cards have no memory, especially when shuffled. (p139).

· Never invest on borrowed convictions. Make your own mistakes. You never want to lose money because you borrowed someone else’s convictions (p143).

· Usually people have decent reasons for buying and selling stocks, and you should understand those reasons thoroughly before you try to game the supposed “stupidity” of your fellow investors (p150).

Tagged: Jim Cramer, Madd Money, Stock Market, Stocks